PRIN OF ECONOMICS
PRIN OF ECONOMICS ECON 203
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This 79 page Class Notes was uploaded by Mr. Tito Legros on Wednesday October 21, 2015. The Class Notes belongs to ECON 203 at Texas A&M University taught by Michael Nelson in Fall. Since its upload, it has received 16 views. For similar materials see /class/225828/econ-203-texas-a-m-university in Economcs at Texas A&M University.
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Money Banks and the Federal Reserve System l A Consider the purchase of a good with money Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts Assets Anything of value owned by a person or a firm Money vs Wealth 1212010 1212010 39 1 In a world without money how would trade occur What s so bad about that I Barter requires a double coincidence of wants Suppose that you want a laptop computer and you have a bicycle to trade Not only do you have to find someone with a laptop computer that you want but that person must Consider a money economy on the other hand You can sell your bicycle to anyone who wants it They pay you with You then use this money to pay the laptop owner for her computer Thus you can specialize in doing one ortwo activities earn money and use this money to buy 39 1 Four Functions of Money 1 Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services 2 Unit ofAccount Consider a barter economy with 4 goods lemons shoes cars and chairs What is the price of a car 3 Store of Value Money allows value to be stored easily If you do not use all your accumulated dollars to buy goods and services today you can hold the rest to use in the future Do other assets store value also 1212010 If some assets store value better than money then why do people hold any money at all Liquidity is the ease with which an asset can be converted to medium of exchange When people decide in what forms to hold their wealth they have to balance the liquidity of each possible asset against the assets usefulness as a 4 Money is useful because it can serve as a standard of deferred Qaymenfin borrowing and lending How does inflation affect the functions of money High inflation limits the ability of money to effectively serve as 39 i The Kinds of Money Definition of commodity money money that takes theform of a commodity with intrinsic value Definition of fiat money money without intrinsic value that is used a 5 money because of government decree Measuring Money in the US Economy There are two common measures of the amount of money often called the money stock in the US economy M1 and M2 M1 includes the most liquid items M2 includes M1 plus some El M1 The Narrowest Definition of the Money Supply includes 1 Currency which is all the paper money and coins that are i circulation where in circulation means not held by banks or the government 2 The value of all checking account deposits at banks 3 The value of traveler s checks although this last category is so small less than 7 billion in May 2007 we will ignore it in our discussion of the money supply M2 A Broader De nition of the Money Supply includes M1 plus savings account balances smalldenomination time deposits CD5 and some other money market deposits Ii El Learning Objective 132 M1 The Narrowest Definition of the Money Supply FIGURE 131 Me asLlring ft39heE Money SupplyA llll Ma y m K Tlavelews checks mutual lund shares 56 5 billion 5369 a hilllan Ml 513533 billlon Small llme sposlls smug billl39u cunency 755 bllllon sawgs deposils 3555326 bllllarl la M1 513639 billion 5 M2 572412 blllion 1212010 How do banks create money Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve Required reserves Reserves that a bank is legally required to hold based on its checking account deposits Required reserve ratio HR The minimum fraction of deposits banks are required by law to keep as reserves Excess reserves Reserves that banks hold over and above the legal requirement Bank Balance Sheets FIGURE 132 Learning Objective 133 BalanceSheettorWachovia Bank Decemberst 2006 Ll ElLITIEE AND STOCKHOLDERS39 AEBEI39B Ill HILLIDIIS EG UlTY IN MlluJQN Hesewss 32749 Uspaslts 40 155 Luans 416198 Swanterm borrowi rig w 020 Derer M111 other banks 2167 Lowgrterm deb 158594 Securities 108819 other llabl ties 41333 Build39ngs am Equipment 6141 Total Iiab lil as 637 105 Other assets 140647 Stockholders equ by 716 Total assets 07121 Total Labquotth and stmkholdere39 equrly 70 121 1212010 1212010 LeameObiec ve 133 r Using TAccounts to Show How a Bank Can Create Money Assets Liabilities Reserves 1000 Deposits 1 000 Your deposit of 1000 into your checking account increases Wachovia39s assets and liabilities by the same amount LeameObiec ve 133 L Using TAccounts to Show How a Bank Can Create Money Assets Liabilities Reserves 1000 Deposits 1000 Loans900 Deposits 900 2 Wachovia has increased the money supply by 900 1 By loaning out 900 in excess reserves 1212010 LearniHQObiective133 Using TAccounts to Show How a Bank Can Create Money Wachovia Assets Liabilities Fleserves100 Deposits 1000 Loans900 2 v and me increase in Wachuvla Bank deposils lalls by 900 lo 1 000 1 When the 900 check than was deposited in a FNC acouunl amVeS in be cleared the increase in Wachovla s iesewes shown in me previous Taocoum lalls by PNC Bank DD 5900 o 51 Assets Liabilities Reserves 900 Deposits 900 l deposils bolh increase by 900 LeameObiec ve 133 Using TAccounts to Show How a Bank Can Create Money PNC Bank Assets Liabilities Reserves 900 Deposits 900 Loans 810 Deposits 810 By making an 810 loan PNC has increased both its loans and ils deposits by 810 Using TAccounts to Show How a Bank Can Create Money BANK INCREASE IN CHECKING ACCOUNT DEPOSITS Learning Objective 133 Wachovia PNC Third Bank Fourth Bank Total Change in Checking Account Deposits 1000 900 09x1000 810 09x900 729 09x810 10000 Note that the initial deposit multiplies through the banking system SimQe dersit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves 1212010 1212010 39 The Simple Deposit Multiplier vs the RealWorld Deposit Multiplier Our multiple deposit creation story made 2 assumptions which are not necessarily true in the realworld 1 We assumed that banks do not have any excess reserves If they do hold excess reserves the realworld multiplier will be 2 We assumed that the whole amount of each check is deposited and that the public does not hold any amount of a check as currency If the public does hold part of a check as currency the realworld multiplier will be Despite these complications let s not lose sight of the forest forthe trees Whenever banks gain reserves they make new which causest e Whenever banks lose reserves they reduce their which causes the You can think of reserves in the banking system as fuel that allows banks to create 1212010 39 1 The US banking system is a fractional reserve banking system This is a banking system in which banks keep less than 100 percent of deposits as reserves Such systems are somewhat susceptible to bank runs in which many depositors simultaneously decide to withdraw money from a bank One bank can likely sustain a bank run as it can borrow money from In the case of a bank Qanic however many banks simultaneously experience bank runs In this case the entire banking system may This possibility is one reason that we have a central bankin the US Central banks help reduce the risk of a bank panic 39 i The US Federal Reserve Bank aka the Fed was created in 1913 as our central bank That is it was created to oversee the banking system and regulate the quantity of money in the economy The primary envisioned role of the Fed was that of lender of last resort to troubled banks 0 Positive aspect ofthis role 0 Negative aspect of this role i The Federal Reserve System The Organization of the Federal Reserve System FIGURE 133 Kansas Clly Cleveland 2 39 aoslnn SL Louis 39 El of the Federal Reserve Svstem 1 12 District Federal Reserve Banks 2 The Board of Governors G 7 Members appointed by the President of the US 0 One of these 7 members is appointed as Chairman of the Fed 3 The Federal Open Market Committee FOMC meets 8 times per year to discuss monetary policy a 12 members 7 B of G members plus 5 Presidents of District Banks 1212010 39 1 Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives The tools of monetary policy are 1 Open Market Operations are the buying and selling of Treasury securities bonds by the Federal Reserve in order to control the money supply C If the Fed wishes to increase the money supply it engages in open market D If the Fed wishes to decrease the money supply it engages in open market 39 i 2 Discount Policy C Discount loans are loans the Federal Reserve makes to banks The Fed charges these banks interest This interest rate is called the discount rate loa which banking system which does what to the money supply 3 Reserve Requirements are set by the Fed Ci When the Fed reduces the required reserve ratio it converts to required reserves in i lfthe Fed lowers the discount rate it encourages banks to take 39 mount of reserves in the 1212010 1212010 39 The Quantity Theory of Money In the early twentieth century Irving Fisher an economist at Yale formalized the connection between money and prices using the quantity equation Where M Money Supply V velocity of money P price level and Y Real output The velocity of money is the average number of times each dollar is used to The quantity equation is an identity We can rewrite the quantity equation as In a recent year in the US we had the following values A key question concerning whether or not the velocity of money is constant over time The evidence says that there are fluctuations in the velocity in the short run but it is fairly constant in the 1212010 Mathematically an equation whose variables are multiplied together is equal to the an equation where the growth rate of these variables are added together Thus we have Or If V is stable in the long run then its long run growth rate is zero and we have 39 1 Inflation rate A in Money Supply A in Real Output Therefore if I Money supply grows faster than output we have I Money supply grows slower than output we have I Money supply grows at the same rate as output we have Very high rates of inflation are termed What causes hyperinflation 1212010 39 Almost all 39 39 quot followthe same pattern The government has a high level of spending and its ability to raise tax revenue is The government s ability to borrow funds is As a result it turns to printing money to pay for its spending The large increases in the money supply lead to large amounts of How does this end LongRun Economic Growth Sources and Policies I l A LongRun Growth You are responsible forall Learning Objectives in this chapter I We are only going to lecture on Learning Objectives 102 and 105 I You need to read 101 103 and 104 on your own I Longrun per capita economic growth comes from increases in I Increases in labor productivity come from 39 J I What causes technological change Ci Better machinery andor equipment Ci Increases in human capital Ci Better means of managing and organizing production We can illustrate longrun economic growth using the PerWorker Production Function It shows the relationship between real GDP per hour worked and capital per hour worked holding I Which Is More Important for Economic Growth More Capital or Technological Change Ci Economic growth coming from more capital is subject to Ci Technological change is not subject to diminishing returns and thus is the key to Ci Tech change means that we can produce higher levels of output while using the L Graphically this is going to show up as an Learningomective 102 lTechnological Change The Key to Sustaining Economic Growth Heal GDP pa FIGURE 104 hour worked YL Technological Change 6 uatvr39mdumlon Increases Output per 875 uncuom d Production quot39 runmiong 775 r r o39 H w Production 14x functian 575 74 4 r gt H Production 739 lunclium 575 Technolugical change causes the perrworker pmuuciiun runcim n m shin up 0 550000 Capilal per hum worked KL Learningomective 102 Solved Problem 102 Using the Economic Growth Model to Analyze the Failure of the Soviet Union s Economy 39 1 New Growth Theory Traditional growth models did not address the origins of technological change New Growth Theoy developed by Paul Romer looks at Romer argues that knowledge capital is a key determinant of growth I At the firm level the effects of knowledge capital are subject to diminishing returns I At the economywide level however knowledge capital is subject to I Why The knowledge once discovered is available I More technically the knowledge capital is nonrival Also knowledge capital is nonexcludable The nonrival and nonexcludable nature of knowledge capital implies that firms can free ride on the efforts of other firms Government policy can help increase the accumulation of knowledge capital How I Protecting intellectual property with patents and copyrights D Subsidizing research and development D Subsidizing education Joseph and Creative Destruction Schumpeter developed a model of growth that emphasized his view that new products unleash a gale of creative destruction in which older products and often the firms that produced them are 39 Growth Policies What kinds of policies can the government follow in order to encourage growth I Enhancing property rights and the Rule of Law I Improving Health and Education I Policies with Respect to Technology I Policies with Respect to Saving and Investment 1212010 Aggregate Demand and Aggregate Supply Analysis 39I In this lecture we begin to develop our most important macroeconomic model the Aggregate Demand and Aggregate Supply model Aggregate Demand shows the relationship between the price level and the quantity of real GDP demanded by households firms the government and foreign entities Why does the AD cunIe slope downward I The Wealth Effect Price Level affects C I The InterestRate Effect Price level affects l I The InternationalTrade Effect Price level affects NX Price Level Real GDP 39 1 Variables that shift the AD Curve Changes in Government Policies I Monetary Policy actions bythe Federal Reserve concerning money supply and interest rates I Fiscal Policy actions by the President and Congress concerning the level of government spending and taxes Taxes Government Spending 1212010 39 J Chanqes in Household and Firm 39 I Households I Firms Changes in Foreign Variables I If US real GDP grows fasterthan real GDP in other countries then US imports will grow faster than US exports and US Net Exports will 39 I I Exchange Rate Effects As the dollar appreciates the foreign currency price peso price of US products sold abroad rises and thus US exports fall US imports rise and US Net Exports As the dollar depreciates the foreign currency price peso price of US products sold abroad and thus US exports rise US imports fall and US Net Exports 1212010 1212010 39 1 Aggregate Supply Longrun aggregate supply curve shows the relationship in the long run between the price level and the quantity of real GDP supplied In the long run the level of output depends on Price level is not in that list In the long run price level changes Thus the LRAS curve is vertical The level of output associated with the LRAS curve is called Price Level Real GDP 1212010 Shortrun aggregate supply curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms In the shortrun as the price level increases firms increase the quantity of goodsservices that they are willing to supply Why Sticky Wages Wages are often set for 1 2 3 or more years These wages are said to be sticky over this time period Sticky Prices Some companies prices are sticky over short periods of time Price Level Real GDP 39 Variables that shift the SRAS CunIe Chanqes in the Labor Force and Capital Stock Technological Change Expected Chanqes in the Future Price Level eg Workers and firms expect 5 inflation over the next year 39 i quot quot of Workers and Firms to Errors in Past 39 the Price Level eg In the past workers underestimated the amount of inflation How will that affect them when they negotiate for wages now about I39 39Chanqes in the Price of an Important Natural Resource supply shock 1212010 1212010 39 1 Macroeconomic Equilibrium Short Run and Long Run In the short run equilibrium occurs where the This may or may not be on the We look at two cases I Static Case simple case AD SRAS and LRAS curves are not continually shifting to the right I Dynamic Case more complex more realistic case AD SRAS and LRAS curves constantly shifting to the right Price Level LRAS Real GDP 1212010 39 J Price Level LRAS SRAS AD1 ReaIGDP 39 1 Price Level LRAS SRAS1 AD1 ReaIGDP Price Level LRAS SRAS AD Real GDP 39 1 Price Level LRAS SRAS AD Real GDP 1212010 Price Level LRAS SRAS Real GDP l Learning Objective 124 I A Dynamic Aggregate Demand and Aggregate Supply Model We can create a dynamic aggregate demand and aggregate supply model by making three changes to the basic model Potential real GDP increases continually shifting the longrun aggregate supply curve to the right During most years the aggregate demand curve will be shifting to the right Except during periods when workers and firms expect high rates of inflation the shortrun aggregate supply curve will be shifting to the right 1212010 1212010 J Learning Objective 124 A What Is the Usual Cause of Inflation FIGURE 129 Using Dynamic mum 5 W 7 ggatrerpena nd warm VSupplyyto Understand Inflation m4 100 t A zmihepric e leveinses 0 100 105 lrillions of 2000 dollars 1 Learning Objective 124 l The Slow Recovery from the Recession of 2001 The recession of 2001 was caused by a decline in aggregate demand Several factors contributed to this decline r The Slow Recovery from the Recession of 2001 LFASzum LFiASzuoz FIGURE 1210 Price IEVEI GDP de alor SHASQW 5 RA92002 I TO Recovery from the 2001 Recession 1042 A Equilibrium in 2002 1024 A02002 szam 0 99 100 101 103 RealGDF trillions of Equilibrium in 2001 2000 dollars Learning Objective 124 39 J L Solved Problem 124 Price oval GDP wlaxor 20m my ACTUAL POTENTIAL PRICE HEAL GDP HEALGDP LEVEL 1974 432trillion 435trillion 347 1975 431 trillion 450trillion 380 0 Showing the Oil Shock of 1974 1975 on a Dynamic Aggregate Demand and Aggregate Supply Graph Learning Objective 124 LEA 97 LRASisw 54m 432 435 A17 RASieiS SHASiEN s 450 Real an trillions at am dollars 1212010 GDP Measuring Total Production and Income 39 if t A It s time for Macroeconomics I Over the business cycle the economy grows and contracts I Some important gauges of macro performance include 39 Measuring gross domestic product GDP production of output Goal To summarize the total production of an entire economy into a single number we call the Definition GDP is the market value of all final goods and services produced within an economy in a given period of time I GDP is the Market Value I ofall I final goods and services D We do not count intermediate goods Why Cl Example Ford purchases 1000 worth of Goodyear tires and puts them on a new 20000 truck We count only the If we counted the tires and the truck we would get 21 000 for GDP What s wrong with this calculation I produced I within an economy I in a given period of time 39 i The Components of GDP Personal Consumption Expenditures or Consumption Gross Private Domestic Investment or Investment Government Consumption and Gross Investment or Government Purchases Net Exports of Goods and Services or Net Exports NX Exports Imports eg US firm produces a 1000 computer in Texas and sells it to a Mexican consumer eg US consumer purchases a 300 pair of Italian produced shoes 391 YCGNX An Equation for GDP and Some Actual Values FIG U RE 72 Co mpohenisolGDP in 2006 COMPONENTS 0 GDP himans or dollars consumpuan 9269 Duvams goods 1070 Nondumble goods 27r5 SSMDES 5 484 Inveslmem 2213 Busr ness xed invesrment 1390 Residemiar oansuucvzan 767 hangs n business nvsntarles 50 advemmsnr Purchases 2525 Federal 927 State and year 1601 Nsr Expurls 453 EXWHS mes Impons 2220 44100 consumpnun Invesrmam Government Nel exports Total GDP 13247 2000 Measuring GDP by the ValueAdded Method Value added The market value a firm adds to a product FIRM VALUE OF PRODUCT VALUE ADDED Cotton Value of raw Value added by cotton Farmer cotton 2 farmer Textile Mill Value of raw cotton woven Value added by cotton into cotton fabric 5 textile mill Shirt Value of cotton fabric Value added by shirt Company made into a shirt 20 manufacturer LL Bean Value of shirt for sale on Value added by LL LL Bean s Web site Bean 43 Total Value Added 39 1 Measuring Production Measuring Income I If you pay Theresa 50 to clean your house your expenditure on the house cleaning 50 is exactly equal to the I For an economy as a whole total income must total expenditures I Recall the circularflow diagram every dollar of spending becomes a dollar of income Rememberthat income includes Calculating Nominal GDP and Real GDP Consider the idyllic enclave of Nelsonville which produces only two goods cars and computers 2008 2008 2009 2009 Quantities Prices Quantities Prices Cars 8 20000 10 30000 Computers 30 1000 40 1000 We need to calculate the market value of the production in each year Nominal GDP the production of goods and services valued at current prices Nominal GDP in 08 Nominal GDP in 09 Growth Rate aka change in of Nominal GDP between 08 and 09 is equal to Notice that Nominal GDP can increase if either When studying GDP over time economists would like to know if output has changed not prices Thus economists measure Real GDP by valuing output using a fixed set of Qrices To calculate Real GDP we use one year s Qrices for all of our calculations This year is termed the Assume that 08 is the base year Real GDP in 08 Real GDP in 09 Calculate the growth rate of Real GDP between 08 and 09 Compare 09 Nominal GDP and 09 Real GDP What accounts for the difference We can use this information to calculate the overall level of prices and the changes in prices over time 39 1 GDP Deflator Price level A measure of the prices of goods and services in the economy GDP deflator A measure of the price level Change in GDP deflator A measure of the change in the price level GDP de ator W x 100 Real GDP GDP Deflator in 08 GDP Deflator in 09 Chanqe in GDP Deflator between 08 and 09 Interpretation of this number I There is a slight problem with Real GDP and the GDP Deflator the way that we have calculated them If you use 09 as the base year you will get slightly different values for growth rates of Real GDP and the GDP Deflator39 In 1996 the commerce department began using chaintype indices help eliminate these distortions 1 Learningomec ve 73 Real GDP versus Nominal GDP Comparing Real GDP and Nominal GDP GDP billions idollarsl 14 000 FIGURE 73 3 Nominal GDP and 00 FleaLGDP 1990 2006 2 000 moon 10 000 9 000 Real GDP ainoo moo Nomlnal GDP 5000 u i i i 1990 1992 1594 1598 1998 2000 2002 2004 2005 Does GDP Measure What We Want It to Measure Shortcomings in GDP as a Measure of Total Production Official GDP statistics fail to include the following kinds of production 1 Household Production 2 The Underground Economy I Do these omissions imply that GDP understates or overstates actual production Application US 1950 Present As more and more women have entered the labor force families have become more likely to pay others for child care cleaning services food preparation etc Li Now These activities L Then These activities Li Implication The growth rates of US GDP from 1950 to present actual growth 39 J Shortcomings of GDP as a Measure of WellBeing Real GDP per person per capita is often used as a measure of well being It is not however a perfect measure of wellbeing I The Value of Leisure Is Not Included in GDP I GDP Is Not Adjusted for Pollution or Other Negative Effects of Production I GDP Is Not Adjusted for Changes in Crime and Other Social Problems I GDP Measures the Size ofthe Pie but Not Howthe Pie ls Divided Up Are there alternative measures of wellbeing The UN uses the Human Development Index HDI which includes the following variables Tradeoffs Comparative Advantage and the Market System 39I Production Possibilities Frontiers PPFs PPFA curve showing the maximum attainable combinations of two products that may be produced with Example A small country produces two goods corn measured in bushels and trucks Points on a production possibilities frontier can be shown in a table or a graph gt 03 O U I39l39l Trucks 0 10 20 30 40 Corn 70 60 45 25 0 Corn Trucks 39 1 I Production is ef cient at points on the curve This implies that the economy is getting all it can from the scarce resources it has available Production at a point inside the curve is inef cient Production at a point outside of the curve is not possible given the economy s current level of resources and technology PPFs show the tradeoffs that society faces These tradeoffs are shown by the The PPF shows the opportunity cost of producing each of the goods The 0c of 10 trucks between A and B from 0 trucks to 10 trucks is The 0c of 10 trucks between B and C from 10 trucks to 20 trucks is The 0c of 10 trucks between C and D from 10 trucks to 20 trucks is The 0c of 10 trucks between D and E from 10 trucks to 20 trucks is Note that the opportunity cost of the good on the horizontal axis is shown by the With a PPF that is bowed outward from the origin concave what happens to the opportunity cost of trucks in terms of corn as the country produces more trucks and fewer bushels of corn Why does this happen What does that mean What would a PPF look like if resources were equally wellsuited to the production of both goods Learningomec ve 21 r Economic growth The ability of the economy to produce increasing quantities of goods and services Tan ks Tanks sou 4m 40W Lieu 2m 7 n 400 A50 500 625 Auxomnhiie 0 506 800 Aummahiies n shining on In production possibllmes quotantler h Technological mange III quotI automobile undus ry L Other examples 39 J Decisions today can affect production ability in the future Capital Goods PPF today Consumption Goods 39 1 Comparative Advantage and Trade I Think of all of the goods and services that you consume that you do not directly produce Why don t you produce all of your own goods and not trade with other people Instead of producing all of our own goods what do we do Does this behavior make us better off Man is the only animal that makes bargains one dog does not exchange bones with another dog Adam Smith IN POUNDS IN POUNDS IN POUNDS IN POUNDS DeVOte all time to picking appes 24 0 8 0 DeVOte all time to 0 48 0 32 picking cherries Absolute advantage The ability of an individual a firm or a country to produce more of a good or service than competitors using the same amount of resources Who has absolute advantage in apple picking Who has absolute advantage in cherry picking Your PPF Apples Cherries Your Neighbor39s PPF Apples Cherries Calculating Opportunity Cost Your opportunity cost of picking one lb of cherries is Your opportunity cost of picking one lb of apples is Your neighbor s opportunity cost of picking one lb of cherries is Your neighbor s opportunity cost of picking one lb of apples is Who has the lowest opportunity cost of cherry picking Who has the lowest opportunity cost of apple picking Comparative advantage The ability of an individual a firm or a country to produce a good or service at a lower opportunity cost than competitors Both parties can be made better off by specializing in the good for which they hold the comparative advantage and then trading with one another Thus you should specialize in apples and M neighbor should specialize in cherries Terms of trade need to be determined The following will be agreeable to both parties With those terms of trade we will assume that you trade 5 lbs of apples for Below we summarize the specialization and trade APPLES CHERRIES APPLES CHERRIES IN I IN I POUNDS POUNDS POUNDS POUNDS Production and 18 12 4 16 consumption without trade Production with trade 24 0 0 32 Trade 5 15 5 15 Consumption with trade 19 15 5 17 Gains from trade 1 3 1 1 increased consumption 39 1 Comparative Advantage and Trade Summary The basis fortrade is comparative advantage Individuals firms and countries are better off if they specialize in producing goods and services for which they have a comparative advantage and obtain the other goods and services they need by Specializing and trading allows Is it possible for an individual to have absolute advantage in everything Is it possible for an individual to have comparative advantage in everything 39 1 Application Should Tiger Woods mow his own lawn I What is Tiger s opportunity cost of mowing his lawn I What is Johnny s opportunit cost of mowing a lawn Johnny is Tiger s 12 year old neighborg I Another quote from Adam Smith It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than buy The Market System and Circular Flow I Trading occurs in I Product markets are markets for goods and services I FaCtor markets are markets for factors of production 1 Labor Cl Capital 1 Natural Resources Ci Entrepreneurial ability I Two key groups operating in markets firms and households Learning Objective 23 l The Market sxstem The Circular Flow of lnco i v w i i Househnlds f r l FIGURE 26 The circularFlow Di a gram The Market System I Under most but not all cases the market system does a good job of producing and allocating goods and services How do firms respond to changes in consumer needs and desires The legal basis of a successful market system Ci Protection of private property rights exclusive use of private property cl Enforcement of contracts and property rights 1212010 Fiscal Policy 39 i la Fiscal Policy is policy followed bythe Congress and President using government spending and taxes to pursue macroeconomic objectives What is fiscal policy What is not fiscal policy What about automatic stabilizers Automatic stabilizers are government spending and taxes that automatically increase or decrease along with the business cycle 1212010 39 J Price Level LRAS SRAS1 AD1 ReaIGDP 39 1 Price Level LRAS SRAS1 AD1 ReaIGDP 39 l 7 The Effects of Fiscal Policy on Real GDP and the Price Level IUsing Fiscal Policy to Influence Aggregate Demand A More Complete Account Learning Objective 152 FIGURE 156 lece LF As level LRAS Increase In AD due to An E qu onary x expansionawllsml pollcy Fiscal PQII y I ADglwnh pollcyl 39 ADzlwllhuul Dolley 120 123 124 Real GDP rilliuns ul dollars J L The Effects of Fiscal Policy on Real GDP and the Price Level IUsing Fiscal Policy to Influence Aggregate Demand A More Complete Account FlGUFtE157 AComractionary Fiscal Policy ADalwllhwl palml Athwln Dolley 124 i25 1212010 Learning Objective 152 J The Effects of Fiscal Policy on Real GDP and the Price Level IA Summary of How Fiscal Policy Affects Aggregate Demand T bl 151 ACTIONS BY TYPE OF CONGRESS AND THE PROBLEM POLICY PRESIDENT RESULT Recession Expansionary Increase government Real GDP and the spending or cut taxes price level rise Rising Contractionary Decrease government Real GDP and the Inflation spending or raise taxes price level fall Don t Let This Happen to YOU Don t Confuse Fiscal Policy and Monetary Policy Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures Suppose that Congress and the President decide to spend 100 billion building roads and bridges How far does that the AD curve shift to the right Note that the 100 billion becomes income to the construction companies asphalt suppliers and everyone else involved in the road and bridge construction They will then increase their spending on many other goods amp servicesand so on and so on 1212010 l Learning Objective 153 r FIGURE 158 The Multiplier Effect andgrAggregate Demand Price level 100 1 An iial 100 billion increase in g ernmen purchases shins ihe greg demand to the righl by 100 ADg billio 0 Real GDP 1 LeameObiecive 153 L The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier Change in equilibrium real GDP Government purchases multiplier Change in government purchases The expression for this tax multiplier is Change in equilibrium real GDP Tax multiplier Change in taxes 1212010 LeameObiec ve 154 r Does Government Spending Reduce Private Spending Crowding out A decline in private expenditures as a result of an increase in government purchases Crowding out can be partial or complete Learning Objective 154 Crowding Out in the Short Hun FIGURE 1511 Ah Expansior1 ary Fiscal Policy Increases Interest Rates Inleresl 5 Money demand Money demand 0 950 Quantity Di mane M billions of dollars 1212010 1212010 Crowding Out in the Short Hun FIG U R E 1 5 1 2 agglegale V p I I supply LRAS The Effeptjof 3dean nce EVE GDP de alor 39 Ht supp SEAS In the Short Run 7 Decrease m AD due to crowding um A020quot WWW ADzcmdenq nun AD 0 122 12 3 124 Real GDP lvlllinrns Of 2000 dollars Learning Objective 154 Crowding Out in the Long Run 1212010 39 Note the difficulties on precisely executing fiscal policy I Multiplier effects I Crowding out effects I Information lags I Effectiveness lags Impacts of fiscal policy on the qovernment budqet I Recession Expansionary fiscal policy I Economic Expansion Contractionary fiscal policy 1212010 Learningomec ve 155 Deficits Surpluses and Federal Government Debt FIG U RE 1513 The Federei Budget De cit 190 42007 Surplus or deficit as a percentage 10 Great Depression Recession 5 Recession World 0919811952 Recession War Ii 01990v1991 1 Learningomec ve 155 L Deficits Surpluses and Federal Government Debt I The Federal Government Debt FIG U RE 1514 The Federal Government Federal 140 government deb as percentage 0 GDP 120 7 Dem 15401 2120 World War II Great Depression World War 1901 1921 1941 1961 1951 200i 1212010 Learning Objective 151 39Maklng IIS Spending on Social Security the and Medicare a Fiscal Time Bomb Connect 39 Social Seminar 2cm I O n Medicare and Medicaid 16 39 spending as a percentage of 5 can 2 193972 193982 193992 2052 202 2amp2 2052 20412 Will the federal government be able to keep the promises made by the Social Security and Medicare programs Is Government Debt a Problem 1O 1212010 39 The LongRun Effects of Tax Policy Tax Reform takes two major forms I Supplyside effects of tax reduction I Tax simplification Price Level LRASiNiTiALLY Real GDP Economic Growth the Financial System and Business Cycles LongRun Longrun economic growth The process by which rising productivity increases the average standard of living Real GDP per capiu 2000 dollars 401000 7 35000 30000 25000 20000 15000 10000 1920 Learning Objective 91 Economic Growth 1940 1950 1950 2000 Learningomective 91 uThe Connection between Economic Prosperity and Lil expectnay at him m an 2006 an 70 m 50 m 3 Lifetime an in ours m 3504100 a smear United United France lndia Slates Kingdom 25mm 2 u w w I meme discretionary hunts Llletlme hours nl paid work 69000 I Lliellme hours oi IElSUIS maroon 50mm 0 i men was 2340 39 I I The growth rate of Real GDP per sagta is the best indicator of advances in the standard of living in a country One way to judge how rapidly a variable is growing is to see how quickly it will double in size An approximation of the of years to double is the Rule of 70 eg Growth rate 2 How many years to double eg Growth rate 5 How many years to double Note that growth rates compound overtime so that small changes in growth rates have large effects in the long run What 39 39 the LonqFiun Growth Rate Labor productivity The quantity of goods and services that can be produced by one worker or by one hour of work total output of labor hours Increases in labor productivity are the key to longrun economic growth Why is our standard of living in the US nearly 8 times as high now as it was in 1900 our workers are nearly 8 times more productive now What causes increases in labor productivity I Learningomec ve 91 I Potential Real GDP The level of GDP attained when all firms are producing at capacity Heal GDP billions of FIGURE 92 2mm dollars i Adu aLand Potential Flea GDP 1 0000 8000 6000 4000 0 i i i i 1950 1950 i970 1980 1690 2000 The Financial System When someone starts a new business they typically need to purchase large amounts of capital Existing firms often incur significant capital purchases as well Where do these firms get the money to finance this investment spending One way or another these firms usually get the funds for investment spending from savers people not spending all of their income Usually these connections between savers and borrowers investors are not direct but instead occur in the financial system Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households Awellfunctioning financial system is essential foran economy in producing economic growth Financial Markets The Bond Market C Bond a certificate of indebtedness E Bond purchaser is the D Bond issuer is the The Stock Market E Stock a claim to partial ownership in a firm Financial Intermediaries Firms such as banks mutual funds pension funds and insurance companies that borrow funds from savers and lend them to borrowers 3 Kev Services to quot Provided bv the Financial Svstem I Reduction of Risk I Liquidity I Providing Information of Saving and 39 Recall our basic relationship between GDP and its components Rememberthat Y is both the total value of production and total In an open economy there is trade and borrowinglending with other countries In a closed economy there is no trade or borrowinglending with others Thus Rearranging to focus on investment spending gives Define T as taxes paid to the government Define TR as transfer payments from the government to households eg Social security unemployment payments etc Thus we can write an expression for private saving savings by households SPRIVATEY TR C T The government also engages in savings public saving SPUBLIC T G TR Note that public saving can be gt0 lt0 or 0 T gt G TR govt budget surplus T lt G TR govt budget deficit T G TR balanced budget Thus our total saving or national saving is SYTR C TT G TR S Y C G We ve shown already that I Y C G Thus for the macroeconomy as whole S Rememberthat investment spending is an important component of long run growth In a closed economy what is the only way to increase our investment spending save more What insures that Saving Investment the financial system 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 There are many financial markets in an economy To keep things simple and clear we assume that there is just one such market We assume that there is one interest rate which simultaneously represents the to saving and the of borrowing The demand for loanable funds comes from The supply of loanable funds comes from Real Interest Rate Loanable Funds Real Interest Rate S of LF it D for LP 1 Loanable Funds 39 It Real Interest Rate S of LF it D for LP Loanable Funds Real Interest Rate SofLF D for LP 1 Loanable Funds i The Business Cycle I Some Basic Business Cycle Definitions FIGURE 96 The Business Cyble HeaIGDF Real EDP billions DI billions ul zaun dollars 2m dullarsl Real GDP Peak Tmugn Expansiun Recession Expansion Expansmn Recession Ewansiun 1m 1999 2500 2001 i An idaahmd humus yclu b quotimmune n run any 15992an Who decides if we are in a recession l The National Bureau of Economic Research NBER Their definition A 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 wholesaleretailtrade LENGTH OF PEAK THOUGH FlECESSION July 1953 May 1954 10 months August 1957 April 1958 8 months April 1960 February 1961 10 months December 1969 November 1970 11 months November 1973 March 1975 16 months January 1980 July 1980 6 months July 1981 November 1982 16 months July 1990 March 1991 8 months March 2001 November 2001 8 months i i What Happens during a Business Cycle The Effect of the Business Cycle on Boeing FIGURE 97 The Ellect OI lh e BusinessCycle on Boeing Heal GDP billions of Number of passenger amen shipped 2000 doliavsl Real GDP 511500 Racessron M 2m son Recession of 199m 55 39 i990 1992 i994 1896 tSQE 2000 2002 2m 2006 i990 i992 i994 i995 i998 2m 2m 2004 2006 lei Movemens in real GDP lb Movements in the number or pessengeveiyeyali Shipped by swemg 11 Learning Objective 93 What Happens during a Business Cycle The Effect of the Business Cycle on the Inflation Rate Inflall Irate percentage ange inlhisn r FIGURE 98 The Effect of theg39om recession on e Inflation Hale tncvease in nmon late m ma expans on 5m at me maven H f wecvease n mnaxmn dang me quot21me y Em ul me a ssss an Jan Jan Jan 0 Jan Jan Jan Jan 1an 1999 20m 20m 2002 2003 2004 What Happens during a Business Cycle The Effect of the Business Cycle on the Inflation Rate all percentage change FIGURE 9 9 ill Ihe consumer pune Index Thellmp gct o Recessions 6 onzlhe In ation Hate 0 Average inuaucn rate during the 2 Average muamn vale dunng me 2 months betave a recessmn begms mmhs a ar a recsssian ends 39 7 Learn ObJeC iVe 9393 W What Happens during a Business Cycle The Effect of the Business Cycle on the Unemployment Rate FIGURE 910 HbiN the39Fleoe ssi39oh ol 2001 Allect d lhe Unemployment Rate Unemployment rate 7 Recession begin March 2001 V gt Recession ends Navember 20m Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan 1998 1995 20m 20m 2052 2003 20011 2005 zone 2007 El What Happens during a Business Cycle The Effect of the Business Cycle on the Unemployment Rate Unemployment FIGURE 911 rate The Impactol39Fleoessions 7 onethe Unemployment Plate s 5 4 A age nemployment rate Average un during the 12 months betore during the t2 months alter recession begins a recession begins employment rate Learningomectve 93 What Happens during a Business Cycle Recessions Have Been Milder and the Economy Has Been More Stable Since 1950 A l Walla FIGURE 912 changain 4 e r m lealGDP Fluctuationsilnj eal GVDP7 1990 2006 I Learning Objective 93 Why Is the Economy More Stable The increasing importance of services and the declining importance of goods The establishment of unemployment insurance and other government transfer programs that provide funds to the unemployed Active federal government policies to stabilize the economy
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