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Inter Macroecon

by: Hallie Kuphal

Inter Macroecon ECON 3010

Hallie Kuphal
GPA 3.74


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This 37 page Class Notes was uploaded by Hallie Kuphal on Wednesday October 28, 2015. The Class Notes belongs to ECON 3010 at University of Wyoming taught by Staff in Fall. Since its upload, it has received 29 views. For similar materials see /class/230362/econ-3010-university-of-wyoming in Economcs at University of Wyoming.


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Date Created: 10/28/15
Chapter 14 Stabilization Policy tHl Hth Learning objectives In this chapter you will learn about two polic debates 1 Should policy be active or passive 2 Should policy be by rule or discretion Nwwnam VHl tHDl Question 1 Should policy be active or passive tUS Real GDP Growth Rate1960120014 195m 1955 19m 1975 19m 1935 mm 1995 2mm Arguments for active policy I Recessions cause economic hardship for millions of peop e 39 Th 1946 it is the continuing policy and responsibility of the Federal Government topromote full employment and production I The model of aggregate demand and supply Chapters 913 shows how scal an monetary policy can respond to shocks and stabilize the economy Change in unemployment during recessions tmugh peak Arguments against active policy 1 Long amp variable lags inside la the time between the shock and the policy response takes time m recognize d10dlt takes time m implementpolicy especially scal policy outside lag the time it takes for policy to affect eoonomy mpad felt may we mummy lmnd sdiangabaorapo venpaqmayendwdestdz lni tllriDl Automatic stabilizers definition policies that stimulate or depress the economy when necessary without any deliberate policy change They are designed to reduce the la associated with stabilization policy Examples income tax unemployment insurance welfare manic ini tHDl Forecasting the macroeconomy Because policies act with lags policymakers must predict future cond39tions Ways to generate forecasls Leade economic indicabors data series that fluctuate in advance of the economy Mamieconometric modes Largescale models with est39mated parameters that can be used to forecast the response of endogenous variables to shocks and policies 0 ti t on The LEI index and Real GDP 19705 annual Fermmage cnancc 19m i972 ism i975 1978 iaoo souvclz ofLEIdam tcaoino Economic lnoicalois m Con wzmlz Boom Real GDP The LEI index and Real GDP 19805 15 E in g 5 E n gaio E45 man 1582 mm woo woo iaan soun39lzofLEIdam Leading Economic lnoicalois no Con wzmlz Board ocai Goo The LEI index and Real GDP 19905 annual paicanlaoa cnanoa lean iaaz iaat iaae iaaa mm mm souvclz ofLEIdam caoing Economic lnoicalois m Con wzmlz Boom cal GDP Mistakes Forecasting the Recession oi1982 Unanyzlnymm 1m me pacth Forecasting the macroeconomy Because policies act with lags policymakers must predict future conditions The Jury s Out answer Question 1 It s hard to identify shocks in the data and it s hard to tell how things would have been different had actual policies not been used Looking at repent history does not clearly Question 2 mmmw be conducted by rule or discretion Rules and Discretion basic concepts IPolicyoonducted by rule Policymakers announce in advance how policy will respond in various situations and commit themselves to following through I Policy conducted by discretion As events occur and circumstances change policymakers use their judgment and apply whatever policies seem appropriate at the time 1 Distrust of policymakers and the political Arguments for Rules process misinformed politidans politicians interests sometimes not the same as the interests of society Arguments for Rules 2 The Time Inconsistency of Discretionary Policy def A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement Destroys policymakers39credibility thereby reducing effectiveness of their policies rm Hth Examples of TimeInconsistent Policies To encourage investment government announces it won t my income from capital d1 raise more lax revenue Nwwnaa ml lnDl Examples of TimeInconsistent Policies To reduce expected inflation the Central Bank announces it will tighten monemry policy But faced with high unemployment Central Bank may be temp ed to cut interestrates Examples of TimeInconsistent Policies Aid to poor countries is cont39ngent on fiscal reforms glven anyway because the donor countries don t want the poor counlIies citizens to starve Monetary Policy Rules a Constant money supply growth rate I advocated by Monebzris s I stabilizes aggregate demand only if velocity is stable I MV FY Monetary Policy Rules a Constant money supply growth rate b Target growth rate of nominal GDP growth when nominal GDP growth exoeeds target Monetary Policy Rules 5 Constant money supply growth rare in Target growth rate of nominal GDP c Target the inflation rate automatically reduce money growth whenever inflation rises above lh target ra Many counh39ies39cenh39al banks now practice in ation targeting but allow themselves a little discretion thi fihDi Monetary Policy Rules a Constant money suppl owt n mus b Target groiit39rh r5 or nominal GDP c Target the inflation rate d The w39l39aylor Rulequot Target Federal Funds rate based on inflation rate gap between actual amp fullemployment GDP Nwwnam Vlrll fHDl The Taylor Rule r 2 057r72 e 05GDPGap where i7 nominal federal funcb rate r7 iyrn real federal funds rate 7 y GDP Gap 100x the percent by which real GDP is below is natural rate The Taylor Rule r 2 057r e 2 e 05GDP Gap If 7r 2 and output is at its natural rate then monetary policy mrgets the real Fed Funds rate at 2 and the nominal ram at 4 For each onerpoint increase in ii men policy is automatically tightened to raise the real Fed Funds rate by For each one percentage po39nt that GDP falls below is natural rate mon policy aimmatically eases to reduce the Fed Funds Rate by 05 Does Greenspan follow the Taylor Rule Central Bank Independence Percent 1987 l99u 1993 1995 1999 mm I A policy rule announoed by Central Bank will work only if the announoement is credible I Credibility depends in part on degree of independence of central bank In ation and Central Bank Independence Avenge mm sm 2 lle mwww 7 IUmude m Awmzbl I quotMk 5 mmmmwmm s o 5119 Ivyquot15m mm a 3mm Chapter 11 Aggregate Demand Context Chapter 9 introduced the model of aggregate demand and supply Chapter 10 developed the IS LM model the basis ofthe aggregate demand curve In Chapter 11 we will use the IS LM model to 7 see how policies and shocks affect income and the inmrest rate in the short run when prices are fixed 7 derive the aggre am demand curve 7 explore various explanations for the Great Depression Policy analysis with the ISLM Model ye71rE WE LrV Pollcvmakers can affect macroecmomlc varlables with fiscal Dolle 6 andor r mmetary policv M We can use the ELM model to anal ze the effects of these policies An increase in government purchases 1i 5 curve snife rignt r 1 bv causng output is r income to rise r 2 This raises money emand causing me ll39iterest rate to rlse wnicn reduces investment so mennal increase in v 1 l5 smaller than lrMPC AG A tax cut Beca se consumers save labPC of the tax cut the mural boostin spending is smaller for AI manforaneoualAG r2 and me We T snife by MPC 17 lVlPC V 2 so me effece on r and v are smaller for a AT man for an equal AG AT Monetary Polic an increase in M 1 AM gt 0 shits the LMcurve down or to me rignt causing me ll39iterest rate to fall increases hi ch investment causing output is income to rise Interaction between monetag amp fiscal policy I Model monetary amp fiscal policy variables M G and T are exogenous I Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa I Such interaction may alter the impact of the original policy change The Fed s response to AG gt 0 I Suppose Congress increases 6 I Possible Fed responses 1 h 2 hold r constant 3 hold Y constant I In each case the effects of the A6 are different Response 1 hold M constant If Cmgress ralses G the 15cdrve 5hle rlght If Fed nolds M T constant tnen LM Fed lncreases M to curve doesn39t snltt snltt LM ccrve ngnt ReSulE Results ya 7 Y M Y r Y Ar I r 1 Ar 0 Response 2 hold r constant ng r keep r constant Response 3 hold Y constant To keep V constant Fed reduces M to shlft LM curve left Estimates of fiscal policy multipliers from the URI mECDEL DDOYEWL nude stimated E stimated Assumption about value of value of Fed holds money 060 4126 supply consbmt Fed holds nominal interest ram constant 13993 quot13919 CASE STUDV The US economic slowdown of 2001 ha 1 Real GDP growth rate 9472000 39 average annual 20 12 2 Unemployment rate Dec 2000 4 0 quotn Dec 2001 5 8 7n CASE STUDY The US economic slowdovvn of 2001 50me l atm l r mted In the signdamn 1 Falling stock prices From Aug 2000 m Aug 2001 725 Wee after 911 712 2 The terrorist attacks on 911 increased uncerminty fall in consumer amp business con dence Ham shocks realloedspendbg and shined we 15 tme Eli CASE sTuDv The US economic slowdown of 2001 The policy response 1 Fiscal policy large longsmrm mx cut immediam 300 rebate d16cks wending i creases aid to New York City amp the airline industIy war on terror39sm 2 Monetary policy F lowered is Fed Funds rate baget 11 times during 2001 from 65 to 175 Money growth increased inmrest rates fell CASE STUDV 39The US economic slowdovvn of 2001 erat s happening now I In the third quarter of 2003 Real GDP rew a an annual rate of 72 according to prelim gures u of Economic Ana I In its news release of July 17 2003 the NBER Business Cycle Dating Committee determined that the trough in economic activity occurred in November 2001 released by ysis What is the Fed s policy instrument What the newspaper says the Fed lowered inmrest rates by onehalf point todayquot paved The Fed conducted expmsionary monetary policy to shift the LM curve to the rightuntil the hmrest ram fell 05 poinE The Fed targets the FeueraFuntlsrate nnauntes a tamer wit it a 19 y and uses manetaly polity to shirt the m u ye asneeded to attain its tatgettate ISLM and Aggregate Demand I So far weVe been using the IS LM model to analyze the short run when the price level is assumed fixed I However a change in P would shift the LMcurve and therefore affect Y e aggregate demand curve 0 chap 9 captures this relationship between P and Y Deriving the AD curve Intuition for slope of AD curve TP 2 lMP M shins left Tr l1 i Y Monetary policy and the AD curve L MIP The Fed can increase aggregate demand TM 2 LM snrfm right 2 lr 2 TI 2 T V at eacn value of P Fiscal policy and the AD curve Expansionaw fiscal policy is andor l T rncreases agg dernand l T 2 Tc 15 snrfm ngnt T V at eacn value of P The SR and LR effects of an IS shock S LMlPl Is 5 7 Y LPAS p SPAS Sfquot V Y The SR and LR effects of an IS shock r L AS Wm S p LPAS p SPAS ADZ v The SR and LR effects of an IS shack I L AS MP 13 Over time 39 Cri a iz lf i quot W s SPAS to move down Pl I WS p to increase which causes mOV DZ V The SR and LR effects of an IS shock I LPAS The SR and LR effects of an IS shock L Tl39lls process continues a longrrurl qulibnum With V V Oer time 7 y p gradually falls which causes S P WAS ms to mme down 5 MP to increase PZ A52 pZ SPASZ Much causes LM to move down 02 DZ i7 V V y The Great Depression a Uriemaloymenl rlghl scale E E Femem mlahnr rm hllllnrls m i 958 dnllars A Real GNP leir scale 1929 1931 1933 1935 my mu The Spending Hypothesis Shocks to the IS Curve I asserts that the Depression was largely cLle to a fall in the demand for goods amp services leftward shift of the IS curve I Caused by stock market crash fall in investment and contractionary fiscal policy I evidence output and interest rates both fell which is what a leftward IS shill would cause The Money Hypothesis A Shock to the LM Curve I asserts that the Depression was largely cLle to huge fall in the money supply and prices leftward shift of the LM curve I Caused by transfer of wealth from debtors to creditors higher r from Fisher effect I evidence M1 and Pfell 25 during 192933 Why another Depression is unlikely Federal deposit insurance makes widespread b Policymakers or their advisors now know much e a acroeconomics The Fed knows better than to let M fall much especially during a contraction Fiscal policymakers know better than to raise taxes or cut spending during a contraction ank failures very unlikely matic stabilizers make scal policy expansionary during an economic downturn Chapter 12 Aggregate Demand in the Open Economy The MundellFleming Model Key assumpbbn Small open economy with perfect capiml mobility r r 39 Goods market equilibr39ummihe 5 curve y Cyer Ir 6 NXe where e nomnal exd1mge ram hams The 3 curve Goods Market Eq m y CYrTIrGNXe The IE Cul ve l5 dawn for a glven value of r Intultlon for the slope Le TNXTY The LM curve Money Market Eq m MP LrY The tWcurve l5 drawn for a glven 6 LM value of r ls vertlcal because glven r there l5 only one value of V a demand With supply regardless of e Equill rlum in the MundellFleming model V CVrT1rGVe MP 14mm bx ejqulllhnum exchange rate Equlllbrlum level at l EDmE Floating amp fixed exchange rates In a system of floating exchange rates e is allowed m fluc ate in response to changing economic conditions In contrast under fixed exchange rates th entral bank trades domestic for foreign currency at a predetermined price We now consider fiscal monetary and trade policy first in a floating exchange rate system then in a fixed exchange rate system increases V snifting 15to tne rignt Results As gt 0 AV o Fiscal policy under floating exchange rates Lessons about scal policy V CV e T 1r 6 Ne In a small open economy with perfect capital MP ms y mobility scal policy is utmrly incapable of 39 affecting real GDP 9 LM39 At any given value of e a fiscal expansion Crowding outquot closed economy Fiscal policy crowds out investment by caus39ng the interest ram to rise 5 lupew economy Fiscal policy crowds outnet exports by caus39ng the exchange rate m appreciate mum Mon policy under floating exchange rates V CVr MP T1r GNXe a Y An increase in M snifm LW rignt because V must rise to restore edrn in the money mark t LMLMZ39 Results AEltO AVgtO Lessons about monetary policy Monetay policy affecE output by affecting one or m e componenE of aggregate demand closed economy TM tr T1 Ty small open economy TM ls Tm Ty Expansionay monetary policy does not raise world aggregam demmd it shfts demand from foreign m domestic products us e increases in income md employment at home come at the expense of loses abroad Trade policy under floating exchange rates Ir GNe J V CVrT MP Lr At anv given value of e a tariff or quota reduces lmDOl E increases Mg and snifts 15 to the rignt Results Aegt0 AVO Lessons about trade policy import restrictions cannot reduce a trade deficit Even tnoug x is uncnanged there is less trade a the trade restriction reduce lm orB e tine exchange rate appreciation reduces exporB tess trade me ns fewer galns from trade39 strictions on specific product irnport re do estic e rn but destrov pbs in export p Hence irnport restrictims ernplovrn t s save pbs in industries tnat produce those products lng sec ors ml ease total Worse vet irnport restrictions create sectoral snife wnicn cause frictional unemployment 397 I Fixed exchange rates 39i iscal policy underfixed exchange rates Under a sxstern of hxed exchange rates the 39 countrv39s centra bank stands readv to buv or seH e ornestrc currencv tor torergn currehcv at a predetermhed rate Under xed rates I In the context of the MuhdeHrFtemhg mode 39 ver Under Hoaung rates tscat Qohcy rnettecuve atc angm t1 t sca Qohcy S 1 the centra bank Shth the LM curve as effect ye at changth required to keep e at rm preahhouhced rate output e Thrs Svatem xes the nornrnat exchange rate Is In the tong run when pnces are exrbte R 15 the tea exchange rate can mov em 5 even rt the nornrnat rate rs hxed AS 0r AV gt 0 x z 4 1 39 n 0411511an 39 x lirade policy under fixed exchange rates U U 2 U U 5 ex 152quot Resu E Is 15 As 0 AV 0 a CASE STUDY MF summary 0f pulicy effects The Mexican Peso Crisis msmriw 39CASE STUDV The Mexican Peso Crisis The Peso Crisis dldn just hurt Mexico I U goocb more expensive to Mexicans US firms lost revenue Hundreds of bankruptcies along USMex border a N us Centsner Mexican Pesn I Mexican assets worth less in dollars Affected retirement savings of millions of US citizens was mmva Understanding the crisis Understanding the crisis In the early 1990s Mexico was an attractive place for foreign investment es During 1994 political developm I Mexico39s central bank had repeatedly increase in Mexico s risk premiu promised foreign investors that it peasant uprising in Chiapas would not allow the peso39s value to fall assass39nation of leading presidential candidate so it bought pesos and sold dollars to rop up the peso exchange rate I These events put downward pressure on the p o ems caused an m 6 momer fad I Doing this requires that Mexico39s central The Federal Reserve raised US Interest rams bank have adequate reserVes of dollars several times during 1994 to prevent US Did in in ation So Ar gt 0 39 Dollar reserves of Mexico s central bank 6 quot the disaster 6 quot Dec 20 Mexico devalues the peso by 13 December 1993 xes e at 25 cenE instead of 29 cents August 17 1994 Investors are dwcked I I I and realize the central bank must be running December 1 1994 out ofreservei December 15 1994 stors dump their Mexican asses and pull their capiml out of Mexico Dec 22 central bank s reserves nearly gone It abandons the xed rate and les 2 oat In a week 2 falls another 30 During 1994 Mexico s central bank hid the fact that its reserves were being depleted The rescue package 1995 US amp IMF set up 50b line of credit to provide loan guarantees to Mexico39s govt I This helped restore confidence in Mexico reduced the risk premium I After a hard recession in 1995 Mexico began a strong recovery 39om the crisis Floating vs Fixed Exchange Rates Argument for floating rates I allows monetary policy to be used to pursue other goals stable growth low inflation Arguments for fixed rates I avoids uncertainty and volatility making international transactions easier I disciplines monetary policy to prevent excessive money growth amp hyperinflation mantra Large between small and closed Many countIies r includ39ng the US r are neither closed nor small open economies A large open eoonomy is in between the polar cases ofclosed amp small open Consider a monetay expansion Like in a closed economy gt 0 lr TI though not as mud1 Like in a small open economy AM gt 0 la Tm though not as much WWS WV w mmmmmm n mmms u f vMmekexmmmeWadebaanoe BHM t W T counmasaradesumm 391 HNXltUJ counnhasaradede cit 1 wmmmmmwm INelcapiLaMut ows 4 neloul owo oanabeunds hr 39 or WNW netpumhaseso oreignassels NJ W IWhengtLmunlmsaneHender Wm WM IWhensqmunmmanelmmwer 1 l W 05 MI WWI H Anotherimporlanlidenlily P 341 quot NX Y CM Implbs Saving andlnveslmenl f inaSmalIOEenEconomy TheSupplyofLoanabIeFunds IAn openemnomy version of the loanable I fundsmodelfromchapter3 Indudes many of the same elem ems MM H production function YYFKL atioal vig I H oonsumptionfunction CCYT investmentfunction I Ir quotexogenous polity variables 65 7 Investment l I Assumptions 9 pm ows The Demand for LoanableFunds a domesticMoreign bondsare perfect substitutes I same risk maturity etc b perfect capital mobility no restric onson international trade in assets I 39 I but the exogenous 0 economy IS small world interest rate cannotaffectthe world interestrate denoted r I determlnes the l l i country s level of investment downwardsloping funch39on r Investment is stilla of the interest rate aampbimpyrr cimplies r is exogenous If the economy were closed But in a small open economy me exogenous d1e interest world 39quotmreSt rate would ad39 St to NX uate 1 investment and saving c 1r 1r m 5 I 1 5 I 5 Two experiments 1 Fiscal policy at home z x 1 Expansionary fiscal policy at home An n ease In G or decrease in r MK2 2 Expansionary fiscal policy abroad reduces saving 3 quotMW ResulE AI 0 ANXASlt0 10 1 5 I 2 Fiscal POIiCy abFOad The nominal exchange rate Expansionary NX r sca poncy 2 e nominal exchange rate abroad raises lg the relative price of the world r I domestic curren 39quotte39esnate39 1 in terms of foreign currency Reillls eg Yequot Per Dollar AI lt 0 10 ANX rAI gt0 5 I 16 Exchange rates as of June 6 2002 South Africa The real exchange rate E real exchange rate the relative prioe of Me lowercase domestic goods EH9 in terms of foreign goods Greek epsilon eg Japanese Big Macs per US Big Mac Understanding the units of E e x P p x Yen xunitUSgoods Yen unit Japanese goods E 7 Yen unit us goods Yen unit Japanese goods unit Japenese goods unit us goods Big Mac Example one good Big Mac price in Japm 2 o Yen A price in USA 3 P 2 5 l quot nominal exd1ange ram 2 s 120 Yens n 195 Iems a U 5 Big Mac IS Worm 7 5 Japanese Big Macs How NXdepends on s39 TE 2 US goods become more expensive relative to foreign goods 2 lEX TIM 2 lle The net exports function reflects this inverse relationship between NXand E The NXcurve forthe US The NX curve for the US E At high enough values of E US goods become so expensive that we export so US net When a is exports will I h relatively low be high esst anrt S goods are we lmpo relatively inexpensive AIME me quotX mus2 0 M 5 Net Exports and the Real Exchange Rate 19752002 How 5 395 determlned E W E 39 The acoounting identity says NX 57 I E 1 39 We saw earlier how 57 I is determined 5 5 depen s on domestic factors output a l 975 lean 1985 WEB 1995 mm el expuns lelt scale eal exchange late quotgm scale fiscal policy variables etc I is determined by the world interest rate rquot 39 So E must adjust to ensure III if Ir Neither Snor I depend on s so the ne capital outflow curve is vertical 1 s adjusE to equate NX 1mg How 5 is determined 5 5 IVquot US net exporE Interpretation supply and demand in the foreig n exchange market 5 5 a rquot outflow 57 I Ax rNAern mopr The net capital out ow 57 139 1m 2 is the supply of dollars to be Ax 39nvesmd abroad Three experiments 1 Fiscal policy at home 1 Expansionary fiscal policy at home rquot 5r a H 2 Expansionary fiscal policy abroad 3 Trade policy to restrict imporls Mr S 2 Fiscal policy abroad 4 Trade policy to restrict imports W At any given value or S r I s 7 HQquot 5 an import quota s demand for dollars snrrm I rig39rt ms 1mg Trade Dolle doesn39t affect Her 1 so 3 quotx capital ows and the a 2 supin ord ll rs N rernarns m The Determinants of the n 4 Trade policy to restrict Imports Nomhal Exchan e Rate 39 Start with the expression for the real Rem5 g s e I exchange rate P a demand E X increase Aw 0 supply xed 39 Solve It forthe nominal exchange rate I lt 1mgZ P Dollcv I e g P AEXlt 0 r rise in s r rNAern The Determinants ofthe Nominal Exchange Rate I So e depends on the real exchange rate and the price levels at home and abroad I and we know how each of them is determined The Determinants of the Nominal Exchange Rate In percentages for a given value of s the growth rate of e equals the difference between foreign and domestic inflation rates In ation and nominal exchange rates Tamm me in quotannual g 39 I mm c mm at 7 e Mmequot 5 ry be 4 mgrwlzsm a y 3 M lmm 5quotquot 2 m 1 is 1 S Mumquot 2 New 3 Us My 1 2 2 4 5 a 7 a mum dmevential Purchasing Power Parity PPP 39 A doctrine that states that goods must sell at the same currencyadjusted price in all countries 39 Reasoning arbitrage the law of one price Purchasing Power Parity PPP ppp exp 3 Costbfa bask etof t foreign 4109 5 ln rerercn cm enc y Cost of a basket of master a ba ketef domestic goods l dome ch yd in foreign currencv acmesnc currency 39 Solve fore e PP 39 PPP implies that the nominal exchange rate between two countries equals the ratio of the countries39 price levels Purchasing Power Parity PPP and the NX curve is horizontal 5 a 1 Under PPP changes ln5 1have n impact on s or e s 1 NX X Does PPP hold in the real world No for two reasons 11nmrnational arbiuage not possible nontraded goo s hansportation cose 2Goods of different counuies not perfect substitutes N0ned1elessPPP is a useful meory It39s Simple amp intuitive In me real world nominal exchange rates have a tendency toward their ppp values over me long run 39The US as a large open economy I So far we39ve learned longrun models for 0 ex reme c s closed economy chapter 3 small open economy chapter 5 I A large open economy lke the USis in between these two extremes I The analysis of policies or other c nges in a arge open econom mixture of the resulls for the closed amp small open economy cases exogenous y i a I Chapter 9 An Introduction to Economic Fluctuations 39 Real GDP Growth in the United States Peitent changem immmuansvs Averagegmwth ea er rate 35 4 19m 1955 197a ms son 1955 199a 1995 mm Nnnvrnu Time horizons I Long run Hices are exible and respond to changes in supply or demand Short run many prices are sticky in Classical Macroeconomic Theory what we studied 1 diapbers 36 Output is determined by the supply side supplies of capital labor technology Changes in demand for goods amp services i C I 6 only affect prices not quantities Rice exibility is a crucial assumption I The economy he laVes quotWCquot 1 so classical theory applies in the long run d erently when p es are sti I 9 When Prlces are St39CkY quot aggregate demand and supply Bum and employmenf also dePerld 0quot I the paradigm that most mainstream I demand for goods amp serVIcesl whlch Is 39 economists at policymakers use to think affected b about economic fluctuations and policies r i to stabilize the economy fiscal policy 6 and T I shows how the price level and aggregate H l i d monetary policy M other factors like exogenous changes in C or I mnnvvn 1 I output are determine how the economy39s behavior is different in the short run and long run Aggregate demand I The aggregate demand curve dwows the relationship between the price level and the quantity of output demanded I For this chapter39s intro to the ADAS model we use the Quantity Theory of Money to derive aggregate demand I Chapters 1012 develop the theory of aggregate demand in more detail The Quantity Equation as Agg Demand I From Chapter 4 recall the quantity equation M V P Y and the money demand function it implies P where V 1k velocity I For given values of M and V these equations imply an inverse relationship between P and Y39 The downwardsloping AD curve An increase in the a money balances MP ausin a decrea e in demand for goods amp e5 AD Shifting the AD curve p An increase in the money Supply we the AD curve to the right 4 AD V Aggregate Supply in the Long Run I Recall from chapter 3 In the long run output is determined by factor supplies and technology 7 F7 I 7is the fullemployment or natural level of h the utput the level of output at whic economy39s resources are fully employed quotFull employment39means Mat mempbyment equals its natural raDe The longrun aggregate supply curve P MAS Th V e is verticai atthe fully mployment level of output Longrun effects of an increase in M P L Ari increase ll l Mshlfts the AD curve 5 to the right in the long run 71 the price level A02 AD but leaves V output the same Aggregate Supply in the Short Run I In the real world many prices are sticky in the short run I For now and throughout Chapters 912 we assume that all prices are stuck at a predetermined level in the short run nd that rms are willing to sell as much as their customers are willing to buy at that price level I Therefore the shortrun aggregate supply SRAS curve is horizontal The short run aggregate supply curve a The SRAS CU39V is horizontal The price level a Jl SRAS poyere de mard Shortrun effects of an increase in M t u when prices are an increase smoky in aggregate demand causes output to rise From the short run to the long run Over time prices gradually become unstuck When they do will they rise or fall kill remain constant This adjustment urprius is whatm H1 c nves 5 Hum y tu its lungrun quililzriwn The SR amp LR effects ofAM gt O P U 5 B l leW oft39 run eq rn a after Fed inereasesM B 5 A I 402 40 l V Demand Shocks A demand Shock alters the demand for goods and services by households government firms or foreigners Examples of demand shocks IThe Fed increases the money supply IConsumers become pessimistic about the future INAFI39A lowers trade barriers and increases regional trade Supply Shocks a the prices that rms c also called price shocks E n A supply shock almrs production costs harge Examples of ilpply d10ds Bad weather reduoes crop yields pushing up food rioes Workers unionize negotiate wage increases New environmental regulations require rms m I c 8 m i o o n a or help cover the cose of com lianoe Faster computer processor is discovered n gher prioes m CASE STUDY The 1970s oil Shocks I Early 19705 OPEC coordinates a reduction in the supply of oil I Oil prices rose In in 1973 68 in 1974 16 in 1975 I Such sharp oil price increases are supply 5 ks because they significantly impact production cosis and prices CASE STUDY The 1970s oil Shocks The Oil price Shock shite SRAS u causing output and employment to fall h U25 In absence of further rlce al Nal oyrnel39lt z CASE STUDY The 1970s oil Shocks predicted ettece of the Oil price shock lnflatlon output l nempicymenti u r and then a gaduai recovery iv 3 W76 W75 im Change in all piices ieii Smle oimislion m pl m scale 4 Urerllplayrllem isle m ScalE nuan i CASE STUDY The 1970s oil Shocks Lam 1970s Aseconom was recovering oil prices shot up 2 ca Supply shock CASE STUDY Stabilization olic The 19805 oil shocks P y 1980 m m I def policy actions aimed at reducing the A favorable w seventy of shortrun economlc fluctuations supply shockquot m all Example Using monetary policy to 1m oombat the effecis of adverse supply in oil prices 2m 4 shocks the model 3 2 would predict 4 in ation a1d l 2 m lee m5 lees l unemployment cmnge ln ml lell scale fell Marlowe pl llgnscalel Stabilizing output with Stabilizing output with monetary policy monetary policy A 5 But the Fed P U 5 supply Shock accommodates movest e we raiSil l a ezonnomy to gas 9 99 F c SPAS Z A SPAS A resuls 402 AD P is permanently AD nlgnel but v 39 V remall ls at ls tulle V 2 employment level l Z fr 39il Chapter2 The Data of Macroeconomics f Learning objectives I 391 In this chapter you will learn about I Gross Domestic Product GDP r I the Consumer Price Index CPI I the Unemployment Rate If quotr 1 u 39l A vy I r quot I Gross Domestic Product Two definitions Total expenditure on domesticallyproduced final goods and servioes Total inoome earned by domesticallylocated factors of production Published by the Bureau of Eoonomic Analygis BEAT r Why expenditure income 39 i In every transaction the buyer s expenditure t v becomes the seller s income n llrrl GDPpurpmnn Wdallm UIU 30000 x zupuo ltl fll v my r r71 r xvi r r r Hill hurnlpnmlmi troll dun lllvlllfnrmu trump frrmvrlrynxulnl l rlrrl Urpu uruu Wurll lllu Wm 39 Wm l llll Will illill resu Who lilo WED will ZIJOD Your i Value added 1 definition Afirm s value added is the value of its output minus the value of the intermediate goods 1 r the firm used to produce that output Exercise Problem 2 p38 I A farmer grows a bushel of wheat and sells it to a miller for 100 The miller turns the wheat into flour and sells it to a baker r 300 I The baker uses the flour to make a loaf of bread and sells it to an engineer for 600 I The engineer eais the bread Compube 7 am aa edateac stage oproauction GDP Final goods value added and GDP I GDP 100 200 300 600 I GDP sum of value added at all stages of uction I GDP value of final goods and services I The value of the final goods already includes 5 so including intermediate goods in GDP would be doublecounting The expenditure components of GDP 0 consumption 0 investment 0 government spending 0 net exports Consumption C the value of all goods ht b def I dLrabe 900 and services boug y laSt a long time households Includes ex an howe appllances 17077 Ie last a short tlme ex food clothlng Saw1 5 Work done for consumers ex dry cleanlng alr travel US Consumption 2001 billions Z g Consumption 70645 692 Durabls 8583 84 Nondurabls 20551 201 Senices 41511 407 Investment I def spending on goods bought for future use Includes business fixed investment spending on plant and equipment by firms residential xed in vestmen spending on housing uniis by consumers inventoryinves n the change in the value of all firms39 inventories US Investment 2001 Investment vs Capital 39 Capital is one of the factors of production At any given moment the economy has a certain overall stock of capital billions Invstment 163349 160 Businss xed 12460 122 Rsidenu39al xed 4463 44 Inventory 584 06 of G 39 Investment is spending on new capital Government spending G I G includs all government spending on goods and services I G excludes transfer payments eg unemployment insuranoe payments More examples because they do not represent spending on goods and services a person s wealth a person s saving z of people with z of new college ooliege degrees graduates the govt debt the govt budget de cit Government spending 2001 Net eXPOI tS NX EX IM 00 of def the value of total exports EX billions DP minus the value of total imports IM Gov spending 18395 180 19602000 Federal 6157 60 Nondefense 2155 21 Defense 3990 39 5 State amp local 12238 120 An important identity Y CIGNX where Y GDP the value of total output C I G NX aggregate expenditure Yuul 5 pmquot 7 mm mm 110quot Gm 1mm mam us cammm mu 21531 sawmill we 2m l 7 m Ulimlblc uedg m x z m 5mm 1 927 0 H255 lnvurmcm Namath NA MWquot nmmminx11rummm 1mm MWquot cmmmm mm m Real vs Nominal GDP 39 GDP is the value of all final goods and duced services pro 39 Nominal GDP measures these values prices using current eal GDP measure these values using ear 39 R the prices of a base y Real GDP controls for inflation Changes in nominal GDP can be due to changes in prices changs in quantities of output produced Practice problem part 1 2001 2002 2003 P l Q P Q P l Q goodA 30 l 900 31 l1000 35 l1050 goodB 5100 192 102 200 5100 205 I Compute nominal GDP in each year I Compute real GDP in each year using 2001 as the base year Answers to practice problem part1 Nominal GDP mapv95 112 From same year 2001 46200 30x900 100x192 2002 51400 2003 58300 Real GDP muUpveam yeaquot gs 012001 P5 2001 46 2002 2003 52000 330 x 1050 100gtlt 205 US Real amp Nominal GDP 19672001 n 1365 lam 1975 man was man 1995 mun NGDP miimns m 3 GDP miimns meals 3 GDP Deflator I The inflation rate is the percentage increase in the overall level of prices I One measure of the price level is the GDP Deflator defined as GDP de ator 100 XW Real GDP Real GDP 2001 2002 2003 I Use your previous answers to corn ute the GDP deflator and inflation rate in each year Answers to Real GDP Chainweighted Real GDP I Over time relative prices change so the base year should be updated periodically I In essence chainweighted Real GDP updates the base year every year Consumer Price Index CPI I A measure of the overall level of prices I RJblished by the Bureau of Labor Sta Istics BLS I Used to 7 back changes in the typical household39s cost of living 7 adjust many conh39acls for inflation 39 LAS llow comparisons of dollar figures from different years um t whom tom fl W wer w w new in t l lilo run on mu on in 9va was not Howthe BLS constructs the CPI 1 Survey consurrlers to determine composition of the typical consumer39s basket of goods 2 Every month collect data on prices of all iterrs in the basket oompute cost of basket 3 CPI in any month equals Cost of basket in that month Cost of basket in base period 100x Exercise Compute the CPI The basket contains 20 pizzas and 10 compact discs prics For each year compute pizza CDs the cost of the basket 2000 10 15 the CPI use 2000 as 2001 11 15 the base year 2002 12 15 the inflation rate 39om 2003 13 15 the preceding year answers cost of inflation basket rate 2000 350 1000 na 2001 370 1057 57 2002 400 1143 81 2003 410 1171 25 n 3 The composition of the CPl s basket 5m 5 I Recteatlan I Educatan u Cammunlcatlan Othel quads and easons w y the CPI may overstate inflation Substitution bias The CPI uses fixed weights it cannot re ect constmers39 ability to substitute mwar goods whose relative prices have fallen Inboduction of new goods The introduction of new goods makes constmers better off and h effect increases the real value of the dollar But itdoes not reduce the CPI because the CPI uses xed weights Unmeasuted changes in quality Quality improvemens increase the value of the dollar but are often not fully measrred The CPl s bias I The Boskin Panel39s best estimate The CPI o the true increase in the cost of living by 11 per year I Result the BLS has re ned the way it calculates the CPI to reduce the bias I It is now believed that the CPI39s bias is slightly less than 1 per year CPI vs GDP deflator prices of capital goods included in GDP deflator if produced domestically excluded 39om CPI prices of imported consumer goods included in excluded 39om GDP deflator the basket of goods CPI ixe GDP deflator changes every year mm mm Two measures of inflation GDP defarc Categories of the population I employed working at a paid job I unemployed not employed but looking for a job I laborowe all employed plus unemployed persons I not in the labor force not employed not looking for work Population 2097 million 15 years and older Not in labor rm 688 million Employed 1552 million m jed 57 miImrr Labarfm te Two important labor force concepts I unemploymentrabe percentage of the labor foroe that is unemployed I labor force participa on rate the fraction of the adult population that participates39 in the labor foroe I Published by the Bureau of Labor Sta 39BLS mam mm W w mmwxmm W MW m m W wow M Okun s Law I Employed workers help produce GDP while unemployed workers do not So one would e ect a negative relationship between unemployment and real GDP I This relationship is clear in the data 041 i t wan m ivy win we win 1960 m mu ma non v okun s Law Dkun39s Law states thata percent Mung cm decrease in mxealGDP unempluymentis assuciated With WEI percentage puints er additiunal grthh lri real GDP 3 Chang m mzmplaymznt m


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