Principles of Macroeconomics
Principles of Macroeconomics ECON 2020
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Macroeconomics 1102011 61500 PM aggregate behavior of entire economy the whole macro economy is greater than the sum of individual actions and outcomes paradox of thrift spend less in hard economic times consumers spend less then businesses have less money and they react by laying workers off as a result families and businesses end up worse off than they were before worlds economies boom and bust business cycle is the short run alternation between economic upturns and down turns most of macro focuses on why the business cycle exists and what can be done to mitigate down turns economists have various measures to test the health of an economy and how it changes over time recessions area periods of economic downturns when output and employment are falling expansions sometimes called recoveries are upturns when employment and out put are increasing depression is a deep and prolonged downturn peak point where economy goes from up to downturn trough point where economy goes from down to upturn theories on the economy in a self regulating economy problems like unemployment are resolved without gov intervention called laissezfaire popular before great depression Keynesian economics slumps caused by inadequate spending can be mitigated my government gained prominence during great depression modern economics uses a combination of both self regulation government intervention gov has 2 tools fiscal and monetary tools fiscal changes in tax policy and government spending monetary quantity of money and interest rate long run growth is the sustained upward trend in economic output over time factors that drive short run growth are largely different than long run growth a country can increase a permanent increase in the standard of living only through long run growth central concern of macro is what causes long run growth inflation and deflation rising aggregate price levels are inflation falling level is deflation inflation rate is annual percent change in the aggregate price level price stability comes with only small increases in the price level international trade an open economy trades goods with other open economies trade deficit is when you import more than you export trade surplus is when you export more than you import tracking the macro economy important actors are households firms government and all other countries each actor interacts with all others to create the aggregate economy in order to measure the health of the economy we create a number of measures that keep track of aggregate wealth and improvements economists need some way to value aggregate income in an economy income accounting uses the following YCIGXIM GDPConsumptionInvestmentsGoveXportsImports Households earn income via factor market interests on bonds dividends on stocks and rent on land Stock is a shore of ownership in a company Bond is borrowing in the form of an iou that pays interest In addition households receive government transfers from the government Households earn income but have to pay taxes Disposable income is total household income minus taxes Private savings is disposable income minus consumer spending Government Gov purchases of goods and services are paid for by taxes as well as government borrowing Exports generate an inflow of funds into the country from the rest of the world while imports lead to an outflow of funds to the rest of the world de Investment spending is on productive physical capital like machinery and construction of structures and changes to inventpories Final goods and services are goods and services sold to the end user Intermediate goods and services and those that are bought from one firm to be used as an input by another firm for the production of a final good Measures the total value of all final goods and services produced in an economy during a given year Aggregate spending is the total spending on domestically produced final goods and services in the economy Can be calculated by Add up all the value added of all producers Add up all spending on domestically produced final goods and services Add up all income paid to factors of production Included in gdp Domestically produced goods and services new construction of structures changes to inventory not included intermediate goods and services inputs used goods financial assets foreign goods and services gdp and in ation nominal vs real gdp real gdp is adjusted for inflation nominal gdp is calculated with prices from current year add up revenue for final goods real gdp uses a base year and uses prices from that year to compare with other years gdp per capita is wealth per person since gdpperson is an average it does not measure inequality the aggregate price level is a measure of the overall level of prices in the economy to measure the aggregate price level economists calculate the cost of purchasing a market basket a price index is the ration of the current cost of that market basket to the cost in a base year multiplied by 100 the inflation rate is the yearly change in a price index typically CPI CPI measures the cost of the market basket of a typical urban American family Inflation can help some people Borrowers pay back less in real terms than they borrowed with inflation Lenders then get paid pack less than they lent in real terms Both borrowers and lenders have some expectation of inflation build that into the contract Unexpected inflation and deflation are important Bringing down the inflation rate is very difficult and painful for an economy Widely thought that in order to bring inflation down must temporarily depress the economy increase unemployment Policy makers try to keep inflation at low levels so they don t have to do this 1102011 61500 PM Unemployment You are employed if you have a job Unemployment is number of people that are looking for work but are not currently employed The labor force is the sum of employment and unemployment Who isn t in the labor force Retired people disabled people homemakers Labor force participation rate labor forcepopulation 16 and older100 Unemployment rate number of unemployed workerslabor force100 Problems with measuring unemployment Overstate unemployment Understate unemployment Some unemployment is natural unemployment rate can overstate employment problem Stringent definitions may cause employment problems to be understated Since it is an average it doesn t say much about employment of various groups Like gdp per capita many people trust unemployment is an excellent indicator of economic health although they should not Discouraged workers are non working people who have given up looking for a job due to the job market Marginally attached workers would like to be employed but have recently stopped looking Underemployment is the number of people who work part time because they cannot find full time jobs Today unemployment is 91 Under employment is 19 Any one spending time trying to find a job is engaged in a job search Frictional unemployment is unemployment due to the time workers spend in a job search Structural unemployment is unemployment that results when there are more people seeking jobs in a labor market than there are jobs available at the current wage Caused by minimum wages gov mandated price floor on the price of labor unions bargaining for all a firms workers collectively unions can often win higher wages from employers than the market would have otherwise provided when workers bargained individually efficiency wages wages that employers set above the equilibrium wage rate as an incentive for better performance side effects of government policies public policies designed to help workers who lose their jobs these policies can lead to structural unemployment as an unintended side effect unemployment insurance most advanced countries have it policy that offers income for those who have lost their jobs Europe has a more generous policy than the us does Some argue that better benefits cause more unemployment Frictional and structural unemployment sum to make the natural rate of unemployment Cyclical unemploymentdeviation in the actual rate of unemployment from the natural rate of unemployment generally caused by recessions Natural unemploymentstructural frictional Actual unemploymentnatural cyclical Cyclical is what macroeconomists want to minimize Younger labor forces frequently have higer unemploymenthigher natural unemployment Women entering the labor market in large numbers after 1960 increased the rate of natural unemployment Changes in union structures and minimum wages affect the natural rate Real wage is the wage rate divided by the price level Real income is income divided by the price level Price levels can increase as long as income increases accordingly Inflation is the difference in price levels between years Inflation is important because it can impose certain costs on an economy Shoeleather costs are the increased costs of transactions caused by inflation so when you hold money in your pocket its value erodes menu costs is the real cost of changing a listed price unit of account costs arise from the way inflation makes money a less reliable unit of measurement comes in an economy where money is a less reliavle means of conducting transactions bartering a ton of corn for 2 pigs interests rates nominal interest rate is interest rate expressed in dollar terms the real interest rate is the nominal interest rate minus the rate of inflation disinflation is the process of brining the inflation rate down Savings and investment 1102011 61500 PM YCIGEXIM GDPconsumptionincomegovexportsimports Investment spending in the national income accounting means spending that increases the stock of capital not the purchase of stock bonds ect According to the savings investment spending identity savings and investment spending are always equal for the economy as a whole The budget surplus is the difference between tax revenue and gov spending when tax revenue exceeds gov spending Budget deficit is when gov spending is more than tax revenue Budget balancetaxesgov spending transfer payments transfer payments are any gov redistribution of wealth national savings is the sum of private savings plus the budget balance Total amount of savings generated within an economy capital income is the net inflow of funds into a country simplified economy total incometotal spending total incomeconsumption spendingsavings total spending consumption spending investment spending consumption spending savings consumption spending investment spending savingsinvestment spending in a closed economy ycig sprivateytrtc sgovttrg nssprivatesgov ytrtcttrg Y39C399 hence Ins investment spendingnational savings in a closed economy in an open economy investment spendingnational savingscapital inflow IsprivatesgovimXnski Market for loanable funds The loanable funds market is a hypothetical market that examines the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders The interest rate is the prices calculated as a percentage of the amount borrowed charged by the lender to a borrower for the use of their savings for one year There are many different interest rates depending on type of investment risk wealth We will assume on rate for this market Rate of return on a project Revenuecostcost 100 firms and people will take loans only is rate of return is higer than interest rate factors that shift demand changes is perceived business opportunities changes in gov borrowing crowding out occurs when a government deficit drives up the interest rate and leads to reduced investment spending factors that can cause the supply of loanable funds to shift include changes in sprivate savings behavior between 2000 and 2006 rising home prices in the us made many homeowners feel richer making them willing to spend more this shifted the supply of loanable funds to the left changes in capital inflows the us has received large capital inflows in recent years with much of the money coming from china and the middle east Those inflows helped fuel a big increase in residential investment spending from 20032006 as a result of the world wide slump those inflows began to trail off for 2 years expected inflation is 3 in the second year something changes and inflation increases to 10 How do the curves for supply and demand of loanable funds shift Real interest ratenominal interest rateinflation rate In reality cant find the real interest rate until after the fact There is some built in expectation of inflation in every loan different for each individualfirm According to the fisher effect an increase in expected future inflation drives up the nominal interest rate leaving the expected real interest rate unchanged Is this is true real interest rate is only changed by business conditions or government policy but inflation does not affect it The financial system A households wealth is the value of its accumulated savings A financial asset is a paper claim that entitles the buyer to future income from the seller A physical asset is a claim on a tangible object that gives the owner the right to dispose of the object as her or she wishes A loan is the most common type of financial asset For example if your bank gives you a loan you are promising some of your future income to the bank If you take a loan or any agreement where moey is owed it creates a liability A liability is a requirement to pay income in the future Unfortunately there are problems with finding an equilibrium in borrowing and lending This decreases the efficiency of the market The recent recession has increased these costs and decreased the amount borrowed and lent Transaction costs are the expenses of negotiating and executing a deal Financial risk is uncertainty about future outcome that involve financial gains and losses The greater the risk the more the return lenders require to make a loan Ie us bonds have a lower interest rate than Greek and Irish ones do Reducing nancial costs Bundle all of a company s loans through one bank instead of dealing with 1000s of investors people are risk adverse they try not to expose themselves to huge losses ie a small business owner takes out loan with bank not with credit card in order to limit risk people diversify transaction costs are costs that are incurred while negotiating a deal provides liquid assetsassets that can be quickly converted into cash an assest is illiquid if it cannot be quickly turned into cash a check is liquid a house is not four main types of financial assets loan bonds stocks bank deposits loan backed security loan lending agreement between a particular lender and a particular borrower default occurs when a borrower fails to make payments as specified by the loan or bond contract Defaults are the cause of risk in the financial system small scale loans usually have high transaction costs collateral research credit history Bonds Avoid most transaction costs Bonds are usually issued by firm and governments Instead of making a single agreement the entity sells bonds to whoever wants to buy them Able to avoid the costs because they have an obvious stake in continuing to operate and have more capital available Again risk of default determines what interest rate creates an equilibrium Stocks Are ownership shares of a company Stocks are issued to create capital for the company they are a liability for the company but a financial asset for the stockholder Stocks typically do not guarantee an income they fluctuate in value based on the markets valuation of the company Also may pay dividend Loan back securities Loan backed securities aggregate many individual loans and sell shares The idea behind this type of asset is that pooling the loans together decreases the risk of default on any single loan Risk aversion means borrowers would prefer for everyone to share the risk What happens if many loans go bad at once This is the problem with the now famous mbs Financial intermediaries An institution that transforms the funds it gathers from man individuals into financial assets A mutual fund is a financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors A pension fund is a type of mutual fund that holds assets in order to provide retirement income to its members Life insurance companies sell policies that guarantee a payment to the policy holders beneficiaries when the policy holder dies A bank deposit is a claim on a bank that obliges the bank to give the depositor his or her cash when demanded A bank is a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments or investment spending needs borrowers Financial fluctuations Value of stocks fluctuate all the time The value of the stock depends on the investors beliefs about the future value of the stock A financial asset is a promise of some portion of future income so an expectation that the company will do well in the future increase the price today and vice versa The fluctuations apply to any traded financial asset Example sony announces a ps4 causing higher demand for sony stock but supply of sony decreases stock goes up Macroeconomic instability can be a source of financial market fluctuations There are two principle competing views about how asset price expectations are determined One view traditional economic analysis says the market is rational efficient market hypothesis o Financial asset prices embody all publicly available information o It implies that fluctuations are inherently unpredictable they follow a random walk Another widely held by market participants emphasizes the irrationality of market participants o Irrationality causes bubbles to form in markets and cause asset pricing problems Bubbles are an overvaluation of a good or an industry 0 Example housing prices soared in the US from 20002006 0 Easy mortgages given out people thought housing prices would increase forever and housing prices went up tremendously 0 Demand fell off in 2007 prices fell and thus the bubble burst Efficient market economists would say that the data available was faulty 2 things change aggregate consumption function o Changes in expected future income o Changes in aggregate wealt Investment spending o Closely tied to recessions rather than to consumer spending o This is due to autonomous consumer spending Planned investment spending investments businesses plan on making in a given period This is negatively related to o Interest rate o Existing production capacity Positively to o Expected future GDP Businesses can reinvest profits called retained earnings o Other options are to pay off loans or to distribute the earnings to owners According to the accelerator principle a higher rate of growth in real GDP leads to higher planned investment spending the opposite is also true Both are circular processes Inventory Stocks of goods held to satisfy future sales It costs money to house inventory so businesses try to keep enough to meet demand but not more Buying new inventory is a form of investment spending in preparation for increased sales Inventory investment value of change in total investment held in economy in a given period Actual investment in the sum of planned investment spending and unplanned inventory investment IIunplannedIplanned Planned aggregate spending Aggregate spending is total expenditure in an economy consumption investing Income expenditure model Economy is an incomeexpenditure equilibrium when aggregate output GPD is equal to planned aggregate spending incomeexpenditure 1102011 61500 PM The money multiplier o The marginal propensity to consume MPC is the increase in consumer spending when disposable income rises by 1 The marginal propensity to save MP5 is the increase in household savings when disposable income rises by 1 0 MPCchange in consumer spendingchange in disposable income Infinite series is to 11x Total increase in GDP from 1000 is 11MPC 1000 Household consumption is broken into autonomous consumer spending and disposable consumer spending Autonomous consumer spending is the amount of consumption a household would do if it had no disposable income Other is disposable income consumption CaMPCyd Yd is disposaple income consumption A is autonomous consumer spending Chousehold spending Consumption function Shows relationship between disposable income and consumption For American households in 2006 the best estimate of the average household s autonomous consumer spending is 56 The aggregate consumption function is the relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending Shifts in the aggregate consumption function o Changes in expected future income o Changes in aggregate wealth 1102011 61500 PM law of demand as price increases while other prices stay constant the quantity demanded decreases and the opposite is true the aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households businesses the gov and the rest of the world price level is some composite measure such as the cpi aggregate demand not limited to domestic demand quantity measured by real gdp why is AD downward sloping o wealth effect this means that the aggregate price level reduces the purchasing power of households wealth and reduces consumer spending ie wealth doesn t go as far o interest rate effect a higher price level reduces the purchasing power of households money holdings leading to a rise in interest rates and a fall in investment spending and consumer spending 0 how does it change the interest rate 0 There is a smaller supply of loanable funds so the price level increases in this case the interest rate 0 As the interest rate goes up investment spending decreases as does consumption because households save more Moving vs shifting Price moves along the curve o Shift the curve o Changes in expectations o Wealth o The stock of physical capital o Government policies including fiscal and monetary Changes in the stock of capital If the stock of the capital is very high it will depress the demand for new capital in the near future Government policy Fiscal policy involves government spending and taxation Monetary policy involves changing the interest rate and how that affects the supply of money Fiscal policy an increase in gov spending or decrease in taxes shifts demand to the right in the short run With monetary policy an increase in the quantity of money in creases demand in the short run Consumer price inflation reached 148 in march of 1980 the fed stuck to a policy of increasing the quantity of money slowly Aggregate price level went up quickly but the quantity of money in the economy was rising slowly Due to the wealth effect and the interest rate effect of a change in the aggregate price level the quantity of aggregate output demanded fell as the aggregate price level rose AS Aggregate supply quantity of aggregate output in the economy Aggregate price level short run aggregate supply curve is upward sloping because nominal wages are sticky in the short run Nominal wagedollar amount of wage paid Sticky wages are nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages Profit piPQcosts Wages are a major cost of production so if they don t change as quickly as prices then increasing Q can increase profits in the short run Commodity prices o Commodities are goods used to produce other goods o Not included in the shift of the supply curve because they aren t final goods o Increase in commodity prices decreases short run aggregate supply Nominal wages o Wages are often sticky but will eventually respond to pressures in the labor market o Increases in wages decrease short run aggregate supply Productivity o Level of ability and skill of a worker at their job o Increase in productivity increases SRAS Long run aggregate supply o In the long run every wage cost and price will change in proportion to changes in price level Potential outputlevel of gdp the economy would produce if all prices were flexible de is usually to the left or right of this curve Shifts in lras o Changes in the level of capital physical and human o The size of population changes LRAS o Level of technology Shocks o Some demand shock causes a leftward shift in AD o People lose their jobs as demand is lower o Falling wages shift SRAS curve to the right o The short run is moved back to potential output There is a recessionary gap when aggregate output is below potential output There is an inflationary gap when agg output is above potential output Output gap is the percentage difference between actual output and potential output The economy is self correcting when shocks to agg demand affect agg output in the short run but not in the long run Classical economists say econ Will fix itself Keynesians believe self regulation can take too long look for gov intervention known as stabilization policy There is debate whether these policies are effective but there is a problem measuring these claims Not hard science hard to test claims Policy for negative demand shocks Gov can increase G decrease T or increase the money supply to shift the AD curve back to the right These policies cause deficit spending or inflation and should be used judiciously Supply shocks o A policy that stabilizes aggregate output by increasing aggregate demand will lead to inflation but a policy that stabilizes prices by reducing demand will deepen the output slump o You can only address higher prices or unemployment o Most governments stabilize prices at the cost of unemployment Review 1102011 61500 PM Ycigexim 2 types of savings privateyct publictgtr national savingsprivatepublic gov savings equals budget balance money multiplier how much will an increase in consumption increase gdp calculated by 11mpcchange in investment mps1mpc if rate of return is lower than interest rate don t invest autonomous spendingspending we do regardless of changes in income fischer effectreal interest rate doesn t change based on inflation nominal interest rate real interest rateinflation Fiscal Policy 1102011 61500 PM how the government can affect GPD in good times and bad attempting to influence demand positively or negatively fiscal policy changes are intentional changes made by the government fiscal policy is the use of taxes government transfers or government spending to shift AD curve when the government is out of long run equilibrium gov uses fiscal policy to bring it back what effect does in increase in G have on GDP What about taxes Increase in G increases GDP Increase in T decreases GDP Gov spending involves all levels of gov Gov purchases of goods and services include military spending education infrastructure and any other goods and services purchased The rest of spending is considered transfers US has three primary programs social security medicare and Medicaid There is also unemployment insurance and food stamps Its difficult to manage these policies people will free ride and game the system and these kinds of policies expand quickly and are hard to reign backin Contractionary fiscal policy may be implemented when the economy is above its long run equilibrium inflationary gap in order to slow down the economy The opposite of expansionary fiscal policy Lag time between when policy is implemented and when it affects the economy Fiscal policy has a multiplier effect on the economy The multiplier on changes in gov purchases 11mpc is larger than the multiplier on changes in taxes or transfers mpc1mpc because part of any change in taxes or transfers are absorbed by savings Ricardian equivalenceraising government spending today means taxes will be raised in the future so raising government spending might be cancelled out by people anticipating higher taxes by saving money now Aspects of fiscal policy o Automatic stabilizers put in place by government involves systems that are already put in place by gov 0 Rules governing taxes and some transfers act as automatic stabilizersreducing the size of the multiplier and therefore reducing the size of fluctuations in the business cycle Unemployment insurance o Discretionary policy policy involves intentional changes 0 discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle decreasing taxes stimulus package the budget balance sgovtrgtr expansionary fiscal policy generally creates or extends gov debt contractionairy generally close or reduces debts some fluctuations in the budget balance are due to effects of the business cycle gov estimates the cyclically adjusted fiscal policy an estimate of the budget balance is the economy were at potential output expansionary fiscal policy involves an increase in g or tr without increasing t thus borrowing increases the amount of lending done by individuals and institutions is known as public debt US gov fiscal year runs from oct 1 to September 30 Us debt as of fy 2010 is 135 t Problems with governments running deficits are crowding out and future budget problems Deficit Difference between amount of money a gov spends and the amount it receives Debt is amount government owes Implicit liabilities Medicare social security ect Must either be paid or defaulted on Poses problems due to demography o too many old people not enough people are paying in 0 could raise retirement rate money and banking 1102011 61500 PM not many people understand money o ie more money than paper currency not the same thing as wealth c we also need to figure out what backs up money in an economy money is an asset that can be easily used to buy goods and services c with out we would have barter system currency in circulation is cash held by public checkable bank deposits checking account the money supply is total value of financial assets in the economy that are considered money roles of money o a medium of exchange an asset that individuals acquire for the purpose of trading rather than for their own consumption o a store of value a means of holding purchasing power over time 0 other goods go bad over time money will keep value c a unit of account a measure used to set prices and make economic calculation gives goods and services value relative to one an other 0 allows for easy decision making types of money o people in an economy generally accept money as inherently valuable but what backs up its value c Commodity money is a good used as a medium of exchange that has other uses 0 Gold silver ect o Fiat money is a medium of exchange whose value derives entirely from its official status as a means of payment 0 Allows flexibility but also allows for more inflation o Commodity backed money no intrinsic value but the value lies in the fact that it can be converted into the valuable good that backs it Gold standard Is a bad idea Restricts growth Measuring the gold supply o A monetary aggregate is on overall measure of the money supply o M1 is currency in circulation cash traveler s checks and checkable bank deposits o M2 is near money 0 These are financial assets that cant be directly used as medium of exchange but can be readily converted in cash 0 This means CDs savings accounts ect a bank is a financial intermideary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers a T account is a tool for analyzing a business financial position by showing in a single table the business assets and the liabilities a bank doesn t hold all of the money people deposit in its vaults they wouldn t be able to lend out any money instead banks hold a percent of the money and loan the rest out bank reserves are the currency banks hold in their vaults plus their deposits at the federal reserve bank reserves are held on hand for people that want to take cash out of their accounts bank reserves the reserve ratio is the fraction of bank deposits that a bank has on hand as reserves a bank run is where many depositors want their money all at the same time bank regulations us regulates and guarantees banks regulations involve deposit insurance capital requirements and reserve requirements Reserve requirements Minimum requirement for reserve ratio is 10 Determining the money supply Banks can create money supply based on their loans the fed 1102011 61500 PM the central bank that oversees and regulates the banking system and controls the monetary base every modern economy has a central bank appointed by president and approved by congress have 14 year terms chairman is appointed every four years purpose of the individual banks is to monitor financial health in their region the board of governors can carry out open market operations the federal funds market allows banks that fall short of the reserve requirement to borrow from banks with excess reserves the fed funds rate is the interest rate determined in the fed funds market discount rate is the rate fed charges on loans to banks both rates a interest rates if an interest rate has too high an interest rate investors will pull their money out of weaker investments and increase demand for it until the interest rate falls to equalize money demand shifters changes in agg price level people need more money if prices are higher changes in real gdpthe higher real gdp a country has the higher its demand for goods and services money facilitates purchases so money demand increases with real gdp changes in technologyas the technology of purchasing increases the demand for money decreases changes in institutionsregulationschanges in regulations on checking accounts allowing banks to pay interest rates money supply liquidity preference model fed determines money supply thru open market operations and other lendingregulation practices according to the liquidity preference model of the interest rate interest rate is determined by the supply and demand for money the feds targets the interest rate fed doesn t directly control the interest rate but changes the money supply in order to affect interest rate fed sets target on fed funds rate and change monetary policy to try to meet it all interest rates are still set by supply and demand example fed buys t bills which increases money supply increase in money supply has negative influence on interest rate long run interest rates and short term interest rates are somewhat independent expectations about short term rates in the future determine long term rates ex short term rates are low today but if lenders anticipate a steep rise in those rates in the next few years they will charge higher long term rates today inflation and disinflation 1102011 61500 PM with monetary neutrality we know that monetary changes have no effect on the economy in the long run according to the classical model of the price level the real quantity of money is always at its long run equilibrium level this is a reasonable assumption for periods of high inflation Why sticky wages evidence shows that sticky wages are much less likely when inflation is very high In other words everyone is much more sensitive to prices then Because of fiat money there is the ability and sometimes incentive for government to print money to pay their bills Unlike borrowing this practice doesn t have any value backing it and causes inflation This practice happens all the time generally in small amounts People holding money are taxed by the inflation caused from changes in the money supply The inflation tax is the reduction in real value of money held by the public caused by inflation equal to the inflation rate times the money supply on those who hold money The real value of resources captured by the government is reflected by the real inflation tax o Not a real tax Indexing People try to protect themselves from future inflation The most common way of achieving such protection is through indexation contracts are written so that the terms of the contract automatically adjust for inflation In a highly indexed economy higher prices feed rapidly into changes in the cpi That in turn quickly leads to increases in wages further leading to increases in other prices The result is thatin the long run the period in which an increase in the money supply raises the overall price level by the same percentage arrives very quickly Under indexation the prospect that a one time increase in prices can spark a persistent rise in inflation poses a much greater risk Hyperinflation Extremely high annual inflation which causes all of the problems of inflation in an economy to be magnified Occurs with some government need to print money due to debt Seignorage is the revenue the government earns from their right to print money in order to avoid paying inflation tax people reduce their real money holdings this forces the government to increase inflation to capture the same seignorage they would have in some cases this leads to a vicious cycle of shrinking real money supply and rising inflation this leads to hyperinflation an a fiscal crises Hyperinflation has analogies in regular taxes the government can place The governments of wealthy politically stable countries like the US and Britain don t find themselves forced to print money to pay their bills Yet over the past 40 years both countries have experienced uncomfortable episodes of inflation In the short run policies that produce a booming economy also lead to a higher inflation and policies that reduce inflation tend to depress the economy This creates both temptations and dilemmas for governments The politics of inflation lead to short run gains for politicians the politics of limiting inflation are generally negative Why does expansionary work lead to inflation Depends on the relationship between output gaps and the unemployment gap When actual agg output rate is equal to potential output actual unemployment rate is equal to natural unemployment rate When output gap is positive the unemployment rate is below the natural rate When the output gap is negative the unemployment rate is above the natural rate Okun s Law Though cyclical unemployment and the output gap move together cyclical unemployment seems to move less than the output gap These don t move together perfectly but still have a definable relationship There is a negative relationship between the output gap and the unemployment ratetypically a rise in the output gap of 1 percentage point reduces the unemployment rate by about 12 a percentage point The short run Phillips curve is the negative relationship between the unemployment rate and the inflation rate This curve is a little too simple some other factors can shift inflation up or down for every level of unemployment like expectations and supply shock Inflation is the best determinate of unemployment ratecheck book Higher expected inflation shifts the Philips curve upward and vice versa If expected inflation in the near future is increasing the worker wants a higher wage and the employer will want to hire quicker before wages rise even more Therefore at every price level of unemployment the matching inflation rate will be higher Policy makers used to believe that they could only pursue low unemployment or low inflation rate but not both Adding expectations allows for an important distinction meaning it may be possible to have both Lr Phillips curve is vertical We have a natural rate of unemployment at which inflation doesn t accelerate over time Nonaccelerating inflation rate of unemployment is the unemployment rate at which inflation does not change over time The long run curve shows the relationship between unemployment and inflation after expectations of inflation have had time to adjust to experience Natural rate of unemployment The portion of the unemployment rate unaffected by the swings of the business cycle The level if unemployment the economy needs in order to avoid accelerating inflation is equal to the natural rate of unemployment Disinflation The process of brining down inflation that is embedded in expectations It is difficult and painful to bring expectations back down once high inflation has become established Policy makers have to run the inflation process in reverse meaning keeping unemployment high and contracting the economy In the short run this means a poorer country and worse business prospects but may be justified by long run benefits Policy makers can limit some of the pain by announcing publicly their commitment to disinflation and demonstrating that they are going to follow through Of course political motive may not always coincide with economic motives and disinflation may start only when it is essential rather than when it is easiest to do Separation from these political motives is one of the main reasons the fed is largely autonomous Due to a number of factors the 705 saw a large rise in inflation levels in modern economies In the US the fed showed a commitment to reducing inflation that sacrificed as much as 18 of output in the early 805 But by mid 805 inflation had returned to a reasonable level and the core inflation rateinflation excluding energy and food priceswas down to about 400 Deflation A falling aggregate price level This does not mean if the price of one good falls that economy is experiencing deflation Deflation was once common in economies across the world Today it is uncommon and considered a problem Deflation takes spending power away from borrowers and redistributes it to lenders Deflation cases borrowers to be short on cash and have to cut spending Deflation gives lenders more value from their loans but with a troubled economy they aren t likely to spend more These 2 effects cause debt deflationthe reduction in aggregate demand arising from the increase in the real burden of outstanding debt caused by deflation Example of expected deflation Nominal interest rate is 5 if inflation is 0 Suddenly deflationary pressure causes a 2 change in the price level Nominal interest rate is now 3 What if deflation became 6 Then nominal interest rate is 1 This cant happen as interest rate s lower bound is 0 This is called a 0 bound on the nominal interest rate this bound can limit monetary policy because the fed cant stimulate the economy by decreasing rates any further Known as a liquidity trapwhich occurs whenever there is a sharp reduction in demand for loanable funds Japan is the only major example of deflation in a modern economy After an extended boom in Japan s economy reaching a peak in the late 80 s the early 905 saw a bust and subsequent attempt by the Japanese central bank to stimulate the economy with lower interest rates The extended bust even caused some deflation and stagnant growth which has marked their economy for the last decade Real gdp per capita takes into account the total wealth of a country and how many people it has to see an average of living conditions in the country How does this change in the long run China and India s growth rates are high but their gdp per capita is low US economy produced 6 times more per person in 2007 than in 1907 Since this in an average this growth accounts for a massive population boom How did this happen Not all at once but in a long run accumulation of small year to year growth rates The rule of 70 tells us that the time it takes a variable that grows gradually over time to double is approximately 70annual growth rate of that variable in the nineteenth century Ireland was desperately poor Recently the Irish economy has grown at extremely high rates in 2007 there gdp was higher than UK France and Germany today Ireland s economy is in trouble Ireland s rapid growth caused a bubble in real estate that spread to the financial sector as well After the bust banks had trouble making day to day expenses their liabilities were greater than the entire Irish economy and the EU is bailing the Irish economy fiscal and monetary policy can stimulate economic growth in the short run but it is not effective in the long run And as we ve seen too much growth can cause a bubble so what can cause growth in the long run There is only one driver of long run growth increasing labor productivity productivity Physical capital consists of humanmade resources such as buildings and machines c There is a maximum but generally the more physical capital a worker has at his disposal the more productive she can be Human capital is the improvement in labor created by the education and knowledge embodied in the workforce o A population with more human capital is more capable in a specific job or a variety ofjobs Technology is the technical means for the production of goods and services c A general measure of workers can produce more than they could before with the same levels of physical and human capital The aggregate production function Shows how productivity depends on the quantities of physical capital per worker and human capital per worker as well as the state of the technology o YLfKLHL T o Ygdp Lworkforce Kcapital Hhuman capital Ttechnology Aggregate production function used for Chinese and Indian economy GDP per workerTphysical capital per worker 4human capital per worker 6 Using this function the economist who made it tried to explain why china grew faster than india About half the difference was due to china s higher levels of investment spending An aggregate demand function exhibits diminishing returns o The first machines you buy increase output tremendously but after adding so many machines you will run out of space Growth Accounting Growth accounting estimates the contribution of each major factor in the aggregate demand production function to economic growth o The amount of physical capital in per worker in the us grows by about 3 each year c According estimates of the aggregate production function each 1 rise in physical capital per worker holding human capital and technology constant raises output per worker by 33 c Total factor productivity is the mount of output that can be achieved with a given amount of factor inputs After 20 years of being sluggish us productivity growth accelerated sharply in the late 90s was it the rise of the internet According to mckinsey the major source of productivity improvement after 95 was a surge in output per worker in retail Stores were selling much more merchandise per worker o Walmart has been a pioneer in using modern technology to improve productivity There is another endowment that can affect the productivity of a country Natural resources are an asset a country produces that are useful in production processes Today they can be a gift and a curse o Resource paradox O O In contrast to earlier times in the modern world natural resources are a much less important determinant of productivity than human or physical capital for the great majority of companies Without appropriate restraints countries rich in natural resources will often fall prey to dictators who exploit the wealth for their own gain and disregard the welfare of their people When the economics field was forming countries with natural resources were emerging as much stronger than their resource poor counter parts Early economists concluded that without resources a country couldn t succeed Of course the didn t foresee the rapid technological advancements to come advancements that can largely overcome resource constraints Now resource rich countries will often ignore the need to innovate depending on their resource like oil 0 Example Libya In the 60s libya was a relatively rich nation gaddafi took over with military dictatorship Miningoil accounted for 95 of gdp Diversification of the economy was not extended relying instead on oil and the 80 s saw lower oil prices dropping gpd by 42 the economy has never really recovered Why growth rates differ Countries tha add to their physical capital human capital andor make significant technological progress can be expected to grow faster than those that don t A robust private sector as well as a government that creates a safe environment for business to flourish A number of factors influence differences among countries in their growth rates Savings and investment spending Foreign investment Education Infrastructure Research and development o Political stability o Protection of property rights The role of government in improving growth is to maintain a healthy infrastructure education system and foster r and d Political stability and protection of property rights are crucial ingredients in long run economic growth Even when governments aren t corrupt excessive government intervention can be a brake on economic growth If large parts of the economy are supported by the government subsidies protected from imports or otherwise insulated from competition productivity tends to suffer because of a lack of incentives Gov must walk a tight rope of creating regulations protection aspects of the economy which they feel need protection without over regulating Finally if the government is too large a factor in the economy they can compete and destroy much of the private sector Government organizations are not nearly as good as the private sector at innovation Growth in 3 areas East Asia economies have done many things right and achieved high levels of growth o South Korea Taiwan Hong Kong and Singapore have had incredibly rapid economic growth that has made them advanced countries very quickly China joined them slightly later all combined as the east Asian miracle East Asia experienced 6 growth per capita real GDP since 1975 The achieved this through high levels of investment improved education and rapid technological progress These countries are an example of the convergence hypothesis which says that differences in real gpd per capita narrows between countries over time because those that start with lower real gpd have higher growth rates o Growth rates of economically advanced countries have converged but not the growth rates of countries across the world o The leads economists to believe that the convergence hypothesis fits data only when factors that affect growth are held equal across all countries Latin America where some important conditions are lacking growth has generally been disappointing o In the early 20th century latin America was considered fairly wealthy o High growth was expected on par with western countries but since 1925 growth has been very disappointing o Understanding why the growth is so meager here is difficult but includes under education political instability and too much government intervention Africa real gdp per capita has declined for several decades although now there are signs of progress o Despite freedom from colonial rule the last 40 years have been bad for Africa o Many countries have become poorer in real terms in this period c Unstable and corrupt governments often embezzle the aid of wealthier nations o Some economists think that this instability is caused by their poverty largely caused by poor geography Extreme heat disease and poor soil are all characteristics of subSaharan Africa How sustainable is growth Early economists believed that growth would become slower or decrease as the world population increased They did not account for the rapid change of technology which allows more to be done with less resources and allows growth to continue Long run growth is sustainable if it can continue in the face of the limitied supply of natural resources and anu impact of growth on the environment Differing views about the impact natural resources on long run growth turn on answers to these 3 questions How large are the supplies of key natural resources How effective will technology be at finding alternatives to these resources Can long run economic growth continue in the face of resource scarcity A more controversial question is how does economic growth affect the climate and if there is climate change will growth continue unabated Environmental concerns are only a concern for rich countries caring about problems like carbon emissions is a luxury 1102011 61500 PM Classical macroeconomics asserted that monetary policy affected only the aggregate price level not aggregate output o Short run is unimportant o Prices are flexible making aggregate supply curve vertical even in the short run By the 19305 measurement of business cycle was a well established subject but there was no widely accepted theory as to why o No one knew why recessions occurred In 1936 keynes presented his analysis of the great depression which was his explanation of what was wrong with the economy s business cycle moves in a book called the general theory of employment interest and money Keynes brought into economics the idea of the short run as important Main practical consequence of his work was that it legitimized policy activism ie monetary and fiscal Keynesian is typically liberal classical is typically conservative but each side adopts a bit of each school of thought o Young economists at the side thought fiscal expansion or deficit spending on a large scale to create jobs o Ww2 was where this deficit spending came from Keynesian economics fell somewhat out of favor til the recent recession o Many people consider its use a failure because it didn t stem unemployment o Krugman claims that the stimulus package wasn t big enough o Keynesian policy held that monetary policy was unimportant Milton friedman believes that fluctuations in the money supply were crucial to changes in the business cycle Monetarism o Asserts that gpd will grow steadily if money supply grows steadily o This is because increasing the money supply wont cause a huge increase in interest rates and crowding out of investment o It called for a shift from monetary policy rule to that of a discretionary monetary policy o This was eventually rejected by many economists When the central bank changes interest rates or the money supply based on its assessment of the state of the economy it is engaged in discretionary policy The velocity equation MV PY Mmoney supply VVelocity Pprice level YOutput GDP The velocity of money tells us how many times per year currency turns over between buyer and seller Monetarists believed that V was stable so the thought that if the fed kept M on a steady growth path nominal gdp would also grow steadily This policy was favored until the 1980 s when velocity started to change drastically and unpredictably In the 1970 s the fed adopted a monetary policy rule began announcing targer ranges for several measures of the money supply and stopped setting targets of interest rates Most people interpreted these changes as a strong move towards monetarism Since 1982 the fed has pursued a discretionary monetary policy which leads to large swings in the money supply Increase in money supply decreases interest rates which increases investment The turn to monetarism largely reflected the events of the 1970s when a sharp rise in inflationm broke the perceived trade off between inflation and unemployment and discredited traditional Keynesianism The turn away from monetarism also reflected events the velocity of money which had followed a smooth trend before 1980 became erratic after 1980 c this made monetarism seem like less of a good idea with the growth following ww2 some economists started to believe fiscal policy could be used to have full employment forever as we ve discussed however there are inflationary problems associated with expansionary policy the natural rate of unemployment is also the non accelerating inflation rate of unemployment or NAIRU according to the natural rate hypothesis because inflation is eventually embedded into expectations to avoid accelerating inflation over time the unemployment rate must be enough that the actual inflation rate equals the expected inflation rate the natural rate hypothesis limits the role of macroeconomic policy in stabilizing the economy the goal is not to seek a permanently lower unemployment rate but to keep it stable the natural rate hypothesis became almost universally accepted The Political Business Cycle This happens when politicians use macroeconomic policy to serve political ends Fear of a political business cycle led to consensus that monetary policy should be insulated from politics Recently new fields of macroeconomics have emerged The new challenges focus monstly on the idea of the sort run which was central to keynes economics 1102011 61500 PM Curriencies get from ian 427 Example 1 usd928 aud or 928 aud 1 usd what determines exchange rates Supply and demand of international currency Assume there are only two currincies usd and euros The exchange rate is then determined by how much Europeans demand American currency for purchases and how much Americans are willing to give up The equilibrium exchange rate is the exchange rate at which the quantity of a currency Like everything else in macro exchange rates can be affected by inflation Real exchange rates are exchange rates adjusted for international differences in aggregate price levels Current account changes depend on the real exchange rate not the nominal Real exchange ratepesos per dollars pUSPmex Pprice level Year 1 cpi is 200 in Thailand cpi is 150 in the us The nominal exchange rate is 1 thai bhat buys 25 usd In year 2 Cpi is 200 in both countries and 1 thai bhat buys 333 usd Year 1 1 usd 4 tb 20015013 Year 2 33usd1 bhat 20020013 No change in real interest rate Real exchange rate Why does current account exchange of goods and services change only with real exchange rate Consider a thai massage that costs 120 baht in Thailand in year 1 which is worth 30 In year 2 this massage still costs 120 baht but because inflation devalued the dollar that is worth 40 in the us Although the nominal exchange rate has seen the usd depreciate the real exchange rate remains the same The purchasing power parity between 2 countries currincies is the nominal exchange rate at which a given basket of goodsservices would cost the same amount in each country Once we understand exchange rates this is straight forward Example Us and Canada 1 computer 500 us 600 canadian 100 gallons of gas 500 900 canadian what is the exchange rate that would give us PPP on this basket purchasing power parity the ppp between 2 countries currency government purchases or sales of currency in the foreign exchange market are exchange market interventions exchange rate policy poses a delimma there are economic payoffs to stable exchange rates but the poliyies used to fix the exchange rate have costs exchangemarket intervention requires large reserves and exchange controls distort incentives if monetary policy is used to help fix the exchange rate it isn t available to use for domestic policy
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