Principles of Macroeconomics
Principles of Macroeconomics ECON 1010
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mg E 9 i I O 4 Ivers Un gt 0 390 o D 0 o n inflation is a sustained continuous increase in the price level It does not refer to a onceandforall increase in prices The opposite is termed Inflation deals with the increase in the average of prices and notjust significant increases in the price of a few goods It is measured using the CPI Over the past sixty years prices have risen on average about 5 per yeah occurred in the 19th tury and briefly in the 20th cen century In the 1970 s prices rose by 7 per yeah From 1990 to 1998 prices rose about 2 per year Since it concerns first and foremost the value of the economy s medium of exchange it is the prime concern of the Fed To understand the cause of inflation we must understand the A gt77 q r M vi J9 n 7 t A z y i sy i w 3 is controlled by the Fede aliReserve Banks Through instruments such as open market operations the Fed directly controls the quantity of money suppHed has several determinants including ltgt interest rates ltgt price level in the economy ltgt income levels The amount of money people choose to hold depends on the prices of the goods and services The value of dollar is inversely related to the price level ltgt the higher are prices the less a single dollar buys In the long run the overall level of prices adjusts to the level at which the demand for money equals the supply Mane Su I Mane Demand and i39quiiiiiium PI39IJCIB Level Value of Money Supply Price Money Level High LOW Equilibrium Equilibrium Price Level Value of Money LOW Money Demand H1 gh The Fed could inject money monetary injection into the economy by buying government bonds Results would be ltgt The supply curve shifting to the right ltgt The equilibrium value of money decreasing ltgt The equilibrium price level increasing This process is referred to as 739 3 n t an 339 u n u m K r r 2 1 3mm pp A ml 1 3 twin will 9 y thk l v has A s w r mama s A a l The Effects of Monetary Injection Value of Money Price M31 Level Money Demand QFixed The Effects of Monetary Injection M31 Price Value of Money The Effects of Monetary Injection 1 Value of MS Price Money Level High A The Effects of Monetary Injection The Effects of Monetary Injection a The quantity of money available in the economy determines the value of money Growth in the qua of money is the l 5 l l 57 In the long run the quantity of money affects only nominal variables in the economy 545 a An increase in the rate of money growth raises the inflation rate but eg real GDP employment real wages and real interest rates changes for real variables is called v U W k t 5311557119 Such irrelevance of monetary a r it 99 51L trad 37 prices nominal interest rates nominal GDP How many times per year is the typical dollar bill used to pay for a newly produced good or service The refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet Where V Velocity P the average price level Y the quantity of output M the quantity of money 1 Rewriting the equation gives the 1 l i it D K F r 5i 7 E I E In 397 4quot xx 2 r n A i 31quot xquot igHii 7 l 1i it gr 9 Xi j U 131 0141 gtz Ly U want J U The velocity of money V is relatively stable over time A proportionate change in the nominal value of output PY is related to changes in the quantity of money M by the Fed Because money is neutral money does not affect output Y Therefore changes in the money supply M that induce parallel changes in the nominal value of output PY are also reflected in changes in the price level since they do not affect real output Y When the Fed increases the money supply rapidly the result is a higher rate of inflation is inflation that M lm i 39 l W 4 l exceeds 50 percent per month a Hyperinflation in some countries is caused because the government prints too much money to pay for their spending ltgt Financing government expenditure by printing money is called n l l Financing government expenditure by printing money increases prices for everyone reducing their spending powerjust as a tax to finance the spending would This is called an The inflation ends when the government institutes fiscal reforms such as cuts in government spending 1 Nominal Interest Rate I Real Interest Rate r Inflation Rate 3 Over the long run a change in the money growth ueto should not affect the Real Interest Rate r d money neutrality thus the U n F 1 1 I V 11M 373 2 74x r 2 73 M 523 42 a 1 its 1 24 5 7s 139 7 r 1 lquot it llSci 33 l v5 L 22 J J s l 52 13 l Ky UtJ 3 USEll JSEJl J h H 7 z llrl J L s5a When the Fed increases the rate of money growth the result is both a high inflation rate and a higher 74 pa u z nominal interest rate This is called the a Fallacy Inflation reduces individuals incomes and causes living standards to decline Fact One person s inflated price is another s inflated income Unless incomes are fixed in nominal terms the higher prices paid by consumers are exactly offset by the higher incomes received by sellers The four major costs of inflation are ltgt Unproductive activities provoked byin a on ltgt Increased variability of relative pnces ltgt Unintended changes in tax liabilities ltgt Arbitrary redistribution of wealth 3 These include ltgt shoeleather costs ltgt menu costs ltgt confusion and inconvenience a All of these reasons lead to people pursuing unproductive activities in order to avoid the effects of in a on a During times of rising prices not all prices are increased at the same time It then becomes difficult to know exact relative prices as prices change irregularly 1 This makes it difficult to make spending decisions that maximize the people s standards of living a With inflation nominal incomes rise yet real incomes do not Taxes do not differentiate between nominal and real income so income increases are treated as real gains a With progressive taxation rising nominal incomes are taxed more heavily even though people are no be ero With unexpected inflation wealth is redistributed between net monetary debtors and creditors This may result in wealth transfers that would not otherwise be acceptable ltgt Recall the Fisher Effect People on fixed incomes seniors on pension for example are also made worse off l J l3 lw sl 739L ll K Jt J J C1J Al Inflation refers to continuously increasing price levels Price levels are determined in the long run by money supply and money demand The more scarce money is the higher it s value and the less money will be needed to buy things prices are lower Higher rates of money growth cause higher inflation rates Money does not affect real variables neutrality Higher inflation rates cause higher nominal interest rates the Fisher Effect The true costs of inflation include redistribution of income tax distortions changes in relative prices and unproductive reactions to inflation Burgess Principles of Macro Economics Econ 1010 1 Topic 6 Measuring the Cost of Living 1 Introduction 2 The Consumer Price Index 1How The Consumer Price Index is Calculated 2 Other Price Indexes 3Problems in Measuring the Cost of Living 4 The GDP De ator versus the Consumer Price Index 3 Correcting Economic Variation for the Effects of In ation lDollar Figures from Different Times 2 Indexation 3Real and Nominal Interest Rates 4 Conclusion Burgess Principles of Macro Economics Econ 1010 2 The Consumer Price Index o The consumer price index CPI is a measure of the overall cost of the goods and services bought by a typical consumer oThe Bureau of Labor Statistics reports the CPI each month oIt is used to monitor changes in the cost of living over time When the CPI rises the typical family has to spend more dollars to maintain the same standard of living Burgess Principles of Macro Economics Econ 1010 3 21 How the Consumer Price Index Is Calculated There are 5 steps that the Bureau of Labour Statistics follows to compute the CPI Step 1 Fix the Basket Determine what prices are most important to the typical consumer The Bureau of Labor Statistics BLS identifies a market basket of goods and services the typical consumer buys The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services Step 2 Find the Prices Find the prices of each of the goods and services in the basket for each point in time Burgess Principles of Macro Economics Econ 1010 4 Step 3 Compute the Basket s Cost Use the data on prices to calculate the cost of the basket of goods and services at different times Step 4 Choose a Base Year and Compute the Index Designate one year as the base year making it the benchmark against which other years are compared Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100 The resulting number is the consumer price index Step 5 Compute the In ation rate The in ation rate is the percentage change in the price index from the preceding period The in ation rate is calculated as follows In ation rate in year 2 CPI in year 2 CPI in year 1 x 100 CPI in year 1 Burgess Principles of Macro Economics Econ 1010 22 Other Price Indexes oThe BLS calculates other prices indexes oThe index for different regions within the country oThe producer price index which measures the cost of a basket of goods and services bought by firms rather than consumers The CPI is an accurate measure of the selected goods that make up the typical bundle but it is not a perfect measure of the cost of living Burgess Principles of Macro Economics Econ 1010 6 23 Problems in Measuring The Cost of Living 1 Substitution Bias oThe basket does not change to re ect consumer reaction to changes in relative prices oConsumers substitute toward goods that have become relatively less expensive oThe index overstates the increase in cost of living by not considering consumer substitution Burgess Principles of Macro Economics Econ 1010 2 Introduction of New Goods oThe basket does not re ect the change in purchasing power brought on by the introduction of new products oNew products result in greater variety which in turn makes each dollar more valuable oConsumers need fewer dollars to maintain any given standard of living Burgess Principles of Macro Economics Econ 1010 3Unmeasured Quality Change olf the quality of a good rises from one year to the next the value of a dollar rises even if the price of the good stays the same olf the quality of a good falls from one year to the next the value of a dollar falls even if the price of the good stays the same o The BLS tries to adjust the price for constant quality but such differences are hard to measure Burgess Principles of Macro Economics Econ 1010 4 The substitution bias introduction of new goods and unmeasured quality changes cause the CPI to overstate the true cost of living oThe issue is important because many government programs use the CPI to adjust for changes in the overall level of prices oThe CPI overstates in ation by about 1 percentage point per year Burgess Principles of Macro Economics Econ 1010 10 24 The GDP De ator versus the Consumer Price Index Economists and policymakers monitor both the GDP de ator and the consumer price index to gauge how quickly prices are rising There are two important differences between the indexes that can cause them to diverge oThe GDP de ator re ects the prices of all goods and services produced domestically oThe consumer price index re ects the prices of all goods and services bought by consumers oThe consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year only occasionally does the BLS change the basket oThe GDP de ator compares the price of currently produced goods and services to the price of the same goods and services in the base year Burgess Principles of Macro Economics Econ 1010 ll 3 Correcting Economic Variables for the Effects of In ation oPrice indexes are used to correct for the effects of in ation when comparing dollar figures from different times 31 Dollar Figures from Different Times case study example 32 Indexation When some dollar amount is automatically corrected for in ation by law or contract the amount is said to be indexed for in ation 33 Real and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past o The nominal interest rate is the interest rate not corrected for in ation It is the interest rate that a bank pays Burgess Principles of Macro Economics Econ 1010 12 oThe real interest rate is the nominal interest rate that is corrected for in ation For example you borrowed 1000 for one year Assume the nominal interest rate was 15 and during the year in ation was 10 Real interest rate Nominal interest rate In ation 15105 Burgess Principles of Macro Economics Econ 1010 13 4 Conclusion oThe consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year oThe index is used to measure the overall level of prices in the economy oThe percentage change in the CPI measures the in ation rate oThe consumer price index is an imperfect measure of the cost of living for the following three reasons substitution bias the introduction of new goods and unmeasured changes in quality oBecause of measurement problems the CPI overstates annual in ation by about 1 percentage point Burgess Principles of Macro Economics Econ 1010 14 oThe GDP de ator differs from the CPI because it includes goods and services produced rather than goods and services consumed oIn addition the CPI uses a fixed basket of goods While the GDP de ator automatically changes the group of goods and services over time as the composition of GDP changes oDollar figures from different points in time do not represent a valid comparison of purchasing power oVarious laws and private contracts use price indexes to correct for the effects of in ation Rob Godby University of Wyoming Job loss means lower living standards in the present anxiety about the future and reduced self esteem Unemployment in the is usually divided into two categories 1 The Natural Rate of Unemployment Structural Unemployment Frictiona Unemployment 2 The Cyclical Rate of Unemployment Unemployment Rate Natural Unemployment Trend Cyclical Unemployment Time represents persistent joblessness that does not go away on its own even in the long run Refers to the amount of unemployment that the economy normally experiences quot0 refers to the Year uctuation in unemployment around its natural rate Deals with short term fluctuations associated with the ups and downs of the business cycle How is unemployment measured ltgt is it accurate What affects it by group What affects duration of unemployment Why does unemployment exist at all Are there policies that can reduce it E ulated by ltgt The BLS surveying 60000 randomly selected households and categorizing each adult ie gt16 years old as l Currently employed have a paying job full or parttime 2 Unemployed but actively seeking a job 3 Not in the labor force ie neither of above a A person is has spent most of the previous week working at a paid job a A person is if he or she is ltgt on temporary layoff ltgt is looking for ajob ltgt is waiting for the start of a new job a A person in neither category is in my A a 9 n if is LQJ a The is the number of employed persons plus the number of unemployed a f t A if s 4 F ny N x n C quotquot x quotaquot I I 39 W 7 1 it 2 K n H j gt L n L m l 11 u I Mu is the unemployment rate MU is the number of unemployed persons s EU is the labor force le l E71 l U illustrates the fraction of the population that has chosen to participate in the labor market Of the adult population approximately 33 are not part of the labor force do not participate in the labor market 1 Although we usually hear only about the national unemployment rate unemployment rates and participation rates vary significantly by gender age and race Demographic Group Adults Total White male White female Black male Black female Teenagers 16 19 yrs old Total White male White female Black male Black female Unemployment Rate 1995 56 49 48 106 102 173 156 134 371 343 Labor Force Participation Rate 1995 666 757 590 690 595 535 585 555 401 398 a It is hard to distinguish between a person who is unemployed and a person who is not in the labor force a It is suggested that the unemployment rate is inaccurately low because it doesn t reflect ltgt Underemployed ltgt Discouraged workers El working part time when they really want fulltime work are those who have given up looking for work and report that they are no longer in the labor force when in fact they would be willing to work if offered a suitable stable job they should actually count as unemployed 1 l ti 7 KL LA 3 a Discouraged workers reduce measured unemployment because they are not included when actually they should be In the calculation U should increase increasing the numerator proportionately more than the denominator n 7 J J9 w u it l7 J9 sf iii 5 91 l3 i ll l fl ll xxxZ ll x 3 so should be bigger in the resence of discouraged workers a This is the term used to refer to people who when they lose their jobs have difficulty finding a new one due to their lack ofjob skills ltgt ie workers with limited skills and education In a modern economy they may experience very long periods of unemployment ltgt Examples fishermen assemblyline and textile workers l c J l L s l l 3quot g d 0 km U Most of the economy s unemployment problem is attributable to the relatively few workers who are jobless for long periods of time structurally unemployed The rate of unemployment is determined by the number ofjobless and the average duration of joblessness they experience ltgt The average duration of unemployment is very short lt 10 weeks for the majority of the unemployed 75 adjust to balance the supply of labor and the demand of labor ensuring all workers full employment 1 Four reasons why the ideal is missed ltgt Minimumwage laws ltgt Unions c Efficiency wages ltgt Job search frictions a When a minimumwage law forces the wage to remain above the level that balances su nd demand it creates a U a Suppose all labor was the same and a single wage cleared the market MinimumWages Price of Labor supply wage Equilibrium Minim um Wage Demand Quantity of Labor MinimumWages Price of Labor Supply wage PM Minimum Wage Law Established Demand Quantity of Labor MinimumWages Price of Labor SUpply Surplus or Unemployment Demand Quantity of Labor Labor is not all the same a Research has shown that minimum wage laws may be too low ltgt In New Jersey the minimum wage was increased while in neighboring states it was not ltgt No appreciable difference in the NJ unemployment rate occurred due to the policy Higher minimum wages became a Presidential policy goal l is a worker association that bargains with employers over wages and working conditions ltgtA union is a type of cartel a The process by which unions and firms agree on the terms of employment is called will be organized if the union and the firm cannot reach an agreement ltgt A strike makes some workers better off and other workers worse off 1 Striking workers worse off in the shortrun 2 Rehired workers better off in the longrun a By acting as a cartel with ability to strike or othenNise impose high costs on employers unions usually result in above equilibrium wages for their members gt J L a At wages set above equilibrium ltgt a very large number of qualified workers are willing to accept the jobs ltgt there are very few jobs and seldom any job openings for aspiring workers job shortage o workers tend to hold out accepting otherjobs in hopes of one day landing the high paying union job Firms operate more efficiently if wages are the equilibrium level Even in the presence of an excess of labor firms may be more profitable by keeping wages higher than equilibrium Unemployment caused by this theory is similar to that caused by the minimum wage laws and unions a Higher than equilibrium wages are set to promote the following goals of the firm ltgt Worker Health Better paid workers eat better and thus are more productive ltgt Worker Turnover A higher paid worker is less likely to look for anotherjob ltgt Worker Effort Higher wages motivate workers to put forward their best effort 0 Worker Quality Higher wages attract a better pool of workers to apply forjobs Unemployment that results from the fact that it takes time for qualified individuals to be matched with available jobs This unemployment is different from the previous three types It is not caused by a wage rate higher than equilibrium It is caused by the time spent in searching or waiting for the right job a Search unemployment is inevitable because the economy is always changing Situations that cause this type of unemployment include ltgt New entrants into the job market ltgt Reentrants into the labor force 0 Relocations o Layoffs due to competition in the economy ltgt Job quitters a Government programs try to facilitate job find in the following ways ltgt Governmentrun employment agencies ltgt Public training programs ltgt Unemployment insurance B These programs can reduce the time or increase the time it takes unemployed workers to find new jobs ltgt Better information aboutjob vacancies and potential workers in order to match workers and jobs more quickly u H lift r 5 n quotr 5 i r7 a 39 7 v w aim ivl i will 5 ilk at but u ubl Ct ltgt Aim to ease the transition of workers from declining to growing industries and to help disadvantaged groups escape poverty j 2 L 4 if LL Lamr ltgt Partial payment of former wages for a limited time period only to those who were laid off ltgt Increases the amount of search unemployment without intending to ltgt Reduces costs of joblessness Since unemployment can impose unusual hardships on individuals and families it is an important concern of policymakers Measured using a national survey unemployment rate UEU x 100 Unemployment rates differ by race age and gender Official urates may understate true problem due to underemployment and discouraged workers Characteristics of work force may influence urates Public policies may have conflicting and sometimes contradictory effects Ul or minimum wage laws Burgess Macroeconomics 1010 Topic 13 The In uence of Monetary and Fiscal Policy on Aggregate Demand 1 Introduction 2How Monetary Policy In uences Aggregate Demand The Theory of Liquidity Preference The Downward Slope of the Aggregate Demand Curve The Role of Interest Rate Targets in FED Policy 3How Fiscal Policy In uences Aggregate Demand Changes in Government Purchase The Multiplier Effect A Formula for the Spending Multiplier The Crowding Out Effect Changes in Taxes Burgess Macroeconomics 1010 4Using Policy to Stabilize the Economy The Case for Active Stabilization Policy The Case Against Active Stabilization Policy Automatic Stabilizers 5 Summary Burgess Macroeconomics 1010 2 How Monetary Policy In uences Aggregate Demand oMany factors in uence aggregate demand besides monetary and fiscal policy oln particular desired spending by households and business firms determines the overall demand for goods and services oWhen desired spending changes aggregate demand shifts causing shortrun uctuations in output and employment oMonetary and fiscal policy are sometimes used to offset those shifts and stabilize the economy 9 The aggregate demand curve slopes downward for three reasons oThe wealth effect The interestrate effect The exchangerate effect For the US economy the most important reason for the downward slope of the aggregate demand curve is the interestrate effect Burgess Macroeconomics 1010 21 The Theory of Liquidity Preference oKeynes developed the theory of liquidity preference in order to explain what factors determine the economy s interest rate oAccording to the theory the interest rate adjusts to balance the supply and demand for money Money Supply oThe money supply is controlled by the Fed through oOpenmarket operations oChanging the reserve requirements Changing the discount rate oBecause it is fixed by the Fed the quantity of money supplied does not depend on the interest rate oThe fixed money supply is represented by a vertical supply curve Burgess Macroeconomics 1010 5 Money Demand oMoney demand is determined by several factors oAccording to the theory of liquidity preference one of the most important factors is the interest rate People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services oThe opportunity cost of holding money is the interest that could be earned on interest earning assets oAn increase in the interest rate raises the opportunity cost of holding money oAs a result the quantity of money demanded is reduced Burgess Macroeconomics 1010 6 Equilibrium in the Money Market oAccording to the theory of liquidity preference oThe interest rate adjusts to balance the supply and demand for money There is one interest rate called the equilibrium interest rate at which the quantity of money demanded equals the quantity of money supplied Assume the following about the economy oThe price level is stuck at some level oFor any given price level the interest rate adjusts to balance the supply and demand for money oThe level of output responds to the aggregate demand for goods and services Burgess Macroeconomics 1010 22 The Downward Slope of the Aggregate Demand Curve oThe price level is one determinant of the quantity of money demanded oA higher price level increases the quantity of money demanded for any given interest rate oHigher money demand leads to a higher interest rate oThe quantity of goods and services demanded falls The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded Burgess Macroeconomics 1010 23 Changes in the Money Supply oThe Fed can shift the aggregate demand curve when it changes monetary policy oAn increase in the money supply shifts the money supply curve to the right oWithout a change in the money demand curve the interest rate falls oFalling interest rates increase the quantity of goods and services demanded oWhen the Fed increases the money supply it lowers the interest rate and increases the quantity of goods and services demanded at any given price level shifting aggregate demand to the right oWhen the Fed contracts the money supply it raises the interest rate and reduces the quantity of goods and services demanded at any given price level shifting aggregatedemand to the left Burgess Macroeconomics 1010 24 The Role of InterestRate Targets in Fed Policy oMonetary policy can be described either in terms of the money supply or in terms of the interest rate oChanges in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply oA target for the federal funds rate affects the money market equilibrium which in uences aggregate demand 3 How Fiscal Policy In uences Aggregate Demand oFiscal policy refers to the government s choices regarding the overall level of government purchases or taxes oFiscal policy in uences saving investment and growth in the long run oln the short run fiscal policy primarily affects the aggregate demand Burgess Macroeconomics 1010 10 31 Changes in Government Purchases oWhen policymakers change the money supply or taxes the effect on aggregate demand is indirect through the spending decisions of firms or households oWhen the government alters its own purchases of goods or services it shifts the aggregate demand curve directly oThere are two macroeconomic effects from the change in government purchases oThe multiplier effect oThe crowdingout effect Burgess Macroeconomics 1010 11 32 The Multiplier Effect oGovernment purchases are said to have a multiplier effect on aggregate demand oEach dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar 33 A Formula for the Spending Multiplier oThe formula for the multiplier is Multiplier 11 MPC oAn important number in this formula is the marginal propensity to consume MPC OH is the fraction of extra income that a household consumes rather than saves olf the MPC is 34 then the multiplier will be Multiplier 11 34 4 oln this case a 20 billion increase in government spending generates 80 billion of increased demand for goods and services Burgess Macroeconomics 1010 12 34 The CrowdingOut Effect oFiscal policy may not affect the economy as strongly as predicted by the multiplier oAn increase in government purchases causes the interest rate to rise oA higher interest rate reduces investment spending oThis reduction in demand that results when a fiscal expansion raises the interest rate is called the crowdingout effect oThe crowdingout effect tends to dampen the effects of fiscal policy on aggregate demand When the government increases its purchases by 20 billion the aggregate demand for goods and services could rise by more or less than 20 billion depending on whether the multiplier effect or the crowdingout effect is larger Burgess Macroeconomics 1010 13 35 Changes in Taxes oWhen the government cuts personal income taxes it increases households takehome pay oHouseholds save some of this additional income oHouseholds also spend some of it on consumer goods olncreased household spending shifts the aggregatedemand curve to the right oThe size of the shift in aggregate demand resulting from a taX change is affected by the multiplier and crowdingout effects olt is also determined by the households perceptions about the permanency 0f the taX change Burgess Macroeconomics 1010 14 4 Using Policy to Stabilize the Economy Economic stabilization has been an explicit goal of US policy since the Employment Act of 1946 41 The Case for Active Stabilization Policy The Employment Act has two implications oThe government should avoid being the cause of economic uctuations oThe government should respond to changes in the private economy in order to stabilize aggregate demand 42 The Case Against Active Stabilization Policy o Some economists argue that monetary and fiscal policy destabilizes the economy oMonetary and fiscal policy affect the economy with a substantial lag oThey suggest the economy should be left to deal with the shortrun uctuations on its own Burgess Macroeconomics 1010 15 43 Automatic Stabilizers oAutomatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession Without policymakers having to take any deliberate action oAutomatic stabilizers include the tax system and some forms of government spending Burgess Macroeconomics 1010 16 5 Summary oKeynes proposed the theory of liquidity preference to explain determinants of the interest rate oAccording to this theory the interest rate adjusts to balance the supply and demand for money oAn increase in the price level raises money demand and increases the interest rate oA higher interest rate reduces investment and thereby the quantity of goods and services demanded oThe downwardsloping aggregatedemand curve expresses this negative relationship between the pricelevel and the quantity demanded oPolicymakers can in uence aggregate demand with monetary policy Burgess Macroeconomics 1010 17 oAn increase in the money supply will ultimately lead to the aggregatedemand curve shifting to the right oA decrease in the money supply will ultimately lead to the aggregatedemand curve shifting to the left oPolicymakers can in uence aggregate demand with fiscal policy oAn increase in government purchases or a cut in taxes shifts the aggregatedemand curve to the right oA decrease in government purchases or an increase in taxes shifts the aggregatedemand curve to the left oWhen the government alters spending or taxes the resulting shift in aggregate demand can be larger or smaller than the fiscal change oThe multiplier effect tends to amplify the effects of fiscal policy on aggregate demand Burgess Macroeconomics 1010 18 oThe crowdingout effect tends to dampen the effects of fiscal policy on aggregate demand oBecause monetary and fiscal policy can in uence aggregate demand the government sometimes uses these policy instruments in an attempt to stabilize the economy oEconomists disagree about how active the government should be in this effort Policy advocates say that if the government does not respond the result Will be undesirable uctuations Critics argue that attempts at stabilization often turn out destabilizing Rob Godby University of Wyoming means that society has less to offer than people wish to have implies decisions regarding economic and social activities pursued 1 Decisions require comparing costs and benefits of alternatives 9 Going to college vs going to up from one alternative choice to get what you want from another choice We can specialize and trade with others leading to a A general observation 9 Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity 1 This gives rise to two ques ons 9 Why is interdependence the norm 9 What determines production amp trade H t H q 5 my 9 g 391 391 L a What determines the pattern of production amp trade I 73 L1 Imagine only two goods potatoes and meat only two people potato farmer and a cattle rancher both have the same amount of land each produce should they trade A World of SelfSufficiency Note the graphs have different scales Farmer Rancher 40 Linear PPF s imply what about the resources used to produce these goods Potatoes 4 5 P tat es a By ignoring each other 0 the farmer and rancher will produce a limited amount of meat and potatoes 9 each consumes what they each produce 9 Suppose the rancher chooses to produce 20 lbs of meat and 25 lbs potatoes while the farmer produces 1 lb of meat and 2 lbs potatoes Farmer If the farmer and the rancher were to the product that they were more suited to produce and then other they would be better off 0 should produce pp l o should produce 9 Farmer and Rancher should a n a What determines who should produce what And how much should be traded for each product a Who can produce products eg potato meat at a lower cost 1 There are two ways to measure rm i 2 i 3 Measuring differences in costs of production 9 inputs required to produce a standardized unit of output a One pound of potatoes or meat 0 Opportunity Cost amount of one item sacrificed to obtain another a Describes the productivity of one person firm or nation to that of another The producer that requires a smaller quantity of inputs such as or to produce a good is said to have an absolute advantage in producing that good a Compares producers of a good according to their opportunity cost The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good a Who has the oThe Farmer or The Rancher a Who has the oThe Farmer or The Rancher t L 2 g th y can each benefit from Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage a Michael Jordan mowing his lawn or shooting a commercial oOpportunity Costs oAbsolute Advantage oGains from trade 3 Should the United States trade with Other Countries eg Canada Mexico or Japan 9 Imports 0 Exports 0 Opportunity costs Trade US and Canada Cars Cars us Canada 4 Slope of PPF 04 20 2 2 cars given up to get 1 Unit of food Slope ofPPF Units of food given up to get Unit ofa car a Who should produce cars and who should produce food Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services Founded upon the my 4 7 D 7 V 7 027 1 s k 2 pro at 52gt v 53 fan quot 7 2 s a quotfix quot393 115 F ri l i ll lci oi l lp u l l lad Ly implies decisions The cost of something is what you give up to get it prtunitv can make US better Off is when one can produce a 1 a nit of a good with less resources is when one s opportunity cost of production is lower than another s Even if a country has an absolute advantage in all goods if they do not have a comparative advantage g m m 0 m f O y uquot S r e N n U y b d O G b O R a Money is the term used to describe the set of assets in the economy that people regularly use to buy goods and services from other people Generally money is used to support in the modern economy anything that is readily acceptable as payment in transactions nit uni serves as a yardstick to help us compare the relative values of goods of a means of keeping some of our wealth in a readily spendable form for future needs n v m Evin something that performs the function of money but has alternative nonmonetary uses ltgt Examples Gold silver cigarettes Fiat something that serves as money but has no other important uses ltgt Examples Paper currency check deposits that bear no interest aWhatever money good is chosen in an economy it must be able to fulfill the functions of required of money ice does not make a good money as it does not store value well E Everyone must believe everyone else will accept money for transactions or else the money good ceases to be a money good ltgtThis is especially true for tiaii as it has no alternative uses a Money was developed to avoid the incurred in a barter economy Transaction costs are costs incurred to make a trade and include time to search for someone who wants what you have and has what you want the required in banen a Initially mo was used in most economies or money that was to a commodity ie gold a After WW II to anchor the world financial system the US dollar was chosen as a reference currency ltgt All other currencies traded at a fixed exchange rate with the US dollar ltgt This was called the Bretton Woods agreement a Since in the US this paper money was to gold the so too were all other currencies indirectly The fixed exchange rate system was replaced by market determined exchange rates in the 1970 s Eventually money replaced commodity money when Nixon cancelled the of the US dollar l l l39 J Jl l y m llr r a In 1996 there was about 3 0 billion of US 1900 in currency per person printed a Recall avg GDPperson is 28000 it ll5397 myquot 1 l w J 3 r a Location of outstanding currency may include ltgt Currency held by firms and households for transaction purposes ltgt Currency held abroad ltgt Currency held by illegal entities To measure the amount of money in the economy one must consider which monetary assets to include Different ways of measuring the money stock in the economy examples ltgt M1 ltgt M2 Measurement of Money Money Stock is the quantity of money assets in the economy This may include more than actual currency in circulation C u The most widely cited measure of money used M1 includes 9 Coins 9 Currency 9 Check Deposits o Travelers Checks a A broader measure of money than M1 is ltgt M1 ltgt Savings Deposits ltgt Small Time Deposits ltgt Money Market Mutual Funds ltgt and other minor categories bank which is designed to oversee the banking system and regulate the quantity of money in the economy The Fed is a privately owned institution authorized in 1914 by Congress to ensure the health of the nation s banking system 1 The Fed is run by its quotfaxgm w 139 i Elx z gt77i J i v i ii ff u 1 if ltgt Seven members appointed by the President of the United States ltgt The Chairman of the Board is the most important position presiding directing and testifying about Fed policy SheHe is appointed by the President a The Federal Reserve System is made up of the Federal Reserve Board in Washington DC and twelve regional Federal Reserve Banks M o n eta F l ry policy is made by the quot Plquot K N uquot it 1 1 Vi y o b I 46 a l a Jquot c yr ill 1 ll frl The private banking industry must follow federal laws intended to promote sound banking practices ensuring the financial system does not break down Act as a making loans to other banks as a l nder of last resort lf banks require funds on a short term basis to cover withdrawals they can borrow money for a short time only paying interest set by the nl Control of the supply of money ie H n a sea m r z a 7 w i w a s M a Vq 11 c limv l J lJ 7 a The primary way the Fed changes the money supply purchase and sale of US government bonds Tbills with newly printed money The Fed also sets the interest rate on these bonds 5 J F F I Win r0 39Twi 55340 A r39r awr quot 47 7 W mi 7 ltgt 0 WJ WE Wla rnlklgl W quotlquot 5 N w 39l JM il quotall N 1w Uk d Lama Pry L7quot Gnu u c u L u 1 L C39 v Fed buys government bond public paying them new money the Fed sells government bonds to the public collecting people s money in exchange for the bonds 1 The behaviour of banks can influence the quantity of demand deposits in the economy and therefore the money supply recall M1 includes the amount of money in such deposits i n n m e m r s J39 Jr n m V7 J x 1 lay an W am 5 4C3 ijl u ALU lliwg r ll nr K h it ll quot zrrlcvyk 7lj 1 L25 quot ww39d W JQ H J 6 gr The practice of holding a fraction of money deposited as reserves and lending out the rest 3 Deposits in a bank are recorded as both assets and liabilities 3 Deposits that have been received but not lent out are called a The money supply in the economy is affected by the amount of reserves and the amount that is lentout 1 Loans become an asset to the bank Bank quotTA ccount Example First National Bank Assets Liabilities Reserves I Deposits 1000 10000 Loans I 9000 Total Assets Total Liabilities 10000 I 10000 Bank quotTA ccount Example First National Bank A TAccountquot notto be confused with T L39ab39I39t39eS bills illustrates the I financial position of a Reserves 9690505 bank that accepts 1000 I 10000 deposits keeps a I portion as reserves Loans and lends out the rest 9000 Assets Total Assets Total Liabilities 10000 I 10000 a When a bank makes a loan the money supply increases due to the assets included in the measurement of money When banks hold only a fraction of deposits in reserve banks create money The creation of money through loans does not create any wealth but allows banks to charge interest several times on the same bit of wealth a When one bank loans money that money is generally deposited into another or the same bank thus creating more deposits and more reserves to be lent out a The is the amount of money that the banking system generates with each dollar of reserves The Money Multiplier First National Bank Assets Liabilities Reserves I Deposits 1000 I 10000 Loans I 9000 Total Assets Total Liabilities 10000 10000 The Money Multiplier First National Bank Assets Liabilities Reserves Deposits 1000 H 10000 Loans 9000 H Total Assets Total Liabilities 10000 10000 Assets Reserves Loans Total Assets Liabilities 39 Total Liabilities The Money Multiplier First National Bank Assets Liabilities Reserves 1000 9000 Deposits 10000 Loans Total Assets Total Liabilities 10000 10000 Assets Liabilities Reserves Deposits Total Assets I Total Liabilities 9000 9000 The Money Multiplier Total Money Supply 27100 a The money multiplier is the reciprocal of the reserve ratio ltgt With a reserve requirement R of 10 or 110 ltgt The process just of deposits loans and deposits just described will continue ltgt The multiplier will be 10 a Two problems that theFed must wrestle that arise due to fractionalreserve banking The Fed does not control the amount of money that households choose to hold as deposits in banks The Fed does not control the amount of money that bankers choosetolend The Fed has three instruments of monetary control N J W 97 V39Ulv 7 7 J 5 I l l Xy fgl ii ll K 74 ltgt Buying and selling b 72 1 397 if ll 7 en t z u l C J C s quot7 wquot M r39 71 L71 u K27 39 x u s u sing or decreasing the r rim 4 fa 1 rer H r ltgt The interest rate the Fed other banks for loans The higher the rate the more banks want to avoid borrowing and the more they hold in reserve above Money fulfills three functions store of value medium of exchange and unit of account Two types of money commodity and fiat The money supply is measured in a variety of ways depending on what is included as money The Federal Reserve is the bank s bank regulating the financial system controlling the money supply and making loans to private banks Money supply is controlled by open market operations regulating the reserves private banks must hold and by setting the discount rate The money multiplier describes how private banks can affect the money supply by lending out their deposits Rob Godby University of Wyoming 1 Recall that the PPF model describes the tradeoff between production choices a The model indicated that trade among agents specializing in what they do best can make everyone better off than they could be othenNise outside the PPF u The model did not explain how much 397 r39 739 7 n mix a quot397T r lw r 1 1 4 c r z w 177 1 l rK ti39 slylyr l vmsl q iy r O a ll rl l Mill Wu 7 deg ryeu 4 out LA 1 s7 9 I t Jc u boo L j o u U cg 1 Many methods are possible for distribution and allocation of goods and services in the economy a most often the type of distribution used depends on how in the economy are owned 9 command economies publicly owned 9 market economies privately owned 9 mixed economies both a Our economy is really a mixed economy but most allocation decisions are made in markets Markets Propergy Rights and Economic ystems Intervention Socialism A Guided Markets Equity lt gt Ef ciency Communism Market Capitalism V Laissezfaire words o en They refer to the behaviour of people as they interact in Modern microeconomics is abou quot 39and quot is where a group of buyers and sellers of a particular good or service interact Hi determine demand determine suppy 3 Markets are the institution used in our society to determine who gets what and how much Markets may be classified by the competitive conditions within them The four main types of market are 0 perfectly competitive o monopoly o oligopoly o monopolistically competitive a Are markets with o with owho sell owho are a This results in a narrow range of prices being established that buyers and sellers act upon 3 Example retail gas stations 3 There is in the market and controls the quantity sold 5 Example The television cable company in Laramie TCI i Lt essively in Example Supermarkets in Laramie Safeway Smith s and Albertson s 9 often their prices differ little on most goods m This causes number of possibly 1 Example Markets for Cola Coke Pepsi RC Private Brands etc refers to the amount quantity of a good ers in a market are g 7quot 7 g 3439 7 refers to th E willing to purchase at a B These concepts can be describ by a Market Price Consumer Income Prices of Related Goods Tastes Expectations Number of Consumers Demand Curve for Beer note it slopes h OJ C m q 0 OJ U 39E D Quantity of Beer There exists an inverse relationship between J u 71quot 7 917 Ri e he 1 Example As l l 3 l 1 J 75 57quotfo fx l l l j Ll lo K a As income increases the and fora will increase Example if your income rises you will buy more beer at all prices because you can afford it 7333 the demand an 70 0 24 11 a As income increases the demand for an decreases finferior goods Raman noodles Kraft dinner Pabst Blue Ribbon Beer l 3 i 3quot f 39vi39w f g 4 t 3 39 w 1 f 1 j l l 7 l l w gti l g ll j A 1 7 When the fall in price of one good the demand for another good the two f goods are Example if the price of liquor fell you might buy less beer at all prices This would the demand curve for beer w l or L 1 i ryv f w wj39n f x g 4 t 3 39 w 1 f n 1 1 i r H t w g i i gf it i A K 1 lt 7 ii When the fall in price of one good the demand for another good the two goods are 7 n flr1 37613 by 4 4 Example if the price of pizza fell you might buy more beer at all prices This the demand curve for beer How would the demand curve for beer in Laramie be changed for the following a You decide you don t like beer as much anymore a You decide that drinking beer every night is making you more likely to get fired 1 The population of Laramie doubles i 7 i i K b 4n ff L13 Q t 7H Silt w A table that shows the relationship between the price of the good and the quantity demanded Table 41 in w an iii1quot I w ii e39 1 JigWt i H H i JH LH itquot I The downwardsloping ine relating price and quantity demanded Figure 41 i u that 99 determinants arid are re ma A I 39 Mai 3 v70 J 9 Lili is Q i C27 4357 at the Example when considering the effect of an increase in the price of beer we don t also consider an increase in the price of wine at the same time fr 5A quot7 x g K4 xquot n 1 v z j the market price of the product Table 43 L 11 5 ix V WM Ht x k V either to the left or right Figure 43 Changes in Quantity Demanded Price Quantity Changes in Quantity Demanded Quantity Change in Demand Quantity Change in Demand The Concept of Supply p Quantity Supplied refers to the amount quantity of a good that sellers are Willing and able to supply for sale at alternative prices for a given point in time Example Supply of Beer Price 5 Supply curve for Beer note it slopes up Quantity Market Price Input Prices Technology Expectations Number of Producers Determinant of Su I Market Pricepp y Law of Supply P There exists an direct positive relationship between Price and Quantity Supplied Why SC A table that shows the relationship between the price of the good and the quantity supplied Table 44 55 lt 7 p r ll 1 F737 of j The upwardsloping line relating price and quantity supplied Figure 44 my F 3 JJ l3 w yhMN U 3 by J u p F2 Caused by a change in the market price of the product Table 46 a a a a A 9 either to the IGft or right Figure 47 Changes in Quantity Supplied Supply Price 200 Quantity Changes in Quantity Supplied quot quot 17 Price I W 200 100 Quantity Change in Supply Supply Quantity Change in Supply SI 82 Quantity Supplied and Quantity Demanded are equal WW J quotWm M 19 77 Forces of Demand Price D Quantity Forces of Demand and Supply Price D Quantity Forces of Demqnd and Supply At Rest Market Equmbrlum Price Quantity therefore producers are unablet sell all they want at the going price therefore consurhers are uhable to buy all they want at the going price Actions of buyers and sellers that move toward equilibrium Price I Demand I Quantity Actions of buyers and sellers that move toward equilibrium Price Excess Supply Supply Quantity
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