PRIN MACROECONOMICS ECON 2010
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Macroeconomics Spring 2012 Thursday February 19 Supply and Demand Where do prices come from Start with the simplest assumptions Perfect Competition 1 Many buyers and sellers 2 Homogeneous products 3 Free entry and exit into the market Demand Law of Demand price and quantity demanded move in opposite direction ceteris paribus all other things equal Demand Schedule Price Unit I Quantity Demanded 1 5 2 4 3 3 4 2 5 1 6 o E 6 Demand Curve 5 4 3 Demand 2 1 o o 1 2 3 4 5 6 Quantity demanded demand Exam 1 1 Macroeconomics Spring 2012 0 What changes quantity demanded Changes in quantity demanded occur because of changes in price They are shown through moves along the demand curve 1 Income Effect As the price of something goes up real income goes down the amount we can actually get with the same amount of money we have goes down Ex Previously you could buy 10 apples for 10 now that the price has increased you can only buy 8 apples for 10 Therefore you demand less now 2 Substitution Effect As the price of something goes up substitute goods become relatively cheaper you39re more likely to buy the cheaper brand 39 What changes demand 1 Income A Normal Good as income increases demand also increase Ex iPhones steak dinner B Inferior Good as income increases demand decreases EX Ramen Noodles bus travel used Kia 2 Prices of Related Goods and Services A Substitutes as the price of one good goes up the demand for a substitute product used in place of increases Exam 1 2 Macroeconomics Spring 2012 B Complements as the price of one good increases the demand for a complete product used with other product decreases 3 Effects of Tastes and Preferences Many things affect people s tastes and preferences such as advertising and marketing 4 Effects of Expected Future Prices If prices are expected to increase in the future the current demand to the product or service will increase It prices are expected to decrease in the future current demand will decrease 5 Effects of Demographics Market demand is the sum of individual demands Ex As the population of older people increases the demand for denture cleaner increase Supply Law of Supply an increase in price causes an increase in quantity supplied ceteris paribus Supply Curve Supply Exam 1 3 Macroeconomics Spring 2012 Quantity Supplied at Supply What determines quantity supplied Changes in quantity supplied occur because of price changes They are shown through moves along the supply curve 0 What determines supply Tuesday January 24 1 Price of Inputs As the price of inputs increase the quantity supplied decreases we can supply less at the same price because it becomes more expensive 2 Technological Change If there is a positive technological change then we are getting better and at the same price we can produce more The supply curve will shift to the right 1 l l A negative technological change will shift a rm39s supply curve to the left 3 Price of Substitute Products An increase in the price of an alternative good good B which a rm could produce instead of producing good A will shift the rm s supply curve for good A the left They will produce less of A and more of B 4 Expectations about Future Prices Exam 1 4 Macroeconomics 1 Spring 2012 If a rm expects the price of its product will rise in the future then the rm has an incentive to decrease supply in the present and increase supply in the future 5 Number of Firms in the Market Relevant to Macroeconomics When firms enter a market the market supply curve shifts to the right When firms exit a market the market supply curve shifts to the left Market Equilibrium a situation in which quantity demanded equals quantity supplied P hi8 Pi P haw D 39 t lng 090 Q Equilibrium Quantity P Equilibrium Price Shortage a situationin which quantity demanded is greater than the quantity supplied which occurs when the market price is below the equilibrium price Smut a situation in which the quantity supplied is greater then the quantity demanded which occurs when the market price is above the equilibrium price Exam 1 Macroeconomics Spring 2012 Example Income increasesSteak dinners normal good Q Initially the quantity demanded becomes much higher than the quantity supplied when the demand increases due to an income increase Therefore the price increases until quantity demanded equals quantity supplied Example Education increase cost of producing childcare increase problem 417 page 95 D D Stricter education requirements for child care workers increases demand and decreases supply Price increases unambiguously but quantity depends on the relative shift of supply and demand Quantity can either increase or decrease Exam 1 6 Macroeconomics l Spring 2012 Consumer and Producer Surplus 1 Consumer Surplus Marginal Bene t the additional bene t to a consumer from consuming one more unit of a good or service The demand curve is also a marginal bene t curve 9 a QA and Q3 are willing to pay a higher price for child care but only actually pay P Consumer Surplus the difference between the highest price a consumer is willing to pay for a good or service and the price the consumer actually pays Total Consumer Surplus The area below the demand curve and above the market price 2 Producer Surplus Marginal Cost the additional cost to a rm of producing one more unit of a good or service The supply curve is also a marginal cost curve Exam 1 7 Macroeconomics Spring 2012 Child Care Supplied 9 5 we 93 Pa 0 QB Q QA and Q3 are willing to supply at a lower price but actually supply at the market price Producer Surplus the difference between the lowest price a rm is willing to accept for a good or service and the price it actually receives ekTotal Producer Surplus the area above the supply curve and below the market price Price Ceiling a legally determined maximum price that sellers may charge Causes a supply shortage P 9 a C T CE U CL 6 Exam 1 Macroeconomics Spring 2012 Before Price Ceiling lAtConsurner Surplus A B Producer Surplus C D E TotalSurplusABCDE After Price Ceiling Consumer Surplus A C Producer Surplus E Total Surplus A C E are Deadweight Loss B D Deadweight Loss the reduction in economic surplus resulting from a market not being in competitive equilibrium Price controls sometimes make some people better off and some people worse off Thursday January 26 39 Consumers are willing to purchase a product until marginal bene t equals price 39 Producers are willing to produce and supply a product until marginal cost equals the price P 5 HUNme C06 9 Mar hex Q Q MOSTQX o In a competitive market at equilibrium the marginal bene t equals the marginal cost 0 If the marginal benefit equals marginal cost then we know it is the economically ef cient level of output Exam 1 9 Macroeconomics Spring 2012 Example Baton Rouge Apartments in Tigerland Qn 1000 6P Qs 2800 10P Equilibrium Price Equilibrium Quantity Q0 Q3 Q1 10000 6800 5200 10000 6P 2800 10P Qs 2800 10 800 5200 2000 16P At equilibrium the quantity P 800 at equilibrium demanded and the quantity supplied is 5200 At what price is Q1 and Q5 equal to 0 Quantity Demanded Quantity Supplied 0 10000 6P 0 2800 10P 10000 6P 2800 10P P 1666 P 280 p S M660 3 300 100 5100 Q al How much is consumer surplus C8 72 5200 x 1666 800 2251600 How much is producer surplus PS 15 5200 x 800280 1352000 How much is total surplus 2251600 1352000 3603600 Add a Price Ceiling at 600 Exam 1 10 Macroeconomics Spring 2012 P 8 1666 Black 1133 marka 6 saw to CUMZ LQL b 5 39m D 10 5200 Price ceiling at 600 causes the quantity supplied to be less than the quantity demanded a shortage Qs at 600 2800 10600 3200 Consumers gained A and lost B Producers lost A and C Are consumers better off Area ofA 3200 X 200 640000 Area ofB 3200 10000 6P 6800 6P P 1133 12 2 1133 800 x 2000 333000 Area of C 15 200 x 2000 200000 Consumers gained 640000 333000 310000 Producers lost 640000 200000 840000 Deadweight lost 330000 200000 530000 Not ef cient because marginal bene t does not equal marginal cost Price Floor a legally determined minimum price that sellers may receive at Black Market a market in which buying and selling take place at prices that violate government price regulations Price ceilings and price oors can lead to a black market Exam 1 1 1 Macroeconomics Spring 2012 Pr c 6 100 r Taxes and Tax Incidence Tax Incidence the actual division of the burden of a tax between buyers and sellers in a market 1 If the supplier pays the tax the supply shifts up by the amount of the tax P 5 is o39x l n 0e 06 quoti L a 94 de oduxlmahk oss rt LieUL D Q Q 2 If the consumer pays the tax then the demand shifts down by the amount of the tax Exam 1 12 Macroeconomics Spring 2012 5 rmxcnua pk ir Cleodmcalxt P 39 los pca fcf c 5 if AULS D Q Q For tax incidence the results of 1 and 2 are identical Tax incidence is not dependent on who is legally required to collect and pay the tax Tax incidence is determined by the degree to which the market price rises as a result of tax This rise in turn is determined by the willingness of suppliers to change the quantity of the good or service they offer and the willingness of consumers to change their quantity demanded as a result of the tax Relatively inelastic demand consumers have the larger tax burden 39 Relatively inelastic supply producers have the larger tax burden Tuesday January 31 Macroeconomics studies the economy as a whole Two important macroeconomic issues 1 Economic Growth The ability of an economy to produce increasing quantities of goods and services 2 Business Cycle Alternating periods of economic expansion and economic recession a Expansion the period of a business cycle during which total production and total employment are increasing b Recession the period of a business cycle during which total production and total employment are decreasing Exam 1 13 Macroeconomics Spring 2012 How do we measure total production Gross Domestic Product GDP Y the market value of all nal goods and services produced in a country during a period of time typically one year 2 Key Words 1 Market Value GDP is measured in 35 E etc Example 1 sandwich 1 hair cut 5 12 17 2 Final Goods or Services Only nal goods and services are used to calculate GDP Not intermediate goods a Final Goods or Services a good or service purchased by a nal user b Intermediate Good or Service a good or service that is an input into another good or service such as a tire on a truck Example Butcher ham sandwich shop sandwich 9 me Ham intermediate good Sandwich nal good The price of the ham is already included in the sandwich If both were included in GDP ham would be doubled GDP is divided into 4 major categories of expenditures Y C I G NX 1 Consumption Spending by households on goods and services not including spending on new houses 3 different types of expenditures a Nondurables food clothing etc b Durable furniture cars washing machine etc c Services hair cuts landscaping etc Exam 1 14 Macroeconomics Spring 2012 2 Investment Spending by rms on new factories of ce buildings machinery and additions to inventories plus spending by households and rms on new houses 3 Government Purchases Spending by federal state and local governments on goods and services a Military spending b Teacher salaries c Roads Does not include all government expenditure Includes only purchases where production occurs Example Food stamps and welfare are not included 4 Net Exports Exports minus imports When we measure the value of total production in the economy by calculating GDP we are simultaneously measuring the value of total income I What does GDP not include in its measurement 1 Household Production Goods and services people produce for themselves Example I lfl cook dinner 9 no value is added in terms of GDP I If go out and buy that same dinner 9 value is added to the GDP by the restaurant 2 Underground Economy Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods or services are illegal Example I If I were to buy weed off the street 9 no value is added to GDP I Is GDP a good measure of well being GDP measures total production but is not a perfect measure of well being because 1 It does not include the value of leisure 2 It is not adjusted for pollution or other negative effects of production 3 Not adjusted for changes in crime and other social problems Exam 1 15 Macroeconomics Spring 2012 4 Inequality Thursday February 2 39 GDP is intended to measure production Since GDP is calculated using quantities of nal goods and services produced at current market prices GDP can change because 1 Production changes 2 The prices of goods and services change 0 Using market values introduces price and guantijy Since purchasing power of the dollar tends to decline you should disassociate prices from quantities Example If the price of a product increases from one year to the next and we produce the same quantity of the product in both years GDP will be higher in the year with the higher price even though production has not increased Nominal GDP the value of nal goods and services evaluated at current year prices Real GDP the value of nal goods and services evaluated at base year prices Real GDP is calculated by designating a particular year as the base year The prices of goods and services in the base year are used to calculate the value of goods and services in all other years 0 In an economy with rising prices nominal GDP will be smaller than real GDP in the years before the base year and nominal GDP will be larger than real GDP in years after the base year Price Levels a measure of the average prices of goods and services in the economy We can use the values of nominal GDP and real GDP to calculate the measure of price levels GDP De ator a measure of the price level calculate by dividing nominal GDP by real GDP and multiplying by 100 GDP De ator x 100 39n Real GDP Test 1 16 Macroeconomics Spring 2012 How to measure in ation Consumer Price Index An average of the prices of the goods and services purchased by the typical family of four 0 Every two years we survey about 30000 households about their spending habits on a market basket of about 211 types of goods 0 We visit about 23000 stores in 87 cities and record prices in order to calculate the average price for a typical family of 4 x i in th r r CPI Expenditures in the base year x 100 Example The value of a dollar in any year CPI 2011 2257 CPI 2008 2153 Real wage in 2008 if you are getting 10 in 2011 10 x 22572153 1048 In ation Rate the percentage increase in the price level from one year to the next Pric I x r39 e Price Index b1 t refers to the current year and t 1 refers to the previous year In ation Rate t x 100 In ation has a large impact on interest rates Example Cars 499 Interest rate 300 In ation 199 Real Interest Rate 39 Is In ation bad It depends on if we know its coming or not o If it is anticipated low and positive then it is a minimal problem Menu costs the cost to firms of changing prices 39 o Unanticipated in ation can affect the distribution of income causing some people to gain and some people to lose 0 What about falling prices De ation a decline in the price level 0 Expected cheaper future prices cause people to hold off on current consumption to wait and get the expected lower price Example housing market in 2007 Test 1 17 Macroeconomics Spring 2012 Tuesday February 7 Unemployment Working Age Population Civilian noninstitutionalized population that is 16 16 is the working age does not include military prisoners and those in mental institutions 39 Civilian Labor Force The sum of employed and unemployed workers in the economy Includes 1 Employed 2 Those that have a job but not currently working due to sickness or strike 3 Unemployed 39 Not in Labor Force 1 Homemaker retirees quotnot available for work 2 Those available to work but not looking because of issues such as unable to nd child care or transportation 3 Discouraged workers people who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them Fulltime students People on active military service In prison In mental hospitals momP Current Population Survey often referred to as the household survey collects data needed to compute the unemployment rate Ask questions about the employment status of people in the household and attempts to determine if a worker is employed out of the work force or unemployed Labor Force Participation Rate The percentage of the workingage population in the labor force quot1 L r c Working Age Population Labor Force Participation Rate y 1 no Underemployment part time workers for economic reasons Unemployed those available for work but did not work last week and have been actively looking for a job within the last four weeks Unemployment Rate The percentage of labor force that is unemployed Test 1 18 Macroeconomics Spring 2012 Unemployment Rate W x 100 Labor Force Bureau of Labor Statistics uses the results of the monthly household survey to calculate the unemployment rate and the labor force participation rate Dynamics and volatility are not captured 0 Types of Unemployment 1 Frictional Unemployment Shortterm unemployment that arises from the process of matching workers with jobs 0 You have a skill but it takes some time to nd the right employer 2 Structural Unemployment Unemployment arising from a persistent mismatch between the skill and attributes of a worker and the requirements of a job 39 No one wants the skills you have Example telephone switchboard operator animation artist that hand draws 3 Cyclical Unemployment Unemployment caused by a business cycle recession Example Construction An unemployment rate of 0 is not possible because of frictional and structural It is also undesirable because an unemployment rate that is too low can be bad because it becomes dif cult for employers to find people to hire Natural Rate of Unemployment the normal rate of unemployment consisting of frictional unemployment plus structural unemployment The economy is said to he at full employment Test 1 19 Chapter 9 Book Notes LongRun Economic Growth LongRun Economic Growth the process by which rising productivity increases the average standard of living Best measure of the standard of living isRea GDP per Capitareal GDP per person 0 Economists rely heavily on comparisons of real GDP per capita bc it is the best means of comparing the performance of one economy over time or the performance of different economies at any particular time Measure Long Run Economic growth by increases in real GDP per capita over long periods of time 0 Use real GDP rather than nominal GDP to adjust for changes in price level over time Connection between Economic Growth Technology and Human Physiology Increased Economic Growth Increased in Technology 9Less hours less years better products food etc Increased better Human PhysiologyHealth 9More productive Increased Economic Growth and so on o In the future people with live long longer life expectancy and work for a smaller fraction of their lives Calculating Growth Rate and the Rule of 70 Growth Rate of Real GDP or Real GDP per Capita during a particular year is equal to the percent change from the previous year Real GDPYear X Real GDPPervious Year Growth of Real GDP in YearX lt 100 Real GDPPervious Year For longer periods of time useAverage Annual Growth Rate which is calculated by averaging the growth rate for each year Real GDPYW A Real GDPYW B Real GDPYW C Total Number of Years Average Annual Growth Rate Tojudge how rapidly an economic variable is growing calculate the number of years it would take to double by using the Rule of70 70 N b Y t D bl um erof ears o on e GrowthRate o The lower the Number of Years to Double9 the greater the increase in standard of living I Small differences in growth rates can have large effects on how rapidly the standard of living in a country increases 0 The Rule of 70 applies to growth in ANY variable notjust real GDP What Determines the Rate of LongRun Growth Labor Productivity and Supportive Government Policies Basic Point Increases in real GDP per capita depend on increases in laborproductivity Labor Productivity the quantity of goods and services that can be produced by one worker or by one hour of work 0 When analyzing longrun growth labor productivity is measured as output per hour to avoid the effects of fluctuations in workday length and the fraction of the population employed If the quantity of goods and services consumed by the average person is to increase then quantity of the goods and services produced per hour of work must also increase 9for consumers to be able to consume more you must have workers that are more productive o Increases in consumption ability Increased in Labor Productivity Two Key Factors that Determine Labor Productivity 0 Quantig of Capital per Hour Worked I Capital manufactured goods that are used to produce other goods and services 0 Ex Computers factory buildings machine tools warehouses and trucks I Capital Stock the total amount of physical capital available in a country 0 Highincome countries have more capital stock than lowincome countries or high income countries in the past I As the capital stock per hour worked increases worker productivity increases 0 Workers with better tools are more productive I Human Capital the accumulated knowledge and skills workers acquire from education and training or from their life experiences I As human capital per hour worked increases worker productivity increases I Increases in human capital are particularly important in stimulating economic growth 0 Level of Technology I Economic growth depends more on Technological Change than on increases in capital per hour worked I Technology the processes a firm uses to turn inputs into outputs of goods and services I Technological Change an increase in the quantity of output firms can produce using a given quantity of inputs 0 Can come from many sources such as rearranging factory floors or store layouts but most is embodied in new machinery equipment or software I Important point Just accumulating more inputs labor capital nature resources will not ensure that an economy experiences economic growth unless technological change also occurs I Entrepreneurs are crucially important in implementing technological change I Entrepreneur someone who operates a business by bringing together factors of production inputs to produce goods and services I Make the decisions about whether to introduce new technology to produce better or lowercost products and whether to allocate the firm s resources to research and development that can result in new technologies The government must provide supportive government policies for longrun economic growth to occur Must provide secure rights to private property for economic growth because a market system cannot function 0 unless rights to private property are secure 0 Can aid economic growth and help the market work by establishing an independent court system that enforces contracts between private individuals 0 Some also believe the government also has a role in facilitating in the development ofan efficient financial system as well as systems of education transportation and communication What Explains Rapid Economic Growth in Botswana Supportive government policies the progrowth policies of the Botswana government have allowed it to experience rapid growth while other countries of its region have experienced slow growth no growth or negative growth 0 Progrowth Policies of the Botswana government I Protecting private property I Avoiding political instability and corruption I Allowing press freedom and democracy 0 These policies provide an environment in which economic growth can occur Potential GDP Potential GDP the level of real GDP attained when all firms are producing at capacity 0 Capacity a firms production when operating on normal hours and using a normal workforce NOT the maximum output the firm is capable of producing If all firms in the economy were operating at capacity the level of total production of final goods and services would equal potential GDP 0 Increases over time as I Labor forces grow New factories and office buildings are built New machinery and equipment are installed Technological changes take place Saving Investment and the Financial System The process of economic growth depends on the ability of the firm to expand their operations buy additional equipment train workers and adopt new technologies 0 Financed by I Retained earnings profits that are reinvested in the firm rather than paid to the firm s owners I Often not sufficient to finance the rapid expansion required in economies experiencing high rates of economic growth I Financial System the system of financial markets and financial intermediates through which firms acquire funds from households I Financial Markets directly acquire funds from households ex the stock and bond markets Financial Intermediates indirectly acquire funds from households ex Banks Without a wellfunctioning financial system economic growth is impossible because firms will be unable to expand and adopt new technologies 0 No country without a welldeveloped financial system has been able to sustain high levels of economic growth An Overview of the Financial System The financial system channels funds from savers to borrowers and channels the borrowed funds back to the savers Financial Markets markets were financial securities are bought and sold 0 Firms raise funds by selling financial securities directly to savers I Financial Security a document sometimes in electronic form that states the terms under which funds pass from the buyer of the security who is lending the fund to the seller I Stock financial securities that represent partial ownership of a firm I Bonds financial securities that represent promises to repay a fixed amount of funds 0 When a firm sells a bond the firm promises to pay the purchaser of the bond an interest payment each year for the term of the bond as well as a final payment of the amount of the loan Financial Intermediaries firms such as banks mutual funds pension funds and insurance companies that borrow funds from savers and lend them to borrowers 0 Firms that act as a gobetween for borrowers and sellers I Pool the funds of many small savers to lend to many individual borrowers I Pay interest to savers in exchange for the use of savers funds and earn a profit by lending money to borrowers and charging borrowers a higher rate of interest on the loan 0 Firms also make investments in stocks and bonds on the behalfof savers I Mutual Funds sell shares to savers and then use the funds to buy a portfolio of stocks bonds mortgages and other financial securities I Large mutual fund companies such as Fidelity Vanguard and Dreyfus offer many alternative stock and bond funds Some funds hold 0 Wide range of stocks and bonds 0 Securities issued by a particular industries or sectors 0 An index fund in a fixed market basket of securities I Over the past 30 years the role of mutual funds in the financial system has increased dramatically therefor today competition among hundreds of mutual fund firms gives investors thousands of funds from which to choose The Financial System provides three key services for savers and borrowers 0 Risk Sharing allowing savers to spread their money among many financial investments I Risk the chance that the value ofa financial security will change relative to what you expect I Ex buying a share of Google for 450 and the price falling to 100 I Ex Savers can divide their money among a bank certificate of deposit individual bonds and a mutual fund 0 Service of Liguidig providing savers with markets in which they can sell their holdings of financial securities I Liquidity the ease with which a financial security can be exchanged for money I Ex Savers can easily sell their holdings of stocks and bonds issued by a large corporation on the major stocks and bonds markets 0 Information providing savers with the collection and communication of information I Information facts about borrowers and expectations about returns on financial securities I Ex The expectation of higher future profits would boost the prices of a firm s stocks and bonds The Macroeconomics ofSaving and Investment Key Point The total value ofsaving in the economy must equal the total value of investment The funds available to firms through the financial system come from saving and when a firms use funds to purchase machinery factories and office buildings they are engaging in investment National lncomeAccounting the methods used by the Bureau of Economic Analysis to track total production and total income in the economy 0 The relationship between GDP Y and its components consumption C investment I government purchases G and net exports NX for an open economy all economies today are open economies is as shown YCIGNX 0 GDP is a measure of both total production in the economy and total income 0 For simplicity we will develop the relationship between saving and investment for a closed economy in this chapter In a closed economy net exports are zero so we rewrite the relationship between GDP and its components as YCIG o For investment we rearrange the relationship to IY C G I In a closed economy investment spending is equal to total income minus consumption spending minus government purchases 0 Can also derive an expression for total savings by adding private saving and public saving I Private Saving SWWE equal to what households retain of their income after purchasing goods and services C and paying taxes T I Receive income form 0 Supplying the factors of productions to firms Y 0 Government in the form of transferpayments TR I Include Social Security payments and unemployment insurance payments SPrivate Y TR C T I Public Saving Spunit equals the amount of tax revenue T the government retains after paying for government purchases G and making transfer payments TR SPublic T G TR I So Total Saving in the economy 5 is equal to the sum of private saving and public saving 5 SPn39uate l39 SPublic or SYTR C TT G TR or SY C G So tota saving equals total investment in a closed economy 5 Balanced Budget when the government spends the same amount that it collects in taxes Budget Deficit when the government spends more than it collects in taxes 0 T is less than G TR which means that public saving is negative which is known as dissaving 0 Holding constant all other factors there is a lower level of investment spending in the economy when there is a budget deficit than when there is a balanced budget Budget Surplus when the government spends less than it collects in taxes 0 Increases public saving and the total level of saving in the economy which results in a higher level of investment spending 9higher level of savings higher level of investment spending 0 Holding constant all other factors there is a higher level of investment spending in the economy when there is a budget surplus than when there is a balanced budget The Market for Loanable Funds Market for Loanable Funds the interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged o Loanable Funds a combination of the funds that flow from lender to borrower in the many markets of the financial system I Ex certificates of deposit at banks stocks bonds mutual fund shares and so on Demand and Supply in the Loanable Funds Market 0 Demand for loanable funds is determined by the willingness of firms to borrow money to engage in new investment projects I Firms compare the return they expect to make on an investment with the interest rate they must pay to borrow the necessary funds I Demand for loanable funds is downward sloping because the lower the interest rate the more investment projects firms can profitably undertake and the greater the quantity of loanable funds they will demand 0 Supply for loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving I When households save they reduce the amount of goods and services they can consume and enjoy today I The willingness of households to save rather than consume their income today is determined in part by the interest rate they receive when they lend their savings I The higher the interest rate 9 the greater the reward to save 9 the larger the amount of funds households will save I The supply curve for loanable funds is upward sloping because the higher the interest rate the greater the quantity of saving supplied 0 Equilibrium in the market for loanable funds determines the real interest rate rather than the nominal interest rate because both borrowers and lenders are interested in the real interest rate they will receive or pay I ReaInterest Rate corrects the nominal interest rate for the impact of inflation and is equal to the nominal interest rate minus the inflation rate I Nominal Interest Rate the stated interest rate on a loan Connection between Ebenezer Scrooge and the Promotion of Economic Growth Savers provide the funds that are indispensable for the investment spending that economic growth requires and the only way to save is to not consume Explaining Movements in Saving Investment and Interest Rate 0 Equilibrium I Determines the quantity of loanable funds that will flow from lenders to borrowers each period and the real interest rate that lenders will receive and that borrowers will pay I A shift in either the demand curve or supply curve will change the equilibrium interest rate and the equilibrium quantity of loanable funds 0 Shift in Demand I Increase in demand in the market for loanable funds shifts the demand curve to the right I Increases Interest Rate I Increases Quantity 0 Quantity of Saving by Households increased 0 Quantity of Investment by Firms increased I Increases the capital stock and the quantity of capital per hour worked I Increases Economic Growth I Decrease in demand in the market for loanable funds shifts the demand curve to the left I Decreases Interest Rate I Decreases Quantity 0 Quantity of Saving by Households decreased 0 Quantity of Investment by Firms decreased I Decreases the capital stock and the quantity of capital per hour worked I Decreases Economic Growth 0 Shift in Supply I Increase in supply in the market for loanable funds shifts the supply curve to the right I Increases Quantity 0 Increases level of total savings in the economy I Decreases Interest Rate 0 Increases level of investment spending by firms I Increases the capital stock and the quantity of capital per hour worked I Increases Economic Growth I Decrease in supply in the market for loanable funds shifts the supply curve to the left I Decreases Quantity 0 Decreases level of total savings in the economy I Increases Interest Rate 0 Decreases level of investment spending by firms I Decreases the capital stock and the quantity of capital per hour worked I Decreases Economic Growth 0 Causes I Shifts in Demand I Technology I Shifts in Supply I Budget Surplus 9 Increase in SupplyShift to the Right 0 Increases the total amount of saving in the economy 0 Increases the level of saving and investment I Budget Deficit 9 Decrease in SupplyShift to the Left 0 Total Amount of Saving in the Economy Decreases o By borrowing to finance its budget deficit the government might crowd out some firms that would otherwise have been able to borrow to finance investment I Crowding Out refers to a decline in investment spending as a result of an increase in government purchases 0 Decline in investment spending due to crowding out means that the capital stock and the quantity of capital per hour worked will not increase as much The Business Cycle Economies experience a business cycle which consists of alternating periods of expanding and contracting economic activity illustrated using the movements in real GDP Some Basic Business Cycle Definitions Expansion Phase the phase of the business cycle where production employment and income are increasing 0 The expansion phase ends with a business cycle peak Recession Phase production employment and income are decreasing in this phase of the business cycle 0 The recession phase ends with a business cycle trough Inconsistent movements in real GDP around business cycle peaks and troughs mean that the beginning and the ending of a recession may not be clearcut How Do We Know When the Economy Is in a Recession Most economists accept the decisions of the Business Cycle Dating Committee of the National Bureau of Economic Research NBER who define a recession as o quotA recession is a significant decline in activity spread across the economy lasting more than a few months visible in industrial production employment real income and wholesaleretail trade 0 The length ofa recession is the number of months from the peak to the following trough The Connection between a Recession and a Good Time for a Business to Expand Since every Recession is followed by an Expansion if you have the resources a recession is a good time to expand a business What Happens during the Business Cycle Each business cycle is different lengths of the expansion and recession phases and which sectors of the economy are most affected are rarely the same in any two cycles BUT most business cycles share certain characteristics 0 At the end ofan expansion both interest rates and wages of workers are usually raising faster than price therefore towards the end of an expansion both households and firms will have substantially increases their debt 0 A recession often begins with a decline in spending by firms or households on capital goods9 as spending declines firms selling capital goods and consumer durables will find their sales declining 9 as sales decline firms cut back on production and begin to lay off workers 9 rising unemployment and falling profits reduce income 9 leads to further declines in spending 0 As the recession continues economic conditions gradually begin to improve 9 households and firms begin to reduce their debt thereby increasing their spending ability 9 interest rates decline making it more likely that households and firms will borrow to finance new spending 9 the decline in spending eventually comes to an end 9 firms begin to increase their spending on capital goods in anticipation of the need for additional production during the next expansion 0 Increased spending by households on consumer durables and by businesses on capital goods will finally bring the recession to an end and begin the next expansion The Effect of the Business Cycle 0 Durables are affected more by the business cycle than nondurables I People and firms are more likely to postpone spending on durable goods because they can often continue using their existing durable goods I Durables goods that are expected to last for three or more years I Nondurabes goods that are expected to last for fewer than three yea rs o The effects of a recession on individual firms is much more dramatic and longlived than the effects on the economy as a whole The Effect of the Business Cycle on the Inflation Rate 0 Inflation Rate the percentage increase in the price level from one year to the next I Price Level the measure of the average prices of goods and services in the economy 0 During the expansion phase of the business cycle inflation rate increases particularly near the end of the expansion I Spending by businesses and households is strong so the producers of goods and services find it easier to raise prices 0 During the recession phase of the business cycle inflation rate decreases I The average decline in the inflation rate is 25 percentage points I Firms find it more difficult to sell their goods and services so they are likely to increase price less than they otherwise might have The Effects of the Business Cycle on the Unemployment Rate 0 During the expansion phase of the business cycle unemployment rate decreases I But at the beginning of the expansion phase unemployment rate is still increasing because I Employment increases more slowing than growth in the labor force resulting from population growth I Some firms continue to operate well below their capacity even after production has begun to increase 0 Firms may not hire back all the workers they laid off 0 May even continue for a while to lay off workers 0 During the recession phase of the business cycle unemployment rate increases Is the quotGreat Moderation Over 0 Can be answered yet Will the US Economy Return to Stability Shorter recessions longer expansions and less severe fluctuations in real GDP relative stability from 19502007 resulted in a significant improvement in the economic wellbeing of Americans Explanations for this period of relative stability Increasing importance of services and declining importance of goods 0 Manufacturing production particularly production of durable goods fluctuate more than the production of services Establishment of Unemployment Insurance and other Government transfer programs that provide funds to the unemployed 0 Allow workers who lose their jobs during recessions to have higher incomes and therefore to spend more than they would otherwise which helps shorten recessions Active Federal Government policies to stabilize the economy 0 Government actively uses policies to end recessions and prolong expansions I Some economists believe this plays a key role in stability I Some economists believe this have little effect on stability Increased stability of the financial system 0 Economists believe that the return of financial system instability is a key reason why the 20072009 recession was so severe 0 To return to stability stability must first return to the financial system
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