Chapter 6 How to Measure an Economy

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Chapter 6 How to Measure an Economy Powered By Docstoc
					                Unit III
Lesson
VIII




                 Macro Tools


   Economics Gone Wild!
                     An Expanded Circular-Flow
                             Diagram

Lesson
VIII




   Economics Gone Wild!
                   National Income Accounting


Lesson
              • Bureau of Economic
VIII            Analysis compiles National
                Income and Product
                Accounts
                    –Assess health of economy
                    –Track long run course
                    –Formulate policy

   Economics Gone Wild!
              Assessing Economy’s Performance
              • Gross Domestic Product
Lesson
                (GDP)
VIII                – A Monetary Measure
              • Avoid Multiple Counting
                    – Market value final goods
                    – Ignore intermediate goods
                    – Count value added
                    – Exclude Nonproduction
                      Transactions
   Economics Gone Wild!
              Assessing Economy’s Performance
              • Financial Transactions
Lesson          Excluded
VIII                –Public Transfer Payments
                    –Private Transfer Payments
                    –Stock (and Bond) Market
                     Transactions
                    –Second Hand Sales
                          • Sell used car to a friend
                          • Yard Sales

   Economics Gone Wild!
                Two Approaches to GDP
              • Income approach
                    – Count income derived from
Lesson                production
VIII
                    – Wages, rental income, interest
                      income, profit
              • Expenditure approach
                    – Count sum of money spent buying
                      the final goods
                    – Who buys the goods?
                    – Final-Product or Value-Added
                    – Sum of the Money Spent to Buy the
                      Output
   Economics Gone Wild!
                Two Approaches to GDP
                   Expenditure            Income
                    Approach             Approach
                Consumption by
Lesson                                     Wages
                  Households
VIII
                          +
                  Investment by
                                             +
                                            Rents
                   Businesses       G        +
                          +       = D=     Interest
                    Government
                     Purchases      P        +
                                           Profits
                          +
                  Expenditures
                                             +
                                          Statistical
                  By Foreigners          Adjustments
   Economics Gone Wild!
                          Expenditure Approach
              • Personal consumption
Lesson          expenditures (C)
VIII
                   –Durable consumer goods
                   –Nondurable consumer
                    goods
                   –Consumer expenditures for
                    services
                   –Domestic plus foreign
                    produced
   Economics Gone Wild!
                  Expenditure Approach
             • Gross private domestic
Lesson         investment (I)
VIII               – Machinery, equipment, and
                     tools
                   – All construction
                   – Changes in inventories
                   – Creation of new capital asset
             • Noninvestment transactions
                   – Capital consumption
                   – Capital transfers
   Economics Gone Wild!
                    Expenditure Approach
                            Gross Investment
Lesson                    - Depreciation
VIII
                          = Net Investment
                                     Net
                                 Investment
                         Gross
                    Investment
                                 Depreciation

                                                Increased

                                 Consumption
                   Stock of      & Government    Stock of
                   Capital         Spending      Capital
                   January 1      Year’s GDP    December 31
   Economics Gone Wild!
                          Expenditure Approach
              • Government purchases (G)
Lesson             –Expenditures for goods and
VIII
                    services
                   –Expenditures for social
                    capital
                   –Excludes transfer payments



   Economics Gone Wild!
                          Expenditure Approach
              • Net exports (Xn)
Lesson
VIII               –Add exported goods
                   –Subtract imported goods
                   –NX = exports - imports




   Economics Gone Wild!
                    Expenditure Approach
             Putting It All Together:
Lesson
VIII

             GDP = C + I + G + Xn
             GDP = $11,249
                 + 2,084
                 + 3,053
                 - 557
                             = $15,829 in 2012


   Economics Gone Wild!
               GDP Approaches Compared
             Accounting Statement for the U.S. Economy, 2012
                          in Billions
                Receipts
                Expenditures Approach
Lesson
VIII                        Personal Consumption (C)   $11,249
                            Gross Private Domestic
                            Investment (Ig)              2,084
                            Government Purchases (G)     3,053
                            Net Exports (Xn)              -557

                            Gross Domestic Product     $ 15,829




   Economics Gone Wild!
                      Comparative GDPs
                            GLOBAL PERSPECTIVE
                          Select Nations GDPs - 2010
Lesson
VIII                                 GDP in Trillions of Dollars
                             0   1    2    3    4    5     6   7      8   9    10     12
               United States                                                     $14.58
                       China                                  $5.93
                       Japan                              $5.48
                    Germany                       $3.28
                      France                   $2.56
             United Kingdom              $2.24
                       Brazil              $2.09
                         Italy           $2.05
                        India          $1.84
                     Canada              $1.58
                      Russia          $1.48
                       Spain          $1.40
                      Mexico           $1.03
                 South Korea           $1.01
                    Australia         $.94
   Economics Gone Wild!                                                   Source: World Bank
             The Income Approach
         •   Compensation of Employees
Lesson   •   Rents
VIII
         •   Interest
         •   Proprietor’s Income
         •   Corporate Profits
                   – Corporate Income Taxes
                   – Dividends
                   – Undistributed Corporate Profits
                   – Taxes on Production and
   Economics Gone Wild! Imports
            The Income Approach
         • From National Income to GDP
Lesson     – Net Foreign Factor Income
VIII       – Statistical Discrepancy
           – Consumption of Fixed Capital
         • Other National Accounts
                   – Net Domestic Product (NDP)
                   – National Income (NI)
                   – Personal Income (PI)
                   – Disposable Income (DI)
   Economics Gone Wild!
                        DI = C + S
              U.S. Income Relationships 2012

              Gross Domestic Product (GDP)            $ 15,829
Lesson        Less: Consumption of Fixed Capital         2036
VIII          Equals: Net Domestic Product (NDP)      $ 13793
              Less: Statistical Discrepancy                -50
              Plus: Net Foreign Factor Income              165
              Equals: National Income (NI)            $ 13,196
              Less: Taxes on Production and Imports      1098
              Less: Social Security Contributions          924
              Less: Corporate Income Taxes                 513
              Less: Undistributed Corporate Profits        344
              Plus: Transfer Payments                    2361
              Equals: Personal Income (PI)            $ 13,936
              Less: Personal Taxes                       1514
              Equals: Disposable Income (DI)          $ 12,422


   Economics Gone Wild!                                      7-18
            GDP Approaches Compared
           Accounting Statement for the U.S. Economy, 2011
                     in Billions
              Receipts                         Allocations
              Expenditures Approach            Income Approach
Lesson
            Personal Consumption (C) $10,858 Compensation                $ 8,242
VIII
            Gross Private Domestic           Rents                           404
            Investment (Ig)           2,000 Interest                         536
            Government Purchases (G) 3,018 Proprietor’s Income              1108
            Net Exports (Xn)           -582 Corporate Profits               1870
                                             Taxes on Production and
                                             Imports                        1036
                                             National Income             $13,196


                                             Net Foreign Factor Income       165
                                             Statistical Discrepancy          -50
                                             Consumption of Fixed
                                             Capital                        1983
              Gross Domestic Product $ 15,294 Gross Domestic Product     $ 15,294
   Economics Gone Wild!
            GDP Approaches Compared
           Accounting Statement for the U.S. Economy, 2011
                     in Billions
              Receipts                         Allocations
              Expenditures Approach            Income Approach
Lesson
            Personal Consumption (C) $10,858 Compensation                $ 8,242
VIII
            Gross Private Domestic           Rents                           404
            Investment (Ig)           2,000 Interest                         536
            Government Purchases (G) 3,018 Proprietor’s Income              1108
            Net Exports (Xn)           -582 Corporate Profits               1870
                                             Taxes on Production and
                                             Imports                        1036
                                             National Income             $13,196


                                             Net Foreign Factor Income       165
                                             Statistical Discrepancy          -50
                                             Consumption of Fixed
                                             Capital                        1983
              Gross Domestic Product $ 15,294 Gross Domestic Product     $ 15,294
   Economics Gone Wild!
                   Circular Flow Revisited
                U.S. Domestic Output and the
                Flows of Expenditure and Income
Lesson
VIII




   Economics Gone Wild!
                 Nominal vs. Real GDP
              • GDP is a dollar measure of
Lesson          production
VIII
              • Using dollar values creates
                problems
              • Nominal GDP
                   –Use prevailing price
              • Real GDP
                   –Reflect changes in price
                   –Use base year price
   Economics Gone Wild!
                           GDP Price Index
                           Use price index to
Lesson
VIII
                          determine real GDP
            Price              Price of Market Basket
            Index                  In Specific Year
            In Given      =    Price of Same Basket
                                                        x 100
            Year                     In Base Year


                Real                   Nominal GDP
                GDP        =
                                Price Index (in hundredths)

   Economics Gone Wild!
                          Shortcomings of GDP
              • Nonmarket activities
Lesson        • Leisure
VIII
              • Improved product quality
              • The underground economy
              • GDP and the environment
              • Composition and distribution of
                the output
              • Noneconomic sources of well-
                being
   Economics Gone Wild!
                           The Free Economy
                               GLOBAL PERSPECTIVE
             Underground Economy as a Percentage
Lesson       of GDP - Select Nations
VIII                                        Percentage of GDP
                                    0   5   10   15       20          25          30
                         Mexico
                  South Korea
                           India
                            Italy
                          Spain
                          China
                        Sweden
                       Germany
                         France
             United Kingdom
                          Japan
                   Switzerland
   Economics Gone Wild!       US                      Source: Journal of Economic Literature
                          C+I+G=Baloney
                • Mainstreamers add government
                  expenditures to Gross Domestic
Lesson            Product (GDP)
VIII            • But it is really a drain depending on
                  the weight of the fiscal extent of
                  government activity in the economy
                • Government expenditure is theft not
                  production
                • So we need to adjust GDP to arrive at
                  Gross Private Product


   Economics Gone Wild!
                                     GPP
              • Corrections to GDP
                    – Transfer payments, because they are
Lesson
                      taken from producers and given to non-
VIII
                      producers, should not be added
                    – Any “goods or services” from
                      government enterprises, need to be
                      subtracted
                    – Public employees’ salaries because it is
                      gathered by means of taxation of the
                      private sector need subtraction




   Economics Gone Wild!
                                 C+I+G=Baloney
                                     X
             • Now from GPP, G must be
               subtracted, but…
Lesson
VIII
                   – If spending is larger than taxes, then
                     the deficit is either financed by issuing
                     new money or by borrowing private
                     savings.
                          • In either case, the deficit constitutes a
                            drain of resources from the private sector.
                   – If there is a surplus of taxes over
                     spending, then the surplus taxes are
                     drains on the private sector.
                   – Subtract which ever larger
   Economics Gone Wild!
                       C+I+G=Baloney
             This subtracted from GPP yields
             the private product remaining in
Lesson
VIII         private hands: PPR (Private
             Output plus Costs of Government
             output)
             • GDP=C+I+G+(X-M)
             • GDP- GI (products or incomes from
               government=GPP
             • GPP- G (receipts or spending)=PPR

   Economics Gone Wild!
Lesson
VIII




   Economics Gone Wild!
                  Magical Mystery Tour
                     BEA Sources of Data for Analysis
                • Consumption
Lesson             – Census Bureau’s Retail Trade Survey
VIII               – Census Bureau’s Survey of Manufacturers
                   – Census Bureau’s Service Survey
                • Investment
                   –      All Consumption Data Sources
                   –      Survey of Manufacturers
                   –      Service Survey
                   –      Industry Sources
                   –      Census Bureau’s Housing Starts Survey
                          and Housing Sales Survey
                     – Retail Trade Survey
                     – Wholesale Trade Survey
   Economics
                     – Survey of Manufacturing
               Gone Wild!
                  Magical Mystery Tour
              • Government Purchases
Lesson
VIII                – Office of Personnel Management
                    – Construction Surveys
                    – Census Bureau’s Survey of
                      Government Finance
              • Net Exports
                    – U.S. Customs Service
                    – BEA Surveys and Analysis


   Economics Gone Wild!
                          Seven Major Sources of
     Lesson
     VIII                   Economic Progress


                                   Common Sense Economics
                                  James Gwartney, Richard L. Stroup, and
                                             Dwight R. Lee




33      Economics Gone Wild!
                      Questions to Consider
                • Capital investments and new
Lesson            technology clearly contribute to
VIII              economic growth and prosperity.
                  What else is needed and what can
                  governments add?
                • Why are sound institutions,
                  governmental policies and money
                  of stable value important? How can
                  they advance economic progress?
                  How can they stifle it?
                • Why do economic growth patterns
                  and rates differ across countries
                  and time?


   Economics Gone Wild!
                           Source #1

Lesson
                          Legal System
VIII                The foundation for economic
                    progress is a legal system that
                   protects the private use of land,
                   natural resources, labor, capital,
                   and entrepreneurial talent in an
                        even-handed manner.



   Economics Gone Wild!
                          The Foundation for
                          Economic Progress
                    Private property rights grant the
                    owner of property the right to
Lesson              buy, sell, or derive income from
VIII                their land, natural resources,
                    capital and entrepreneurial
                    talent.
                    Even-handed enforcement
                    protects these rights to
                    exclusive use, protection
                    against abuse, and transfer
                    rights, thus allowing property
                    owners to focus on resource
                    allocation, efficient production,
                    investment, and technological
                    advancement.



   Economics Gone Wild!
                          Property Rights
             Encourage people to use their
             property productively.
Lesson
VIII
             Promote wise stewardship.
             Encourage people to develop
             their property in ways beneficial
             to others for possible exchange,
             transfer or sale.
             Promote the wise development
             and conservation of resources for
             the future.

   Economics Gone Wild!
               The U.S. Will Run Out of Oil! Or
                              Will It?
              1. In which year(s) did experts
Lesson           predict that the U.S. would run
VIII             out of oil in the near future?
                    a.    1914
                    b.    1926
                    c.    1970s
                    d.    2008
                    e.    All of the above



   Economics Gone Wild!
                  Why Have Doomsday Forecasts Been
                              Wrong?

                • When the scarcity of a
Lesson              privately owned resource
VIII                increases, the invisible
                    hand of the market takes
                    over and prices rise.
                • Buyers and sellers seek
                    substitutes, discover
                    ways to conserve, and
                    innovate!
                • Historically, competitive
                    markets and flexible
                    prices spur conservation,
                    substitution, and
                    technological
                    advancement.
   Economics
                • And the “sky” never falls!
               Gone Wild!
                          Source #2
                   Competitive Markets
Lesson
VIII            Competition promotes the
                efficient use of resources
                      and provides a
                 continuous stimulus for
                innovative improvements.



   Economics Gone Wild!
                               Consumers Rule!
                  • Competition places pressure on producers to operate
                    efficiently.
     Lesson       • Competition forces businesses to cater to their
                    customers’ preferences and provide goods and
     VIII           services for which they are willing to pay prices
                    sufficient to cover their costs.
                  • Consumers vote with dollars on which businesses
                    stay and which must go. (e.g. Target vs. Wal-Mart vs.
                    Sears vs. K-Mart)
                  • They make sure that sole proprietors, partnerships
                    and large corporations charge low prices, produce
                    quality products and provide services of value relative
                    to costs!




41      Economics Gone Wild!
                          Source #3
                    Limits on Government
Lesson                    Regulation
VIII
                   Regulatory policies that
                   reduce trade also retard
                      economic progress.



   Economics Gone Wild!
                 Governments Limit Trade and
                     Retard Progress By
             Limiting entry into some
             businesses and occupations
Lesson             •      Licensing requirements,
                          completing bureaucratic forms,
VIII                      etc.
             Substituting political authority for
             rule of law and freedom of contract
                   •      Imprecise, ambiguous and
                          discriminatory laws invite
                          people to spend resources on
                          bribery and lobbying efforts
                          rather than production.
             Imposing price controls
                   •      Price floors and ceilings
                          interfere with trades between
                          buyers and sellers, distort
                          prices, and lead to inefficient
                          levels of production and
                          employment.


   Economics Gone Wild!
                              Source #4

Lesson
VIII                      An Efficient Capital
                                 Market
                   To realize its potential, a
                       nation must have a
                    mechanism that channels
                   capital into wealth-creating
                             projects.
   Economics Gone Wild!
                 Capital Investment and Its Role in Growth


             • Capital is anything used to produce
Lesson         something else and helps us produce more
VIII           goods and services in the future.
                   – Machines, buildings, computers, tools


             • Capital investment requires consumption
               sacrifices today. It requires savings. The
               payoff is increased production and
               consumption in the future.

             • A mechanism is needed to channel savings
               into productive investments. Capital
               markets perform this function.
   Economics Gone Wild!
                              Capital Markets
               • Capital markets, broadly defined, include markets
                 for:
                     – Loanable funds, real estate, stock markets &
                       financial markets
Lesson
               • Institutions like banks, credit unions and
VIII             investment firms bring savers and investors
                 together.
               • Interest rates provide people with incentive to
                 save. Productive investments will yield a return
                 sufficient to cover all costs, including borrowing.
               • Not all investment projects are productive. In a
                 world of uncertainty, investments can and do fail.
                 But failures hold investors accountable and
                 provide them the incentive to discover and
                 undertake productive projects.




   Economics Gone Wild!
                Capital Markets and Government Intervention

              • Governments can and do intervene in
                capital markets by restricting capital
Lesson
                movements, setting interest rates, and
VIII
                using taxes and budgets to allocate
                capital.
              • These actions:
                    – Distort market incentives.
                    – Increase the importance of political rather than
                      economic considerations.
                    – Make unproductive investments more likely.




   Economics Gone Wild!
                               Source #5
                            Monetary Stability
Lesson
VIII                      Inflationary monetary
                           policies distort price
                          signals, undermining a
                             market economy.



   Economics Gone Wild!
                    Money, Money, Money!
              • “Money is to an economy what
Lesson          language is to communication.”
VIII          • Money serves three functions
                   – Medium of exchange
                   – Unit of account
                   – Store of value
              • When the value of money is
                stable,
                   – Many potentially beneficial exchanges
                     will take place.
                   – Borrowers and lenders will face less
                     uncertainty.
                   – Gains from trade will be maximized.
   Economics Gone Wild!
                Money and Who Controls It
              • The nation’s money consists of
Lesson          its currency held by the public,
VIII            checking accounts, and traveler’s
                checks.
              • A nation’s central bank controls
                its money by buying and selling
                assets, usually government
                bonds.


   Economics Gone Wild!
                          The Value of Money
             • The value of money is determined by supply
               and demand.
Lesson       • The value of money is steady when the
VIII           supply of money grows slowly (e.g. at
               approximately the same rate as goods and
               services).
             • When a central bank expands the money
               supply rapidly relative to the production of
               goods and services, inflation results and the
               purchasing power of money is eroded.




   Economics Gone Wild!
                          Inflation’s Uncertainty
             • Difficult to forge long-range
               plans when you cannot
Lesson         predict the value of money
VIII
             • Confidence in government
               declines when citizens lack
               confidence in the value of
               their nation’s currency

             • Harms different sectors of
               population, differently




   Economics Gone Wild!
                 The Keys to Sound Money
                    and Price Stability
Lesson       Central banks and their officials should be held
VIII         accountable for following a sound money
             policy and keeping the nation’s rate of inflation
             within a narrow range; or be dismissed.
             A currency board in one nation could establish
             a fixed rate of exchange between its domestic
             currency and a selected foreign counterpart
             with a sound money policy. This is often
             attractive for small countries.

             A country could adopt another nation’s
             currency to provide stability. For example, the
             euro or dollar are often used.

   Economics Gone Wild!
                           Source #6

Lesson                    Low Tax Rates
VIII
                    People will produce more
                    when they are permitted to
                     keep more of what they
                               earn.



   Economics Gone Wild!
                          High Marginal Tax
                                Rates
Lesson
VIII

               Discourage work effort and reduce the
               productivity of labor.
               Reduce both the level and efficiency of
               capital formation.
               Encourage individuals to consume tax-
               deductible goods when nondeductible
               goods may actually be more desirable.


   Economics Gone Wild!
                          Source #7
Lesson                     Free Trade
VIII
                   A nation progresses by
                  selling goods and services
                    that it can produce at a
                    relatively low cost and
                   buying those that would
                     be costly to produce.
   Economics Gone Wild!
                   Increased Production and
                Consumption Among All Trading
                           Partners
              • International trade makes it possible
Lesson          for each country to acquire goods and
VIII
                services more cheaply.
              • It allows domestic producers and
                consumers to benefit from the
                economies of scale.
              • It promotes competition in domestic
                markets and allows consumers to
                purchase a wider variety of goods at
                lower prices.

   Economics Gone Wild!
                          Free Trade Allows:
             • Consumers to find the lowest
Lesson         prices, the best value from
VIII           their expenditures, and the
               greatest variety of goods and
               services.
             • Domestic producers to sell
               their goods and services
               where they can get the highest
               price for the value of what
               they offer in the marketplace.
   Economics Gone Wild!
               Government Barriers to Trade
                          • Include tariffs, domestic
Lesson                      subsidies, quotas, etc.
VIII                      • Do not create or destroy domestic
                            jobs; they just shuffle them
                            around.
                          • Create inefficiencies in the
                            protected industries, forcing
                            domestic consumers to pay higher
                            prices.




   Economics Gone Wild!
                International Trade: Imports and Exports

              • Trade restrictions that reduce imports will
                also reduce the ability of foreigners to buy
Lesson          our exports.
VIII          • Quotas and tariffs decrease the number of
                dollars earned by foreigners through the sale
                of imports to us.
              • Therefore, reductions in imports
                simultaneously reduce exports.




   Economics Gone Wild!
             If goods can’t cross borders,
                     soldiers will.
Lesson
VIII           “More than any other single action,
                  unilateral removal of our trade
                 restrictions would establish the
                 environment for a more peaceful
                     and prosperous world.”




   Economics Gone Wild!
                          Concluding Thoughts
              How important are the following
Lesson        institutions/policies for a country’s
VIII          prosperity?
                    a. Secure protection of privately owned
                       property
                    b. Even-handed enforcement of contracts
                    c. Stable monetary environment
                    d. Low marginal tax rates
                    e. Minimal barriers to trade
                    f. Market versus government allocation
                       of capital

   Economics Gone Wild!
                          The Evidence Indicates
              • The countries with the highest levels of
                economic freedom have the highest per
Lesson          capita GDP and growth rates.
VIII          • Free economies spur savings and
                investment resulting in economic growth
                and prosperity.
              • Differing institutions and policies explain
                why growth rates vary across countries and
                time.




   Economics Gone Wild!
                                        Selected Growth Rates
                                                            GLOBAL PERSPECTIVE

                                                    6
Lesson
VIII              Percentage Change (annual rate)
                                                             U.S.
                                                    4
                                                             France

                                                            Germany                  U.K.
                                                    2

                                                                      Japan                                 Italy
                                                    0


                                                    -2


                                                    -4
                                                     1997       1999          2001               2003                 2005
   Economics Gone Wild!                                                              Source: Economic Report of the President, 2006
                          Economic Growth
              • Increase in Real GDP
Lesson        • Increase in Real GDP Per
VIII
                Capita
              • Growth as a Goal
              • Arithmetic of Growth
                    – Rule of 70
               Approximate                       70
               number of years
               required to double
                                    =
                                        annual percentage rate
               real GDP                       of growth
   Economics Gone Wild!
          Ingredients of Growth
         • Supply Factors
Lesson             –Increases in Quantity and
VIII                    Quality of Natural
                        Resources
                   –Increases in Quality and
                        Quantity of Human
                        Resources
                   –Increases in the Supply (or
                        Stock) of Capital Goods
                   –Improvements in
   Economics Gone Wild!
                        Technology
                  Ingredients of Growth
              • Demand Factor
Lesson              –Households, Businesses,
VIII                 And Government Must
                     Purchase the Economy’s
                     Expanding Output of Goods
                     and Services
              • Efficiency Factor
                    –Must Achieve Economic
                     Efficiency and Full
                     Employment
   Economics Gone Wild!
                Production Possibilities
              Production Possibilities Curve
              From Chapter 1
Lesson                                    C
VIII

                                          A
                                                             Economic
                          Capital Goods

                                                             Growth

                                                         c   b
                                                 a




                                                     B           D
   Economics Gone Wild!                       Consumer Goods
             Labor and Productivity
             Labor Productivity
Lesson      Real GDP = Hours of Work x Labor Productivity
VIII
                 • Size of
                   Employed
                   Labor Force      Labor
                                    Inputs
                 • Average          (Hours of
                   Hours            Work)
                   of Work

                                                   Real
                  • Technological                  GDP
                    Advance
                  • Quantity of     Labor
                    Capital         Productivity
                  • Education and   (Average
                    Training        Output per
                  • Allocative      Hour)
                    Efficiency
                  • Other
   Economics Gone Wild!
                   Growth in the AD-AS Model
                   Production Possibilities and
                    Aggregate Supply
Lesson
VIII
                                                            ASLR1 ASLR2
                         C
             Capital Goods




                         A




                                              Price Level
                                B      D
                             Consumer Goods                  Real GDP
   Economics Gone Wild!
              Growth in the AD-AS Model
              Production Possibilities and
               Aggregate Supply
Lesson
VIII          Depicting U.S. Growth with AD-AS Model
                                       ASLR1              ASLR2
                                                                  AS2

                                                 AS1
                    Price Level




                                  P2

                                  P1
                                                                  AD2

                                                 AD1


                                        Q1                 Q2
   Economics Gone Wild!                        Real GDP
                                     Accounting for Growth
                  • Growth Accounting
                  • U.S. Economic Growth Rates
Lesson        U.S. Economic Growth, Annual Averages for Five Decades
VIII                                              5
                                                                                      Real GDP
              Average Annual Increase (Percent)



                                                                                      Real GDP Per Capita
                                                  4


                                                  3


                                                  2


                                                  1


                                                  0
                                                      1950-1959 1960-1969 1970-1979 1980-1989 1990-1999 2000-2005

   Economics Gone Wild!                                                     Year           Source: Bureau of Economic Analysis
                Accounting for Growth
              • Factors Underlying Growth
Lesson              –Increases in Hours of Work
VIII                –Increases in Labor
                     Productivity
                       Accounting for Growth of U.S. Real GDP, 1953-2013
                       (Annual Percentage Changes)

                                                    1953 Q2   1973 Q4    1995 Q2     2001 Q1      2007 Q3
                                                       to        to         to          to           to
                Item                                1973 Q4   1995 Q2    2001 Q1     2007 Q3      2013 Q4*


              Increases in Real GDP                   3.6      2.8         3.8          2.6         2.8

                 Increases in
                     Quantity of Labor                1.2      1.3         1.4         -0.1         0.3

                 Increases in
                     Labor Productivity               2.5      1.5         2.4          2.7         2.5
   Economics Gone Wild!       *Beyond 2005 are Projections     Source: Economic Report of the President, 2008
                Accounting for Growth
              • Technological Advance
Lesson        • Quantity of Capital
VIII                – Infrastructure
              • Education and Training
                    – Human Capital
              Changes in the Educational Attainment of the U.S. Adult Population
                                                  100
                    Percent of Adult Population




                                                   80


                                                   60


                                                   40


                                                   20


                                                    0
                                                        1960   1970   1980   1990   2000    2005
   Economics Gone Wild!                                               Year                 Source: U.S. Census Bureau
                     Accounting for Growth
Lesson       • Factors affecting
VIII           productivity growth
                   –Technological advance (40%)
                   –Quantity of capital (30%)
                   –Education and training (15%)
                   –Economies of scale and
                    resource allocation (15%)

   Economics Gone Wild!
                Accounting for Growth
                              GLOBAL PERSPECTIVE
              Average Test Scores of Eighth Students
Lesson        In Math and Science, Top 10 Countries
VIII          and the United States
                          Mathematics                 Science
               1   Singapore            605    1 Singapore       578
               2   South Korea          589    2 Taiwan          571
               3   Hong Kong            586    3 South Korea     558
               4   Taiwan               585    4 Hong Kong       556
               5   Japan                570    5 Estonia         552
               6   Belgium              537    6 Japan           552
               7   Netherlands          536    7 Hungary         543
               8   Estonia              531    8 Netherlands     536
               9   Hungary              529    9 United States   527
              10   Malaysia             508   10 Australia       527
              15   United States        504
   Economics Gone Wild!
                Accounting for Growth
              • Economies of Scale
Lesson
VIII
              • Improved Resource
                Allocation
              • Other Factors
                    –Economic Freedom
                    –Political Freedom
                    –“Growth Friendly”
                    –Positive Attitudes Toward
                     Work and Risk Taking
   Economics Gone Wild!
                                        Tax Rates
                          Country                        Rate of All Taxes on Goods


Lesson                       UK                                    20%
VIII                       France                                  19.6%
                          Germany                                  19%
                    EU 15 Original Average                        20.77%
                           Canada                                5 to 13%*
                            China                                  17%
                           Mexico                                  16%
                            India                                  12.5%
                            Japan                                   5%
                             US                                    35%


                           *Canada has varied provincial rates

   Economics Gone Wild!
                          Economic Growth

             • Is accelerated productivity
Lesson
VIII           growth sustainable?
             • Is economic growth
               desirable and sustainable?




   Economics Gone Wild!
                      Growth Desirability
              • The Antigrowth View
Lesson
                    –Adverse Spillovers
VIII                –Alternative Quality of Life
                     Opinions
                    –Environmental and resource
                     issues




   Economics Gone Wild!
                      Growth Desirability
              • In Defense of Economic
                Growth
Lesson
VIII
                    – Higher Standard of Living
                    – Poverty Reduction
                    – Limited Only by Human
                      Imagination
                    – Human imagination can solve
                      environmental and resource
                      issues


   Economics Gone Wild!
                 The Production Possibilities
                 Frontier
Lesson
VIII




              The Consumption-
              Investment Tradeoff
              And the Essence of
              Economic Growth



   Economics Gone Wild!
             In any economy, some
             resources are devoted to




                                             CONSUMPTION
             producing consumables, the
             remaining resources being
             available for maintaining and
 Lesson      expanding the economy’s
 VIII        productive capacity.
The PPF
              The Production Possibilities
                                                           INVESTMENT
              Frontier (PPF) depicts these
              A “fully employed market economy” allows
              alternatives during a given
              time so-called “natural
              for aperiod, typically one rate of
              unemployment,” which is about five or six
              year.
              percent. That is, frictional and structural
             The tradeoff between CONSUMPTION (in the present) and
              unemployment are characteristic of even part of our
             INVESTMENT (for the future) should be an integral a
             macroeconomic thinking.
              healthy economy.
             Under favorable conditions, a fully employed market economy
             allocates resources to both uses, making the most of the
             trade-off.
   Economics Gone Wild!
                                                                  A PPF with
              If resources were and capital
              But raw materials                                homogeneous
                                                              heterogeneous




                                              CONSUMPTION
              characterized by perfect
              equipment are                                           inputs
              homogeneity, such that each
              heterogeneous. Riverboats
              unit of input is equally
              and river barges are not
              suitable for producing either
              readily substitutable one for
Lesson        kindother.
              the of output (consumption
VIII          goods or investment goods),
              then the PPF would be linear.
                                                            INVESTMENT




              The heterogeneity of equipment and materials implies a
              convex PPF.

              As the tradeoff is made away from consumption and
              toward more investment, the scope for still more
              investment diminishes.
              Microeconomists would describe this feature of the PPF
              in terms of a diminishing marginal rate of substitution.
   Economics Gone Wild!
                                             CONSUMPTION
             “Investment” in this
             construction represents gross
             investment, which includes
             replacement capital.
Lesson
             Typically, the investment
VIII         needed just to replace
             The out or obsolete capital
             wornextent to which gross
                                                                         INVESTMENT
             is substantial but
             investment exceeds the                        Replacement
                                                           Capital
             “replacement” than gross
             something lessmagnitude
                                                                             Net Investment
             investment.net investment
             constitutes
                                                            Gross
             and allows for the expansion                   Investment
             of the economy.

             Positive net investment means that the economy is growing.
             The PPF shifts outward from year to year, permitting
             increasing levels of both consumption and investment.
             This outward shifting of the PPF represents sustainable
             economic growth.
   Economics Gone Wild!
                                                                                          YEAR 34
                                                                                           YEAR0
                                                                                               2
                                                                                               1
              Watch the economy grow.




                                                CONSUMPTION
              Four periods of growth are
              shown—with consumption, as
              well as investment, increasing
Lesson        in each period.
VIII
              The actual rate of expansion of
              the PPF depends upon many
                                                                            INVESTMENT
              factors. For instance, with                     Replacement
                                                              Capital
              economic expansion, more
                                                                             Net Investment
              resources are needed for
                                                              Gross
              capital replacement. And the                    Investment
              desired trade-off between
              consuming and investing can
              itself change as the economy
              generates more wealth.



   Economics Gone Wild!
             Watch the economy grow.




                                          CONSUMPTION
             Importantly, we note that
             forgoing some consumption
Lesson       with an eye toward
VIII         consuming more in the
             future triggers a movement
             along the initial PPF and                            INVESTMENT

             hence affects the rate at
             which the PPF expands                      Watch the movement
             outward.                                   along the PPF.




   Economics Gone Wild!
              Now watch the economy




                                              CONSUMPTION
              grow.                                                   0
                                                                 YEAR 1
                                                                      3
                                                                      2
                                                                      4



Lesson
VIII

                                                             INVESTMENT



              Increased thriftiness makes the difference.


                              Let’s compare the high-
                              growth economy with the
                              original low-growth economy.




   Economics Gone Wild!
                                                          CONSUMPTION
          CONSUMPTION

Lesson
VIII

                              INVESTMENT                                 INVESTMENT

                        Note the difference that an initial trading off of consumption for
                        investment makes in the subsequentat the expense of
                        With an initial increase in investment pattern of consumption
                        and investment. consumption and investment increase
                        consumption, both
                        Without an initial increase in investment, consumption and
                        dramatically from period to period.
                        investment increase modestly from period to period.
                        By the fourth period, that initial increase in investment pays off
                        as a higher level of consumption than would otherwise have
                        been possible.



   Economics Gone Wild!
                        The time dimension is




                                                           CONSUMPTION
                        represented by the sequence
                        of shifts of the PPF.
                        We can add to our
Lesson                  understanding if we
VIII                    represent time explicitly on a
                        horizontal axis and then keep
                        track of consumption on the
                                                                                  INVESTMENT
                        vertical axis.
                                                                      In both representations,
                                                                     Explicitly tracking the level of
CONSUMPTION




                                                                      consumption is seen to fall
                                                                     consumption over time allows
                                                                      as the economy tradeoff is
                                                                     us to see that theis adapting
                                                                      to a higher growth rate, after
                                                                     essentially an intertemporal
                                                                      which consumption rises
                                                                     tradeoff.
                                                                      more rapidly than before…
                                                                      and eventually surpasses
                                                                    Consumption in the present the
                                                                      old projected is traded for
                                                                    and near futuregrowth path.
                                                                    consumption in the more
                                                    TIME
                                                                    distant future.
              Economics Gone Wild!
             There is nothing pre-




                                            CONSUMPTION
             ordained about the economy                                     YEAR 1
                                                                                 0
                                                                                 4
                                                                                 2
                                                                                 3
             actually having a positive
             rate of growth.
Lesson       Suppose that gross
             investment in the economy is
VIII         just enough to replace worn
             out and obsolete capital—
                                                                           INVESTMENT
             which means that net                         Replacement
                                                          Capital
             investment is zero.
                                                             Gross               Net Investment
                                                                            Net Investment = 0
             The levels of consumption                       Investment

             and (gross) investment
             would be maintained, but the                     Gross
                                                              Investment
             economy would not grow.                      Watch the economy not
                                                          grow.




   Economics Gone Wild!
             In a no-growth economy
             (meaning no net investment),




                                               CONSUMPTION
             would it be possible for                                           3
                                                                                2
                                                                                1
                                                                                4
                                                                           YEAR 0
             people to increase
             consumption?
Lesson      Yes, there is still some scope
            for movement along the PPF in
VIII
            the direction of more
            consumption and less
                                                                           INVESTMENT
            investment.                                      Replacement
                                                             Capital

             But what would be the
                                                             Gross
             consequences for the PPF in                     Investment
             subsequent years?

             Watch the economy experience negative growth, i.e., watch it
             contract.
             Notice that consumption rises initially and then falls as the
             economy’s productive capacity diminishes over time.

   Economics Gone Wild!
                        As in the case of a clockwise




                                                           CONSUMPTION
                        movement along the PPF, we
                        can add to our understanding
                        of this counterclockwise
                        movement by representing
Lesson                  time explicitly on a horizontal
VIII                    axis and then keeping track of
                        consumption on the vertical
                        axis.                                                 INVESTMENT


                                                                 In both representations,
CONSUMPTION




                                                                   The increase seen to rise
                                                                 consumption isin consumption
                                                                   in the present is adapting
                                                                 as the economyand near future
                                                                 to a negative growth rate, a
                                                                   comes at the expense of
                                                                   declining consumption
                                                                 after whichrate of consumption
                                                                 declines—soon falling below
                                                                   in the more distant future.
                                                                 the initial level.


                                                    TIME

              Economics Gone Wild!
CONSUMPTION


                                             If gross investment exceeds
                                             replacement capital, the
                                             economy expands.
Lesson
VIII

                                     TIME
CONSUMPTION




                                            If gross investment falls
                                            short of replacement capital,
                                            the economy contracts.




              Economics Gone Wild!   TIME
              Consider two separate
              economies, one large




                                                CONSUMPTION
              and one small.
               On what basis can you make
               a prediction about the sizes
Lesson         of the two is broadly
               Each PPF economies, say,
VIII           descriptive of two particular
               two or three decades after
               countries at the end of
               the war?
               World War much faster than
              Japan grewII.                                    INVESTMENT
              the United States—not              Post-war United these?
               Apart from their differing What two countries are States
              because it had been bombed,
               sizes, one possibly
              but because the consumption-




                                                CONSUMPTION
               relevant difference is that
              investment tradeoff in post-war
               the small country’s
              Japan was made in favor of a
               economy had been
              high level of investment.
               wrecked by bombing to a
               much greater extent the
              In the United States, than
               the large country’s
              tradeoff was made in the
               economy.
              opposite direction by the
              consumption-oriented                             INVESTMENT
              Americans.                         Post-war Japan
   Economics Gone Wild!
              To this point, we’ve assumed
              that the economy is either on




                                              CONSUMPTION
              its PPF or is being
              expeditiously moved by market
              forces toward a point on its
Lesson        shifting PPF.
VIII          Suppose, though, that during a
              given year, some market
              malfunction (or some perverse
                                                            INVESTMENT
              policy) takes the economy off its
              PPF.
              If the economy is pushed beyond the PPF, its unemployment
              rate being driven below the 5-6 percent band, we say the
              economy is “overheated.”
              Points very far beyond the PPF are simply out of reach (in
              real terms). Strong market forces pushing in this direction
              will impinge on prices rather than on quantities. The
              economy will experience price inflation.
              And in extreme cases, it can experience hyper-inflation.
   Economics Gone Wild!
              To this point, we’ve assumed
              that the economy is either on




                                               CONSUMPTION
              its PPF or is being
              expeditiously moved by market
              forces toward a point on its
             Points very far beyond the PPF
Lesson        shifting PPF.
             are simply out of reach (in real
              Suppose, though, that during a
VIII         terms). Strong market forces
              given year, some market
             pushing in this direction will
              malfunction (or some perverse
             impinge on prices rather than on                 INVESTMENT
              policy) takes the economy off its
             quantities. The economy will
              PPF.
             experience price inflation.
              If the economy is pushed beyond the PPF, its unemployment
              rate being driven below the 5-6 percent band, we say the
              If the economy is pushed inside its PPF, its unemployment
              economy is “overheated.”
              rate rising above the 5–6 percent band, we say that the
              economy is in a recession.
              And in extreme cases, it can experience hyper-inflation.
                    If the economy is pushed far inside its PPF
                    for an extended period of time, we say that
                    the economy is in a depression.

   Economics Gone Wild!
              Notice that, together with
              the locus of the fully




                                            CONSUMPTION
              employed economy, the
              What do you suppose is
              various possible market
              the significance of the
              malfunctions (or
              straight line that passes
Lesson        consequences of perverse
              through these points?
              policy) are arrayed along
VIII          a linear path:
                A depressed economy
                                                           INVESTMENT
                A recessed economy          Economists who believe that
                                           Economists who believe that
                                            the market economy is
                A fully employed           “markets work” argue that
                economy                     inherently flawed argue that
                                           market forces can move the
                                            market forces will move the
                An over-heated             economy along the PPF in
                                            economy along the linear path
                economy                    response to changes in
                                            producing periodic bouts of
                                           intertemporal preferences.
                An inflated economy         unemployment and inflation.
                                           They argue that movements off
                A hyper-inflated            They argue that “stimulus
                                           the PPF are largely a
                economy                     packages” and price controls
                                           consequence of perverse
                                            are essential to the economy’s
                                           macroeconomic policy.
   Economics Gone Wild!                     macroeconomic health.
                          Phases of the Business Cycle




Lesson
VIII




   Economics Gone Wild!
                    Causes of Business Cycles
             •   Shocks and price stickiness
Lesson
             •   Supply and productivity shocks
VIII         •   Monetary shocks
             •   Financial bursts and bubbles
             •   Unexpected political events
             •   Common link
                   – Unexpected changes in spending
             • REAL CAUSE: Government
               Interference in Money and Interest
               Rates
   Economics Gone Wild!                               9-100
                          Austrian Macroeconomics
Lesson
VIII

                Sustainable and Unsustainable Growth
                The Macroeconomics of Boom and Bust




   Economics Gone Wild!
                                                       2011
               Capital-Based Macroeconomics in
                          Perspective
             The Elements of Capital-Based
Lesson       Macroeconomics
VIII
               The Production Possibilities Frontier
               The Loanable-Funds Market
               The Structure of Production
               Stage-Specific Labor Markets

             Sustainable Growth (supported by saving)
             Unsustainable Growth (triggered by credit creation)


   Economics Gone Wild!
              Capital-Based Macroeconomics is an outgrowth of the
              Austrian theory of the business cycle—a theory set out in
              1912 by Ludwig von Mises and developed in the 1930s by
              Friedrich A. Hayek and others.

Lesson
VIII




              LUDWIG VON MISES              FRIEDRICH A. HAYEK
              1881-1973                     1899-1992


   Economics Gone Wild!
                Three Views of the Market Economy
                                Capital-based high level of
                               Theorizing at a macroeconomics is
                              Milton Friedman’s monetarism was
                                distinguished higher level Keynes
                               aggregation, John Maynardof
                              based on a stillby its propitious
Lesson                         argued that Thewhich brings into
                              aggregation.market economies
                                disaggregation, equation of
VIII                           perform perversely—especially an
                              exchange MV=PQ made use of the
                                view both the problem of inter-
                               market mechanisms that are and
                                temporal resource allocation
                              all-inclusive output variable (Q),
                               supposed eclipse saving solution.
                              putting intoto bring market and the
                                the potential for a the issue of
                               investment resources between
                                    F. A. Hayek balance with one
                              allocation ofinto showed that a
                               another.
                                coordination of saving and
                              current consumption and investment
                                   Seeing unemployment and
                                investment decisions could be
                              for the future.
                               resource idleness as the norm,
                                   Seeing no problems emerging
                                achieved by market-governed
                               Keynes marketinterest rates. He
                              from the called for countercyclical
                                movements in itself, Friedman
                                also and monetary policies and
                               fiscalrecognized that this aspect of
                              focused on the relationship between
                               ultimately for a “comprehensive
                                the market economy is especially
                              the government-controlled money
                                vulnerable to investment.”
                               socialization of overall price level.
                              supply and thethe manipulation of
                                interest rates by the central bank.


   Economics Gone Wild!
             The Macroeconomics of
                       Boom and Bust
Lesson
VIII

                          A Methodological Point:

                          Before we can even ask how things
                          might go wrong, we must first explain
                          how they could ever go right.

                                               — F. A. Hayek



   Economics Gone Wild!
               The market process is entrepreneurs and investors
               responding to profit and loss signals. (1)

                    More production needed


Lesson
Demand
                            Prices           Profits                 Production
>VIII
                            Increase         Increase                Increases
 Supply

                                                        Existing firms increase
               Entrepreneurs
                                                        production of that
               increase prices to try
                                                        product, and new firms
               to maximize profits
                                                        enter the market.




                                               The structure of production is
                                               rearranged to increase production


     Economics Gone Wild!
              The market process is entrepreneurs and investors
              responding to profit and loss signals. (2)

              Less production needed; resources are needed elsewhere


Lesson
 Supply
                                                                       Productio
VIII                      Prices              Profits                  n
 >
                          Decrease            Decrease                 Decrease
 Demand
                                                                       s

              Competition impels                      Existing firms
              entrepreneurs to                        decrease production
              decrease prices to try                  of that product, and
              to maximize profits                     some firms go
                                                      bankrupt.



                                               The structure of production is
                                               rearranged to decrease production


   Economics Gone Wild!
             In capital-based
             macroeconomics, consumption




                                                   CONSUMPTION
             and investment represent
             alternative uses of the economy’s
             resources.

Lesson       Under favorable conditions, a fully
VIII         employed market economy
             allocates resources to both uses,
             making the most of the trade-off.                    INVESTMENT


             The Production Possibilities Frontier
             The Production Possibilities Frontier (PPF) is often used for
             emphasizing the concept of scarcity and illustrating the implied trade-
             off and for expositing theories of capital and interest, economic
             growth, and international trade. But the PPF rarely appears in
             macroeconomic constructions.
             Featuring the trade-off between consumption and investment
             provides a contrast to Keynesian constructions, in which these two
             macroeconomic magnitudes are treated as additive components of
             private-sector spending.
   Economics Gone Wild!
             “Investment” in this construction
             represents gross investment,




                                                  CONSUMPTION
             which includes replacement
             capital.

             Typically, the investment needed
Lesson       just to replace worn out or
             obsolete capital is something less
VIII         than total, or gross, investment.

             The difference between the                         Replacement     INVESTMENT

             “replacement” and the “gross”                      Capital

             magnitudes constitutes net                                             Net Investment
             investment, which allows for the
                                                                   Gross
             expansion of the economy.                             Investment


             Positive net investment means that the economy is growing. The PPF
             shifts outward from year to year, permitting increasing levels of both
             consumption and investment.

             This outward shifting of the PPF represents sustainable economic
             growth.

   Economics Gone Wild!
              Watch the economy grow.




                                             CONSUMPTION
              Four periods of growth are
              shown—with consumption,
              as well as saving and
Lesson        investment, increasing in
VIII          each period.
              The actual rate of expansion
                                                                          INVESTMENT
              of the PPF depends upon                      Replacement
                                                           Capital
              many factors.
                                                                               Net Investment

                                                             Gross
                                                             Investment


               For instance, with economic expansion, capital
               depreciation increases, too. But increasing incomes
               are generally accompanied by further increases in
               saving and investment.


   Economics Gone Wild!
              Watch the economy grow.




                                                  CONSUMPTION
              Four periods of growth are
              shown—with consumption, as
              well as saving and investment,
              increasing in each period.
Lesson        The actual rate of expansion of
VIII          the PPF depends upon many
              factors.
              For instance, with economic                           INVESTMENT
              expansion, capital depreciation
              increases, too. But increasing        Watch the movement
              incomes are generally                 along the PPF.
              accompanied by further saving preferences, which provokes a
               Importantly, a change in
              increases in saving and
               movement along the initial PPF, affects the rate at which the PPF
              investment.
               expands outward.

              Suppose people become more thrifty, more future oriented. They
              reduce their current consumption and save instead.
              With the increased saving (and investment), the economy grows at a
              faster rate.
   Economics Gone Wild!
                                               CONSUMPTION
             Now watch the economy grow.



Lesson
VIII

                                                                INVESTMENT



                  Increased thriftiness makes the difference.


                          Let’s compare the high-growth economy
                          with the original low-growth economy.




   Economics Gone Wild!
   CONSUMPTION




                                                      CONSUMPTION
Lesson
VIII

                       INVESTMENT                                     INVESTMENT

                 Note the difference that an initial increase in saving makes in the
                 pattern of consumption and investment.
                 Without an initial increase in saving, consumption and investment
                 increase modestly from period to period.

                 With an initial increase in saving, investment increases at the
                 expense of consumption, after which both consumption and
                 investment increase dramatically from period to period.

              Starting with the fourth period, the initial saving pays off as a
              higher level of consumption than would otherwise have been
              possible.
   Economics Gone Wild!
             The Production Possibilities Frontier shows us what is possible—
             given the state of technology, resource constraints, and
             (intertemporal) preferences.


Lesson       Remaining to be shown is how the “possible” can actually happen in a
VIII         market economy. How can intertemporal preferences—and especially
             changes in intertemporal preferences—get translated into
             accommodating decisions in the investment community?


             The key price signal is the rate of interest, which is broadly associated
             with the market for loanable funds.


             In actual application, of course, account must be taken of a spectrum
             of interest rates, the variations deriving from considerations of risk,
             uncertainty, and maturity structure.




   Economics Gone Wild!
                 The Market for Loanable Funds
              Loanable-funds theory was a staple in pre-Keynesian
              macroeconomics.
              Saving constitutes the supply of loanable funds.
Lesson
              Demand reflects the business community’s willingness to borrow and
VIII          undertake investment projects.
              With the interest rate serving as
              the price, loanable-funds theory
              is a straightforward application
              of Alfred Marshall’s supply-and-




                                                  RATE OF INTEREST
              demand analysis.                                                             S
              Both Eugen von Böhm-Bawerk
              and John Maynard Keynes
              recognized that the relevant
              interest rate should be a broadly
              conceived one and that the                                                  D
              correspondingly broad market
              being equilibrated is the market
              for investable resources.                              Investable       SAVING (S)
                                                                     Resources    INVESTMENT (D)
   Economics Gone Wild!
             The Market for Loanable Funds
             Loanable-Funds theory was most closely identified with
             Dennis Robertson, a contemporary of Keynes and a critic of
             Keynes’s alternative theory—his liquidity-preference theory of
Lesson       interest.
VIII

                            Sir Dennis H. Robertson (1890 —1963)




                                             RATE OF INTEREST
                                                                         S




                                                                        D


                                                                    SAVING (S)
                                                                INVESTMENT (D)
   Economics Gone Wild!
                The Market for Loanable Funds
              Loanable-Funds theory was most closely identified with
              Dennis Robertson, a contemporary of Keynes and a critic of
              Keynes’ alternative theory—his liquidity-preference theory of
Lesson        interest.
VIII            On the suggestion of Roy Harrod, who
                was pro-Keynesian, Keynes included in
                his General Theory (p. 180) a graph of
                the loanable-funds market.




                                              RATE OF INTEREST
                                                                          S
              This is the only diagram to
              appear in his book. Keynes’s
              purpose was to show he was
              discarding Harrod’s loanable-
              funds theory.
                                                                         D


                                                                     SAVING (S)
                                                                 INVESTMENT (D)
   Economics Gone Wild!
             The Market for Loanable Funds
             The Austrian economists based much of their theorizing about saving,
             investment, and the interest rate on the loanable-funds framework,
             though they rarely included a graphical rendering of it.
Lesson
VIII         If people become more future-
             oriented, they increase their                           Watch the saving curve
             saving, causing the interest rate                       shift rightward.
             to fall and thereby encouraging
             the business community to




                                                  RATE OF INTEREST
             undertake more investment                                                    S
             projects.


             With a given technology, saving
             and investment are prerequisite to
             genuine (sustainable) economic                                              D
             growth.

                                                                                     SAVING (S)
                                                                                 INVESTMENT (D)
   Economics Gone Wild!
                          The interest rate is a reflection of
                                  time-preferences
             •   The interest rate is the price of borrowing money.
             •   Like all prices, in a free market, the interest rate is
                 determined by supply and demand. The supply of
Lesson           money to be loaned (savings) and the demand for loans.
VIII         •   The free market interest rate is therefore a reflection of
                 the time-preferences of the individuals in society; that
                 is, how highly people value current consumption over
                 saving that will allow them future consumption.
              High time-preferences   High spending, low saving   High interest rates


              Low time-preferences    Low spending, high saving   Low interest rates



             •   Interest rates coordinate the time-structure of
                 production. That is, the profitability of short-term versus
                 long-term production projects.



   Economics Gone Wild!
              The loanable-funds market and




                                                   CONSUMPTION
              the production possibilities
              frontier tell mutually reinforcing
              stories.

Lesson       The loanable-funds market
             shows how the interest rate
VIII         brings saving and investment in
             line with one another.
                                                                      INVESTMENT
             The production possibilities
             frontier shows how the tradeoff
             is struck between consumption




                                                   RATE OF INTEREST
             and investment.                                                   S

             Market adjustments in output
             prices, wage rates, and other
             input prices keep the economy
             functioning on its PPF.
                                                                              D


                                                                          SAVING (S)
                                                                      INVESTMENT (D)
   Economics Gone Wild!
             These two elements of capital-
             based macroeconomics show the




                                                    CONSUMPTION
             pattern of movements in
             consumption, saving, investment,
             and the interest rate that are
             consistent with a change in
Lesson       intertemporal preferences.
VIII         As before, we let people become
             more future-oriented. They save
             more, which transmits a signal (a                         INVESTMENT
             lower interest rate) to the business
             community.




                                                    RATE OF INTEREST
             Watch the saving-induced                                           S
             The lowerin the interest rate and
             decrease interest rate
             establishes a new equilibrium in
             the corresponding movement
             the loanable-funds market, as
             along the PPF.
             the economy moves along the
             PPF in the direction of more
                                                                               D
             investment and less (current)
             consumption.
                                                                           SAVING (S)
                                                                       INVESTMENT (D)
   Economics Gone Wild!
             Even the possibility that a market
             This is only to recognize, of
             economy could work in this way is




                                                  CONSUMPTION
             course, that movements along the
             at odds with Keynesian theory.
             PPF necessarily entail opposing
             Note that moreconsumption and
             movements of investment is
             undertaken as consumption falls.
             investment.
Lesson       According to Keynes, however,
VIII         any reduction in consumer
             spending would result in excess
             inventories, which in turn would
                                                                     INVESTMENT
             cause production cutbacks,
             worker layoffs, and a spiraling
             downward of income and




                                                  RATE OF INTEREST
             expenditures. The economy would
             go into recession, and the                                           S
             business community would
             commit itself to less, not more,
             investment.
             This is Keynes’s “Paradox of                                    D
             Thrift.”
                                                                         SAVING (S)
                                                                     INVESTMENT (D)
   Economics Gone Wild!
              If retail inventories were a
              “representative” investment, then




                                                    CONSUMPTION
              Keynes would be right. Here, the
              derived-demand effect dominates.
              Reduced consumer spending
              means reduced inventory
Lesson        replacement. In general, late-stage
              investments move with consumer
VIII          spending.
              However, the interest-rate effect                        INVESTMENT
              dominates in long-term, or early-
              stage, investments. A lower
              interest rate can stimulate




                                                    RATE OF INTEREST
              industrial construction, for
              instance, or product development.                                     S

              To keep track of changes in the
              general pattern of investment
              activity, we need to consider the
              structure of production and stage-                               D
              specific labor markets.
                                                                           SAVING (S)
                                                                       INVESTMENT (D)
   Economics Gone Wild!
                   The Structure of Production




                                       CONSUMPTION
Lesson
VIII

            STAGES OF PRODUCTION


            Capital-based macroeconomics disaggregates capital intertemporally.
            Consumable output is produced by a sequence of stages of production,
            the output of one stage feeding in as input to the next.
                                                            is exemplified by
                           Early-stage investment activity Late-stage investment
                                                           activity is from left to by
             The temporally defined stages are arrayed graphicallyexemplified right,
                           product development.
             the output of the final stage constituting consumable output.
                                                           inventory management.




       PRODUCT            INVENTORY
   Economics Gone Wild!
       DEVELOPMENT        MANAGEMENT
              The Structure of Production




                                       CONSUMPTION
Lesson
VIII

                STAGES OF PRODUCTION


             For pedagogical convenience, the initial capital structure is shown as
             having five stages. With growth, the number of stages will increase.

              Although all five of these stages are in operation during each time
              period, resources can be tracked through the structure of production
              over time.
             Watch the resources, or “goods in process,” move through the
             stages.



   Economics Gone Wild!
           The Structure of Production




                                     CONSUMPTION
Lesson
VIII

           STAGES OF PRODUCTION

           For pedagogical convenience, the initial capital structure is shown as
           having five stages. With growth, the number of stages will increase.
            Although all five of these stages are in operation during each time
            period, resources can be tracked through the structure of production
            over time.
           Watch the resources, or “goods in process,” move through the
           stages.
              NOTE: Hayek introduced his triangle in 1931, when Henry Ford was
              still producing the Model A. If only Hayek had had PowerPoint, he
              could have shown how the abstract triangle aligns with real-world
              output.
   Economics Gone Wild!
                                       CONSUMPTION
Lesson
VIII

                STAGES OF PRODUCTION


             Together, the sequence of stages form a Hayekian triangle, a
             summary depiction of the economy’s intertemporal structure of
             production.
             In a growing economy, the triangle increases in size along with the
             outward expansion of the production possibilities frontier.




   Economics Gone Wild!
                                                    CONSUMPTION
                                      CONSUMPTION
Lesson
VIII

               STAGES OF PRODUCTION                               INVESTMENT


             Together, the sequence of stages form a Hayekian triangle, a
             summary depiction of the economy’s intertemporal structure of
             production.
             In a growing economy, the triangle increases in size along with the
             outward expansion of the production possibilities frontier.

             Watch the PPF and the Structure of Production expand together.




   Economics Gone Wild!
                                        CONSUMPTION
Lesson
VIII

                 STAGES OF PRODUCTION


              When people choose to save more, they send two seemingly
              conflicting signals to the market:

              1. Decreased consumption dampens the demand for the
                 investment goods that are in close temporal proximity with
                 consumable output. This is the derived demand effect.
              2. A reduced interest rate, which means lower borrowing costs,
                 stimulates the demand for investment goods that are temporally
                 remote from consumable output. This is the time-discount, or
                 interest-rate, effect.
   Economics Gone Wild!
                                        CONSUMPTION
Lesson
VIII

                STAGES OF PRODUCTION


             Derived demand and time discount are in conflict only if “investment”
             is conceived as a simple aggregate—as it is in Keynes’ C + I + G.
             In capital-based macroeconomics, capital—and hence investment—is
             conceived as a structure. Changes in the demand for investment,
             then, can add differentially to (and/or subtract differentially from) the
             several stages of production that make up the structure.
             Keynes’s theorizing in terms of an aggregate rather than in terms of a
             structure underlies Hayek’s claim that “Mr. Keynes’ aggregates
             conceal the most fundamental mechanisms of change.”

   Economics Gone Wild!
                                       CONSUMPTION
                                                     Watch the structure of production
Lesson                                               respond to an increase in saving.
VIII                                                 Note the emergence of a sixth
                                                     stage of production.
              STAGES OF PRODUCTION

              Increased saving results in a reallocation of resources among the
              stages of production. The two effects (derived demand and time
              discount) have their separate and complementary effects on the
              capital structure:
            1. Derived demand effect: A decreased demand for consumption
               goods dampens investment activities in the late states of
               production, reducing the height of the Hayekian triangle.
            2. Time-discount effect: A reduced rate of interest stimulates
               investment activities in the early stages of production, increasing
               the base of the Hayekian triangle.

   Economics Gone Wild!
                                       CONSUMPTION
Lesson
VIII

                STAGES OF PRODUCTION




   Economics Gone Wild!
              Watch the economy respond to




                                                      CONSUMPTION
              an increase in saving.




                                        CONSUMPTION
Lesson
VIII

               STAGES OF PRODUCTION                                 INVESTMENT

              Increased saving, then, has an effect on both the magnitude of the
              investment aggregate and the temporal pattern of capital creation.
              The PPF shows that more saving permits more investment.
              The Hayekian triangle shows that capital creation in the late stages
              (such as retail inventories) is decreased while capital creation in the
              early stages (such as product development) is increased.

              The structure of production is given more of a future-orientation,
              which is consistent with the saving that made the restructuring
              possible. That is, people are saving now in order to increase their
              future spending power.
   Economics Gone Wild!
                                                                         CONSUMPTION
                                                    CONSUMPTION
              Lesson
              VIII

                             STAGES OF PRODUCTION                                                  INVESTMENT


                 Watch the economy grow more rapidly.                                  As tracked by both the PPF and
                                                                                       the Hayekian triangle,
                                                                                       consumption is seen to fall as
                                                                                       Saving implies the giving up of
CONSUMPTION




                                                                                       the economy is adapting to a
                                                                                       some consumption in the
                                                                                       higher growth rate, after which
                                                                                       near future …
                                                                                       consumption risesin order to
                                                                                                          more rapidly
                                                                                       enjoybefore…
                                                                                       than more consumption in
                                                                                       the intermediate (and possibly
                                                                                       far) eventually surpasses the
                                                                                       and future.
                                                                                       old projected growth path.

                 Economics Gone Wild!
                                                                  TIME
              Stage-Specific Labor Markets

                                                             While most macroeconomic theories




                                               CONSUMPTION
                                                             deal with THE labor market and THE
Lesson                                                       wage rate, capital-based
VIII                                                         macroeconomics allows for stage-
                                                             specific labor markets. With a
                STAGES OF PRODUCTION
                                                             change in the interest rate, stage-
                                                             specific wage rates change in a
                                                             pattern rather than change uniformly.



       W                         W                           Although a labor market for each
                                                             stage could be depicted, the pattern
                                                             of changes (the wage-rate gradient,
                     N                               N
                                                             as Hayek called it) is revealed by
                                                             distinguishing between early-stage
   EARLY-STAGE LABOR MARKET   LATE-STAGE LABOR MARKET
                                                             and late-stage labor markets.

   Economics Gone Wild!
             Stage-Specific Labor Markets

                                                             An increase in saving has differential




                                               CONSUMPTION
Lesson                                                       effects on the demand for labor in
                                                             the early and late stages.
VIII

            STAGES OF PRODUCTION                             In the late stages, the derived-
                                                             demand effect (labor demand moves
                                                             with consumption) dominates the
                                                             interest-rate effect.

       W                         W
                                                             In the early stages, the interest-rate
                                                             effect (favorable credit conditions)
                                                             dominates the derived-demand
                                                             effect.
                     N                               N

   EARLY-STAGE LABOR MARKET   LATE-STAGE LABOR MARKET
                                                             The differential shifting of labor
                                                             Watch the economy respond to
                                                             demands gives rise to
                                                             an increase in saving. a
                                                             “wage-rate gradient.”
   Economics Gone Wild!
                                                             CONSUMPTION
                                               CONSUMPTION
Lesson                                                                          PRODUCTION
VIII          STUCTURE OF                                                       POSSIBILITIES
              PRODUCTION                                                        FRONITER
                STAGES OF PRODUCTION                                                   INVESTMENT




                                                             RATE OF INTEREST
                                                                                                 S

       W                         W


              STAGE-SPECIFIC                                                    LOANABLE-FUNDS
              LABOR MARKETS                                                     MARKET
                     N                               N                                     D
   EARLY-STAGE LABOR MARKET   LATE-STAGE LABOR MARKET


                                                                                            SAVING (S)
                                                                                        INVESTMENT (D)
   Economics Gone Wild!
                                                             CONSUMPTION
   Watch the economy respond to
   an increase in saving.




                                               CONSUMPTION
Lesson
VIII

            STAGES OF PRODUCTION                                                INVESTMENT




                                                             RATE OF INTEREST
                                                                                         S

       W                         W




                     N                               N                                  D
   EARLY-STAGE LABOR MARKET   LATE-STAGE LABOR MARKET


                                                                                    SAVING (S)
                                                                                INVESTMENT (D)
   Economics Gone Wild!
                                                             CONSUMPTION
              Watch the economy respond to
              an increase in saving.




                                               CONSUMPTION
Lesson
VIII

               STAGES OF PRODUCTION                                             INVESTMENT




                                                             RATE OF INTEREST
                                                                                         S

       W                         W




                     N                               N                                  D
   EARLY-STAGE LABOR MARKET   LATE-STAGE LABOR MARKET


                                                                                    SAVING (S)
                                                                                INVESTMENT (D)
   Economics Gone Wild!
             Sustainable and Unsustainable Growth
             The Macroeconomics of Boom and Bust
Lesson                          With interest rates artificially low,
VIII                            consumers reduce savings in favor
                                of consumption, and entrepreneurs
                                increase their rate of investment
                                spending. And then you have an
                                imbalance between savings and
                                investment. You have an economy
                                on an unsustainable growth path.
                                This, in a nutshell, is the lesson of
                                the Austrian critique of central
                                banking developed in the 1920s and
                                1930s.

                                ---from Steve H. Hanke’s “Panic Time at the
                                Fed ,” Forbes, May 2008.
   Economics Gone Wild!
                 Sustainable and Unsustainable Growth
                 The Macroeconomics of Boom and Bust

Lesson                          “Booms have always appeared with a
                                great increase in investment, a large
VIII                            part of which proved to be erroneous,
                                mistaken. That, of course, suggests that
                                a supply of capital was made apparent
                                which wasn’t actually existing. The
                                whole combination of a stimulus to
                                invest on a large scale followed by a
                                period of acute scarcity of capital is
                                consistent with the idea that there has
                                been a misdirection due to monetary
                                influences. And that general schema, I
                                still believe, is correct.”
                                --from an interview conducted by Jack High as part
                                of the UCLA Oral History Program (1978).
   Economics Gone Wild!
                                     Credit Expansion
             Increases in the money supply enter the economy through credit
             markets. The central bank literally lends money into existence.

Lesson       The new money masquerades as saving. That is, the supply of
             loanable funds shifts rightward—but without there being any
VIII         increase in saving.
             Watch the opposing movements
             of saving and investment as the
             central bank adds money (ΔM) to
             the supply side of the market for




                                                      RATE OF INTEREST
             loanable funds.                                                      S
                                                                                          +ΔM
            Responding to a lower interest
            rate, people actually save less
            and consume more.
              The result is not a new                                            D
              sustainable equilibrium but rather
              a disequilibrium that, for a time, is
              masked by the infusion of                                      SAVING (S)
                                                                         INVESTMENT (D)
              loanable
   Economics Gone Wild! funds.
             Pumping new money through credit markets drives a wedge between
             saving and investment.

             Investors move down along their demand curves, taking advantage of
             the lower borrowing costs.

Lesson       Savers move down along their unshifted saving curves in response to
VIII         the weakened incentive to save.

             The discrepancy between saving
             and investment is papered over
             with newly created money, which
             itself represents no investable




                                                 RATE OF INTEREST
             resources.                                                      S
             Much of Hayek’s writings on                                         S+ΔM
             money is aimed at shifting the
             focus away from the bedrock
             relationship between money and
             the general level of prices and                                D
             toward the intertemporal
             discoordination that is caused by
             credit expansion.                                          SAVING (S)
                                                                    INVESTMENT (D)
   Economics Gone Wild!
             Favorable credit conditions spur




                                                    CONSUMPTION
             on investment activity→
             clockwise movement along the
             PPF to more investment.
             But income-earners are actually
Lesson       saving less (and hence
VIII         consuming more)→
             counterclockwise movement to
             consumption.
                                                                       INVESTMENT

             The wedge between saving and
             investment translates into a tug-of-




                                                    RATE OF INTEREST
             war between consumers and                                          S
             investors.                                                             S+ΔM
             Noting the investment dimension of
             the clockwise movement and the
             consumption dimension of the
             counterclockwise movement, we                                     D
             see that credit expansion pushes
             the economy toward a point that lies
             beyond the PPF.                                               SAVING (S)
                                                                       INVESTMENT (D)
   Economics Gone Wild!
                                                     CONSUMPTION
                                       CONSUMPTION
Lesson
VIII

             STAGES OF PRODUCTION                                       INVESTMENT

             The low interest rate, consistent
             with a future orientation,




                                                     RATE OF INTEREST
             stimulates investment activities to
             In fact, increased consumer                                         S
             earlier stages some resources
             demand draws                                                            S+ΔM
             toward the late stages, further
             But not enough resources being
             reducing elsewhere, many
             freed up the prospects for
             completing a new capital
             projects will never be completed.
             structure.
                                                                                D


                                                                            SAVING (S)
                                                                        INVESTMENT (D)
   Economics Gone Wild!
                                                                        Overconsumption
                                                     CONSUMPTION
                 Overconsumption




                                       CONSUMPTION
Lesson
                                                                                          Overinvestment
VIII
   Malinvestment


              STAGES OF PRODUCTION                                                        INVESTMENT
              The dynamics of boom and bust
              entail both overinvestment (as shown




                                                     RATE OF INTEREST
              in the PPF diagram) and                                                              S
              malinvestment (an unsustainable                                                          S+ΔM
              lengthening of the Hayekian triangle).
              These distortions are
              compounded by overconsumption
              (as shown in both the PPF and
              the Hayekian triangle).                                                             D

              Mises repeatedly used the phrases
              “malinvestment” and “overconsumption.”                                          SAVING (S)
                                                                                          INVESTMENT (D)
    Economics Gone Wild!
                                                                        Overconsumption
                                                     CONSUMPTION
                   Overconsumption




                                       CONSUMPTION
Lesson
                                                                                          Overinvestment
VIII
   Malinvestment


                STAGES OF PRODUCTION                                                      INVESTMENT
              The tug-of-war that pits
              consumers against investors




                                                     RATE OF INTEREST
              pushes the economy beyond the                                                        S
              The temporally conflicted
              PPF. The low interest rate favors                                                        S+ΔM
              structure of production (dueling
              investment, and increasingly
              triangles) eventually turns boom
              binding resource constraints keep
              into bust, and the economy goes
              the economy from reaching the
              into recession—and possibly into
              extra-PPF point.
              deep depression.                                                                    D


                                                                                              SAVING (S)
                                                                                          INVESTMENT (D)
    Economics Gone Wild!
                                                     CONSUMPTION
                                                   TUG–OF–WAR BETWEEN




                                     CONSUMPTION
Lesson                                             CONSUMERS & INVESTORS
VIII             DUELING
                 TRIANGLES
              STAGES OF PRODUCTION                                      INVESTMENT




                                                     RATE OF INTEREST
                                                                                 S
                                                                                     S+ΔM


                                                              WEDGE BETWEEN
                                                              SAVING & INVESTMENT
                                                                            D


                                                                            SAVING (S)
                                                                        INVESTMENT (D)
   Economics Gone Wild!
                    Watch the economy respond to
                    a credit expansion.




                                                     CONSUMPTION
                                       CONSUMPTION
Lesson
VIII

              STAGES OF PRODUCTION                                      INVESTMENT

            Padding supply of loanable funds
            with new money → wedge between




                                                     RATE OF INTEREST
            saving and investment.                                               S
            Papering over the saving and                                                 +ΔM
            investment gives play to the tug-of-
            war between consumers and
            investors.
            Pitting early-stages against late-                                  D
            stages distorts the triangle in both
            directions, eventually turning boom                             SAVING (S)
            into bust.                                                  INVESTMENT (D)
   Economics Gone Wild!
                                                    CONSUMPTION
                                      CONSUMPTION
Lesson
VIII

             STAGES OF PRODUCTION                                      INVESTMENT



              Increased Saving vs. Credit




                                                    RATE OF INTEREST
                                                                                S
              Expansion:
              A summary Comparison

            Saving supports genuine
            growth.
            Watch.                                                             D


                                                                           SAVING (S)
                                                                       INVESTMENT (D)
   Economics Gone Wild!
                                                   CONSUMPTION
                                     CONSUMPTION
Lesson
VIII

              STAGES OF PRODUCTION                                    INVESTMENT


            Increased Saving vs. Credit




                                                   RATE OF INTEREST
            Expansion:                                                         S
            A summary Comparison
                                                                                       +ΔM
             Credit expansion triggers boom
             and bust.
             Watch.
                                                                              D


                                                                          SAVING (S)
                                                                      INVESTMENT (D)
   Economics Gone Wild!
                          Unemployment
              • Twin Results of the Business
Lesson          Cycle
VIII                – Unemployment
                    – Inflation
              • Measurement of Unemployment
              • Labor Force
              • Unemployment Rate
                    – Part-Time Employment
                    – Discouraged Workers
                                      Unemployed
              Unemployment Rate   =                 x 100
                                      Labor Force
   Economics Gone Wild!
                          Unemployment
             Labor Force, Employment, and Unemployment, 2012
                                      Under 16
                                       And/or
Lesson                            Institutionalized
VIII                                (70.7 Million)

                                       Not in
                                   Labor Force
                                   (89.0 Million)
                         Total
                   Population
                (315.3 Million)

                                     Employed         Labor
                                   (143.3 Million)    Force
                                                      (155.6 Million)



                                   Unemployed
   Economics Gone Wild!            (12.3 Million)
                          Unemployment
              • Types of Unemployment
Lesson          – Frictional Unemployment
VIII            – Structural Unemployment
                – Cyclical Unemployment
                – Seasonal??
              • Full Employment Defined S=D
                    – No Cyclical Unemployment
              • Full-Employment Rate of
                Unemployment

   Economics Gone Wild!
                          Unemployment
             • Natural rate of unemployment
Lesson             – 1980s 4-6%
VIII               – Today 5.25%
             • Aging labor force
             • Temp agencies and the internet
             • New welfare laws and work
               requirements
             • Prison population has doubled

   Economics Gone Wild!
                          Cost of Unemployment
             • Foregone output
Lesson       • Potential output
VIII
             • GDP gap
                   – (Actual output – potential output)
             • Okun’s Law
                   – Each 1% above NRU creates
                     negative 2% output gap


   Economics Gone Wild!
             United States population: 315 million.
             To quantify the extent of the problem
Lesson
VIII
             of unemployment, we start with the
             civilian, non-institutionalized, off-the-
             farm population (16 and older) of
             244.6 million. Then, surveying by
             phone, we ask a series of questions
             to arrive at the unemployment rate.

   Economics Gone Wild!
             1. Are you currently employed?
Lesson       A. Yes.
VIII
             B. Yes, but only part time.


             A + B = Employed = 143.3 million.

   Economics Gone Wild!
             1. Are you currently employed?
Lesson       A. Yes.
VIII
             B. Yes, but only part time.
              C. No.

             No = 244.6 – 143.3 = 101.3 million.
             Are all these people actually unemployed?
   Economics Gone Wild!
              2. If “No,” are you actively
Lesson
                looking?
VIII
              A. Yes.


              Yes = Unemployed = 12.3 million.

   Economics Gone Wild!
              2. If “No,” are you actively
Lesson
                looking?
VIII
              A. Yes.
              B. No.
              No = not working; not looking
              No = 101.3 – 6.6 = 94.7 million.
              These people are not in the labor force.
   Economics Gone Wild!
             The Unemployment Rate =

Lesson       Unemployed           Unemployed
VIII
                             Employed + Unemployed
             Labor Force

               Unemployed           Looking
               Labor Force     Working + Looking


   Economics Gone Wild!
             The Unemployment Rate =
Lesson         Unemployed             Unemployed
VIII
               Labor Force       Employed + Unemployed

             Unemployment Rate = 12.3/ (143.3 + 12.3)
             Unemployment Rate = 12.3 / 155.7
             Unemployment Rate = 0.0789 = 7.9 %


   Economics Gone Wild!
To those not employed and not looking:
3. Why aren’t you looking for a job?
Lesson
VIII
A. I don’t want a job.
B. I’m discouraged—I can’t find one.


“Discouraged Workers” = 1.3 million.
   Economics Gone Wild!
              Unemployment Rate
Lesson        (Discouraged Worker included)
VIII
                    Unemployed plus Discouraged Worker
                    Labor Force plus Discouraged Worker
             = (12.3 + 6.6) / (155.7 + 6.6)
             The U+ DW Rate = 0.116 = 11.6%

   Economics Gone Wild!
Lesson
VIII

                      What is the current
                      Unemployment Rate?




   Economics Gone Wild!
Lesson
VIII                      7.9%
               This is the unemployment rate for January of 2013,
               as reported by the BLS on Friday, February 1, 2013.
               For updates, check the BLS website.




   Economics Gone Wild!
                Labor Force Participation Rate

Lesson
VIII
                              Labor Force
                                     65.8%
                          Population (16 and older)

            LFPR = 155.7million / 244.6 million
            LFPR = 0.641 = 64.1 percent
   Economics Gone Wild!
                  To get a real unemployment rate

             Use the average LFPR since 1980: 65.8%
Lesson       Apply this participation rate to the civilian
VIII         noninstitutional population
             This is the “implied" labor force number
             Now calculate the implied unemployed

             Calculating the jobless rate using this new
             implied data, as of December, the real implied
             unemployment rate was 11.4% - basically
             where it has been ever since 2009.
             ZEROHEDGE

   Economics Gone Wild!
Lesson
VIII




   Economics Gone Wild!
Lesson
VIII




   Economics Gone Wild!
             CATEGORIES OF UNEMPLOYMENT:
             frictional (still looking)
Lesson
VIII




                      Not in the Labor Force
   Economics Gone Wild!
             CATEGORIES OF UNEMPLOYMENT:

Lesson
             frictional (still looking)
VIII
             plus structural (a mismatch)

                                If this typewriter
                                repairman loses
                                his job, he’ll be
                                structurally
                                unemployed!



   Economics Gone Wild!
                   W                             W                                 W
                               Supply                                 Supply                         Supply

                               Demand                                     Demand                  Demand
                               N                                      N                              N

   Lesson Market for Labor                            Skilled Labor                    Unskilled Labor

   VIII
In a that the natural rate this
Notehealthy economy, to of 5%–6%
Macroeconomists referfrictionally
                                                 W                                 W
unemployment, like the of unemployment.
unemployed workers and structurally
band as the natural ratenormal levels of
                                                                      Supply                         Supply
unemployed workers make consistent
inventory is other markets, isin a market
That is, it in perfectly naturalup five-to-six
with labor-market equilibrium.
economy for the workforce to experience
percent of the workforce.                                                 Demand                  Demand
unemployment in this range.
                                                                      N                              N

                                                       Industrial Labor                 Agricultural Labor


                                                 W                                 W
                                                                      Supply                         Supply

                                                                          Demand                  Demand
                       Structural Unemployment                        N                              N

                                                     Western-States Labor              Plains-States Labor
         Economics Gone Wild!
            Employment and Unemployment In a Healthy Market Economy


                                                      unemployment rate is the
                                                      ratio of the workforce to
                                        NOTE: The economy’s labor force(or the
                                        ratio population (16 years old and the
                                        laborof the unemployed workers toolder
                                        adult force) includes employed workers
                                        labor force. In the U.S., the ratio
                                             not institutionalized) and
                                        and unemployed workersis calledisthe
Lesson
     W                                  labor-force about economy in
                                        constitutes participation rate.US the U.S.,
                                        5%–6% when the half of the isIn good
VIII                                    population. abouthealth.
                                        macroeconomic 65%.
                                        this ratio is

     W
                        Supply

                        Demand

                        N       N
                                      Adult population (16 years old and older)
           Market for Labor
                                        minus military personnel
                                        minus the institutionalized citizenry
                              Employed workers

                              Frictionally and structurally unemployed workers

                                      Not in the labor force


   Economics Gone Wild!
              Cyclical Unemployment In a Depressed Market Economy


                                               unemployment occurs
                                      CyclicalThe amount ofstructural when
                                                    unemployment rate
                                      NOTE: Frictional and cyclical reported
                                      unemployment makefrictional, the3.9%)
                                      there is an overall reduction in structural,
                                                       (currently 3.4% showing
                                      by the BLS includes no explicitor
                                      demand for labor (a reduction not in
                                      makes an exaggerated appearance
                                      in the analytical reckoning.
                                      and cyclical unemployment.
Lesson
     W                                warranted by some change in
                                      the analytical reckoning.
VIII                                  preferences or in overall resource
                                      availabilities).


                      Supply

                      Demand

                              N
                                     Adult population (16 years old and older)
                                       minus military personnel
                          Cyclically unemployed workers
                                       minus the institutionalized
                        Employed workers
                     Employed workers

                           Frictionally and structurally unemployed workers

                                    Not in the labor force


   Economics Gone Wild!
             CATEGORIES OF UNEMPLOYMENT:

Lesson
             frictional (still looking)
VIII
             plus structural (a mismatch)



              = THE NATURAL RATE = 5%-6%

   Economics Gone Wild!
              THE RESIDUAL CATEGORY:
Lesson
VIII


              Measured Rate of Unemployment
              minus the Natural Rate

            = CYCLICAL UNEMPLOYMENT
   Economics Gone Wild!
              The level of unemployment
              consistent with sustainable
Lesson        prosperity--i.e., the natural rate of
VIII
              unemployment--has long been
              believed to be in the range of
              A. 2 to 3 percent.
              B. 3 to 4 percent.
              C. 4 to 5 percent.
              D. 5 to 6 percent.
   Economics Gone Wild!
             Ferris Beuller graduated from college during the
             Bush recession. He spent 1990 looking in vain
             for reasonable employment. Totally discouraged,
Lesson
VIII         he spent 1991 playing Minesweeper on his
             girlfriend’s computer. The Bureau of Labor
             Statistics would classify Mr. Beuller (in 1991) as
             A. self-employed.
             B. institutionally unemployed.
             C. a discouraged worker.
             D. structurally unemployed.
   Economics Gone Wild!
                                                    Unemployment
                                                              Unemployment Rate 1985-2013

Lesson                                10   10


               (percent of civilian
VIII                                                                  The Unemployment Rate
                 Unemployment
                                            8
                  Labor force)
                                      8     6




                                            4




                                      6     2




                                            0
                                             1985      1987    1989    1991     1993          1995          1997          1999      2001     2003     2005


                                      4
                                                1985   1987   1990       1993          1996          1999          2002          2005      2008     2011




   Economics Gone Wild!                                                 Source: Congressional Budget Office & Bureau of Economic Analysis
                          Unemployment
                           Actual and Potential GDP

Lesson
VIII




   Economics Gone Wild!
                          Unemployment
              • Unequal Burdens
Lesson
VIII
                    –Occupation
                    –Age
                    –Race and Ethnicity
                    –Gender
                    –Education
                    –Duration
              • Noneconomic Costs
   Economics Gone Wild!
                          Unemployment
                          GLOBAL PERSPECTIVE
              Unemployment Rates, 1995-2007
Lesson
VIII




   Economics Gone Wild!                       Source: Bureau of Labor Statistics
                                   Inflation

               • Rise in general level of prices
Lesson
VIII           • Consumer price index (CPI)
                    – Market basket
                    – 300 goods and services
                    – Typical urban consumer
                    – 2 year updates

                          Price of the Most Recent Market
                           Basket in the Particular Year
             CPI =         Price estimate of the Market
                                                            x   100
   Economics Gone Wild!        Basket in 1982-1984
                                  Inflation
                             GLOBAL PERSPECTIVE
               Inflation Rates in Five Industrial Nations, 1995-2007
Lesson
VIII
                          Italy




   Economics Gone Wild!                                 Source: Bureau of Labor Statistics
                          Really?


Lesson
VIII




   Economics Gone Wild!
                          Actual Inflations


Lesson
VIII




   Economics Gone Wild!
                               Inflation
              • Types of Inflation
Lesson              –Demand Pull Inflation
VIII                –Cost-Push Inflation
                          • Per Unit Production Costs
              • Redistributive Effects
                    –Nominal and Real
                     Income
                    –Anticipations
                          • Anticipated Inflation
   Economics Gone Wild!
                          • Unanticipated Inflation
                                Inflation
              • Who is Hurt by Inflation?
Lesson
                    –Fixed-Income Receivers
VIII                –Savers
                    –Creditors
              • Who is Unaffected or Hurt
                by Inflation?
                    –Flexible-Income Receivers
                          • Cost-of-Living Adjustments
                            (COLAs)
                    –Debtors
   Economics Gone Wild!
                                   Inflation
             • Anticipated Inflation
Lesson
                  –Nominal Interest Rate
VIII              –Real Interest Rate
                  –Inflation Premium

                                                        6%
                       11%         =              +   Inflation
                                                      Premium
                                        5%
                        Nominal          Real
                        Interest       Interest
   Economics Gone Wild!   Rate           Rate
                  Other Inflation Issues
              • Deflation
Lesson        • Mixed Effects
VIII
              • Arbitrariness
              • Cost-Push Inflation and
                Real Output
              • Demand-Pull Inflation and
                Real Output
              • Hyperinflation
   Economics Gone Wild!
                              Inflation
                          Too Damn Much Money
Lesson
VIII




   Economics Gone Wild!
Lesson
VIII

                      How Much is a Trillion?
                  Inquiring minds want to know




   Economics Gone Wild!
                 What does one TRILLION dollars look
                                like?
                  All this talk about “stimulus packages” and “bailouts”...
                  A billion dollars...
                  A hundred billion dollars...
Lesson
                  Eight hundred billion dollars...
VIII
                  One TRILLION dollars...
                  What does that look like? I mean, these
                  various numbers are tossed around like so
                  many doggie treats, so I thought I’d take
                  Google Sketchup out for a test drive and try
                  to get a sense of what exactly a trillion
                  dollars looks like.



   Economics Gone Wild!
                          Here’s a hundred bucks
                  We’ll start with a $100 dollar bill. Currently
                  the largest U.S. denomination in general
Lesson            circulation. Most everyone has seen them,
VIII              slightly fewer have owned them. Guaranteed
                  to make friends wherever they go.


                                      “A Benny saved
                                      is a Benny earned!




   Economics Gone Wild!
                              Serious coin
                  A packet of one hundred $100 bills is less
                  than 1/2" thick and contains $10,000. Fits in
Lesson            your pocket easily and is more than enough
VIII              for a week or two of shamefully decadent
                  fun.
                                        “Party! Party!




   Economics Gone Wild!
                          One Million Dollars!!!
                  Believe it or not, this next little pile is $1
                  million dollars (100 packets of $10,000). You
Lesson            could stuff that into a grocery bag and walk
VIII              around with it.



                                      “Sa-weet!




   Economics Gone Wild!
              That’s what I’m talkin’ about!
                  While a measly $1 million looked a little
                  unimpressive, $100 million is a little more
Lesson
                  respectable. It fits neatly on a standard
VIII
                  pallet...
                                 “Lemme get my truck!




   Economics Gone Wild!
                                  Holy cow!
                  And $1 BILLION dollars... now we’re really
                  getting somewhere...
Lesson
VIII
                          “Whoa, dude!




   Economics Gone Wild!
                          Please have a seat
                  Next we’ll look at ONE TRILLION dollars.
                  This is that number we’ve been hearing so
Lesson            much about.
VIII
                  What is a trillion dollars? Well, it’s a million
                  million.

                  It’s a thousand billion.

                  It’s a one followed by 12 zeros.

                                You ready for this?
   Economics Gone Wild!
                           Ladies and gentlemen...
                            I give you $1 Trillion dollars...

Lesson
VIII   “No flippin’ way!”




                  And notice those pallets are double stacked
                  $100 dollar bills!
                  So the next time you hear your Congressman toss
                  around the phrase “trillion dollars”... that’s what
                  they’re talking about. Read on…
    Economics Gone Wild!
                          A Little More Perspective


Lesson
VIII




   Economics Gone Wild!
                          Current National Debt


Lesson
VIII




   Economics Gone Wild!
                                    Unfunded Mandates

                          The 114.5 Trillion dollar super-skyscraper is the
Lesson                    amount of money the U.S. Government knows
                          it does not have to fully fund the Medicare,
VIII
                          Medicare Prescription Drug Program, Social
                          Security, Military and civil servant pensions. It
                          is the money USA knows it will not have to pay
                          all its bills.

                          If you live in USA this is also your personal
                          credit card bill; you are responsible along with
                          everyone else to pay this back. The citizens of
                          USA created the U.S. Government to serve
                          them, this is what the U.S. Government has
                          done while serving The People.




   Economics Gone Wild!
                          For a Greener America
                  At the rate Congress is spending our money,
                  we’ll be out of trees before 2015!
Lesson
VIII
                  For this reason, a new bill will be issued to
                  reduce paper waste and commemorate the
                  new monetary philosophy in America…




   Economics Gone Wild!
                          Presenting, the all new
                           Trillion Dollar Bill…
Lesson
VIII




   Economics Gone Wild!
                          Spread the Wealth!
                   Now that you’ve seen a Trillion, tell your friends
                    and family. The more people who know, the
Lesson
                   more we can do to stop this runaway spending
VIII
                                       train.


                   “A wise and frugal government, which
                   shall leave men free to regulate their
                   own pursuits of industry and
                   improvement, and shall not take from
                   the mouth of labor the bread it has
                   earned - this is the sum of good
                   government.”           – Thomas Jefferson
   Economics Gone Wild!
                          Incomes around the World

Lesson
VIII




   Economics Gone Wild!
                          Macroeconomic Goals

Lesson          •Full Employment
VIII



                •Price Stability


                •Economic Growth

   Economics Gone Wild!
                     Basic Relationships
              • Income-Consumption
Lesson
VIII          • Income-Saving
              • 45° Line
              • C = DI on the Line
              • S = DI - C


   Economics Gone Wild!
               Income and Consumption
             Consumption and Disposable Income, 1983-2005
                                                 10000




                   Consumption (billions of dollars)
Lesson                                                 9000
                                                                                                                                                            05

VIII                                                   8000
                                                                            45° Reference Line                                                         04
                                                                            C=DI                                                                  03
                                                                                                                                             02
                                                       7000                                                                             01
                                                                                                                                   00

                                                       6000
                                                                                                                              99                        C
                                                                           Saving                                   97
                                                                                                                         98


                                                       5000
                                                                           In 1992                           95
                                                                                                               96
                                                                                                            94
                                                                                                          93
                                                                                                         92
                                                       4000                                         91
                                                                                                  90
                                                                                                 89
                                                                                               88
                                                       3000                                  87
                                                                                            86
                                                                                          85
                                                                                     84
                                                       2000                     83                                  Consumption
                                                                                                                    In 1992
                                                       1000

                                                                  45°
                                                          0
                                                              0          2000                 4000             6000                     8000                     10000


   Economics Gone Wild!                                                 Disposable Income (billions of dollars)
               Consumption and Saving
              • The Consumption Schedule
Lesson
VIII
              • The Saving Schedule
              • Break-Even Income
              • Average Propensity to
                Consume (APC)
              • Average Propensity to Save
                (APS)
                        Consumption           Saving
                  APC =               APS =
                          Income              Income
   Economics Gone Wild!
              Consumption and Saving
              • Marginal Propensity to
Lesson
VIII
                Consume (MPC)
              • Marginal Propensity to
                Save (MPS)
                            Change in Consumption
                      MPC =
                              Change in Income

                                Change in Saving
                          MPS = Change in Income
   Economics Gone Wild!
               Consumption and Saving
                (1)                               (4)        (5)         (6)       (7)
              Level of                         Average    Average     Marginal  Marginal
              Output      (2)                 Propensity Propensity Propensity Propensity
Lesson          And
              Income
                       Consump-
                         tion
                                     (3)
                                  Saving (S)
                                             to Consume to Save
                                                (APC)      (APS)
                                                                    to Consume to Save
                                                                       (MPC)     (MPS)
VIII         (GDP=DI)     (C)       (1-2)       (2)/(1)    (3)/(1)    Δ(2)/Δ(1) Δ(3)/Δ(1)


             (1) $370     $375       $-5       1.01        -.01
                                                                       .75        .25
             (2)   390    390          0       1.00         .00
                                                                       .75        .25
             (3)   410    405          5        .99         .01
                                                                       .75        .25
             (4)   430    420         10        .98         .02
                                                                       .75        .25
             (5)   450    435         15        .97         .03
                                                                       .75        .25
             (6)   470    450         20        .96         .04
                                                                       .75        .25
             (7)   490    465         25        .95         .05
                                                                       .75        .25
             (8)   510    480         30        .94         .06
                                                                       .75        .25
             (9)   530    495         35        .93         .07
                                                                       .75        .25
             (10) 550     510         40        .93         .07



   Economics Gone Wild!
               Consumption and Saving
                                                                   Consumption and Saving Schedules

                                                                   500




                               Consumption (billions of dollars)
Lesson                                                             475
                                                                                                                  C
VIII
                                                                   450

                                                                   425   Saving $5 Billion          Consumption
                                                                                                    Schedule
                                                                   400

                                                                   375

                                                                                         Dissaving $5 Billion

                                                                          45°
                    (billions of dollars)




                                                                                370 390 410 430 450 470 490 510 530 550
                                                                           Disposable Income (billions of dollars)
                           Saving




                                                                    50
                                                                         Dissaving Saving Schedule         S
                                                                    25   $5 Billion
                                                                     0                        Saving $5 Billion

   Economics Gone Wild!                                                         370 390 410 430 450 470 490 510 530 550
               Consumption and Saving
                               GLOBAL PERSPECTIVE
                      Average Propensities to Consume
Lesson                Select Nations GDPs
VIII                                  Average Propensities to Consume
                                .80        .85     .90                 .95              1.00

                 United States                                                  .963
                          Canada                                              .958
             United Kingdom                                                  .953
                           Japan                                     .942
                      Germany                       .896
                  Netherlands                      .893
                            Italy        .840
                          France        .833
   Economics Gone Wild!                          Source: Statistical Abstract of the United States, 2006
               Consumption and Saving
              • MPC + MPS = 1
Lesson        • MPC and MPS as Slopes
VIII
              • Nonincome Determinants of
                Consumption and Saving
                    – Wealth Effect
                    – Expectations
                    – Real Interest Rates
                    – Household Debt
   Economics Gone Wild!
               Consumption and Saving
              • Other Important Considerations
Lesson        • Changes Along Schedules
VIII
              • Switch to Real GDP
              • Schedule Shifts
              • Stability
              • Taxation
              • Debt repayment?
                                                 G 8.1

                    – Savings after the fact!
   Economics Gone Wild!
               Consumption and Saving
                                  Consumption and Saving Schedules
                                                                                                       C1




                                  Consumption (billions of dollars)
Lesson                                                                                                 C0
VIII                                                                                                   C2




                                                                      45°
                      (billions of dollars)




                                                                      Disposable Income (billions of dollars)
                                                                                                       S2
                             Saving




                                                                                                       S0
                                                                                                       S1

   Economics Gone Wild!
              Interest Rate and Investment
              • Expected Rate of Return (r)
Lesson
VIII
              • The Real Interest Rate (i)
              • Meaning of r = i
              • Investment Demand Curve




   Economics Gone Wild!
               Interest Rate and Investment
                   The Investment Demand Curve
Lesson                     Cumulative
VIII                        Amount of
                           Investment                           16
                           Having This
              Expected       Rate of                            14
               Rate of   Return or Higher
                                                                12




                                            r and i (percent)
              Return (r)        (i)
                                                                10
               16%            $ 0
               14%              5                                8
               12%             10                                6
               10%             15
                8%             20                                4

                6%             25                                2                                           ID
                4%             30
                                                                 0
                2%             35                                    5    10    15    20    25    30    35    40
                0%             40                                        Investment (billions of dollars)


   Economics Gone Wild!
              Interest Rate and Investment
              • Shifts of the Investment
Lesson          Demand Curve
VIII
                    – Planned inventory changes
                    – Acquisition, Maintenance, and
                      Operating Costs
                    – Business Taxes
                    – Technological Change
                    – Stock of Capital Goods on Hand
                    – Expectations
   Economics Gone Wild!
              The Market for Loanable Funds
              The loanable funds market is a
Lesson        hypothetical market that examines the
VIII
              market outcome of the demand for funds
              generated by borrowers and the supply of
              funds provided by lenders.
              The interest rate is the price, calculated
              as a percentage of the amount borrowed,
              charged by the lender to a borrower for
              the use of their savings for one year.
   Economics Gone Wild!
              The Demand for Loanable Funds
                          The demand curve for loanable
                          funds slopes downward: the lower
                          the interest rate, the greater the
Lesson                    quantity of loanable funds
VIII                      demanded.
                          In this example, reducing the
                          interest rate from 12% to 4%
                          increases the quantity of loanable
                          funds demanded from $150 billion
                          to $450 billion.




   Economics Gone Wild!
                 The Market for Loanable Funds


Lesson
VIII          The rate of return of a project is the profit earned
              on the project expressed as a percentage of its cost.




   Economics Gone Wild!
                  The Supply for Loanable Funds


Lesson                                The supply curve for
VIII                                  loanable funds
                                      slopes upward: the
                                      higher the interest
                                      rate, the greater the
                                      quantity of loanable
                                      funds supplied.
                                      In this example,
                                      increasing the
                                      interest rate from
                                      4% to 12%
                                      increases the
                                      quantity of loanable
                                      funds supplied from
                                      $150 billion to $450
                                      billion.
   Economics Gone Wild!
                     Equilibrium in the Loanable
                            Funds Market

Lesson
VIII




   Economics Gone Wild!
                 At the equilibrium interest rate, the
                  quantity of loanable funds supplied
                  equals the quantity of loanable funds
Lesson            demanded. Here the equilibrium
VIII              interest rate is 8%, with $300 billion of
                  funds lent and borrowed. Investment
                  spending projects with a rate of return
                  of 8% or higher receive financing; those
                  with a lower rate of return do not.
                  Lenders who demand an interest rate of
                  8% or lower have their offers of loans
                  accepted; those who demand a higher
                  interest rate do not.
   Economics Gone Wild!
                Savings, Investment Spending,
                   and Government Policy

Lesson
VIII




                Qty of
   Economics Gone Wild!   private loanable funds demanded falls
              A government must borrow if it runs a
              deficit, and this borrowing adds to the total
              demand for loanable funds. As a result, the
Lesson        demand curve for loanable funds shifts
VIII          rightward by the amount of the
              government borrowing and the equilibrium
              moves from E1 to E2. This leads to an
              increase in the equilibrium interest rate
              from r1 to r2 and crowding out: the increase
              in the interest rate reduces the private
              quantity of loanable funds demanded from
              Q1 to Q2, as shown by the movement up the
              demand curve D1.
   Economics Gone Wild!
                      Increasing Private Savings


Lesson
VIII




   Economics Gone Wild!
              Some economists have urged reforms in
              the tax system and adoption of other
              policies that would, they say, increase
Lesson        private savings but keep tax revenue
VIII          unchanged. If they are correct, the
              effect would be to shift the supply curve
              of loanable funds to the right, leading
              to a reduction in the equilibrium
              interest rate and a larger quantity of
              funds lent and borrowed. Private
              investment spending in the economy
              would rise and so, ultimately, would
              long-run economic growth.
   Economics Gone Wild!
               Interest Rate and Investment
                                          Shifts in the Investment
                                               Demand Curve
Lesson
VIII                                                                       Increase in
                      r and i (percent)
                                                                       Investment Demand




                                              Decrease in
                                          Investment Demand                          ID2 ID0 ID1
                             0
                                                  Investment (billions of dollars)
   Economics Gone Wild!
               Interest Rate and Investment
              • Instability of Investment
Lesson
VIII
                    –Durability
                    –Irregularity of Innovation
                    –Variability of Profits
                    –Variability of Expectations



   Economics Gone Wild!
               Interest Rate and Investment
                              GLOBAL PERSPECTIVE
                   Gross Investment Expenditures as a
Lesson             Percent of GDP, Select Nations
VIII                                Percent of GDP, 2006
                               0      10         20              30
                  South Korea
                           Japan
                          Mexico
                          Canada
                          France
                 United States
                      Germany
             United Kingdom
                          Sweden
   Economics Gone Wild!                                    Source: World Bank
               Interest Rate and Investment
                   The Volatility of Investment
Lesson
VIII




   Economics Gone Wild!
                     The Multiplier Effect
                                   Change in Real GDP
               Multiplier =
Lesson                          Initial Change in Spending
VIII
              The Multiplier and the Marginal Propensities

                                            1
                          Multiplier =
                                          1 - MPC
                                   -or-
                                            1
                          Multiplier =
                                           MPS

   Economics Gone Wild!
                                           Graphically…
                          The Multiplier Effect


Lesson        • More spending results in
VIII
                higher GDP
              • Initial change in spending
                changes GDP by a multiple
                amount



   Economics Gone Wild!
                    The Multiplier Effect
              • Causes of the initial change
Lesson
                in spending
VIII               – Changes in investment
                   – Other changes
              • Rationale
                   – Dollars spent are received as
                     income
                   – Income received is spent (MPC)
                   – Initial changes in spending
                     cause a spending chain
   Economics Gone Wild!
                     The Multiplier Effect
                      Tabular and Graphical Views
                                                          (2)        (3)
                                               (1)     Change in Change in
                                            Change in Consumption Saving
Lesson                                       Income (MPC = .75) (MPC = .25)
VIII           Increase in Investment of $5   $ 5.00     $ 3.75   $ 1.25
               Second Round                     3.75       2.81        .94
               Third Round                      2.81       2.11        .70
               Fourth Round                     2.11       1.58        .53
               Fifth Round                      1.58       1.19        .39
               All other rounds                 4.75       3.56      1.19
                  Total                      $ 20.00    $ 15.00    $ 5.00
               $20.00
                                                                             $4.75
                 15.25
                 13.67                                               $1.58
                 11.56                                     $2.11
                                                   $2.81
                  8.75
                          ΔI=
                          $5 billion       $3.75
                  5.00
                                   $5.00

                                       1    2       3        4        5       All
   Economics Gone Wild!                         Rounds of Spending
                     The Multiplier Effect
                      The MPC and the Multiplier
Lesson                    MPC                    Multiplier
VIII                       .9                       10


                           .8                5


                           .75           4


                           .67       3


                            .5   2

   Economics Gone Wild!
                   Macroeconomic Relationships
Lesson                    Graphing Consumption
VIII
                               Functions




   Economics Gone Wild!
Lesson
VIII




              The are given the coordinates of two points on this Y (income).
             C We MPC is the Marginal Propensity to Consume, ofconsumption
                (consumption spending) is a linear function which is simply
              the slope of theso we can the function (C = a + bY) the Y being
               equation, and consumption equation.
             Note the specific form ofdetermine both the RISE andwith RUN.
               The RISE is 33-21, horizontal axis 40-20, being measured
             measured along theor 12; the RUN is and C or 20. The SLOPE
               of the line, then,
                                  axis. The other symbols or 0.6.
             along the verticalis RISE/RUN, which is 12/20,take their meaning
             from the role they play in the equation. The stand-alone term
             "a" is the vertical intercept: the coefficient "b" is the slope.


   Economics Gone Wild!
Lesson
VIII




             C We are given the coordinates of two points on this consumption
                (consumption spending) is a linear function of Y (income).
               equation, and so we can the function (C = a + bY) the Y being
             Note the specific form ofdetermine both the RISE andwith RUN.
               The RISE is 33-21, horizontal axis 40-20, being measured
             measured along theor 12; the RUN is and C or 20. The SLOPE
               of the line, then,
                                  axis. The other symbols or 0.6.
             along the verticalis RISE/RUN, which is 12/20,take their meaning
             from the role they play in the equation. The stand-alone term
             "a" is the vertical intercept: the coefficient "b" is the slope.


   Economics Gone Wild!
Lesson
VIII




               C = a + bY
               21 = a + 0.6(20)
               21 = a + 12
                 This is the level of consumer spending
               a = 21 - 12
                 we
               a = 9 would expect to see even if income
                  has (temporarily) fallen to zero.

   Economics Gone Wild!
Lesson
VIII




              So, now we visualize a right triangle with one acute vertex touching
              To get the slope, we need to find two points on the equation
              the C-intercept and the other touching the intersection with the 45-
              degree coordinates are known. triangle, the RISE, is such
              whose line. The vertical leg of theThe intercept is one15-6, or 9;
              The horizontal leg of The other the RUN, is 15. The SLOPE is the
              point: Y = 0; C = 6. the triangle,point is the intersection of the
              RISE over the line with the 45-degree line: Y = 15; C = 15
              consumption RUN: 9/15 = 0.6.
              (Remember that the 45-degree line has a slope of 1.0, which
              means that, starting from the origin, the Y-distance and the C-
              distance to any point on that line are the same).
   Economics Gone Wild!
Lesson
VIII




             Now we know both the vertical intercept (a = 6) and the slope
             (b = 0.6) and can write the equation describing consumption
             behavior:
             C = a + bY
             C = 6 + 0.6Y



   Economics Gone Wild!
Lesson
VIII




             This question calls your bluff: Show me you can actually make use of
             Alternatively, you could write the saving equation by observing
             You equation relating C to 35 for Y the level offor C:
               There simply ways to calculate and solve saving. The
             this canare two substitute Y.
             the 6 + 0.6Y form: S = -a + (1 - b) Y, and then evaluating for
                = general
             Ceasiest is simply to recognize that saving is what's left of your an
             income0.6(35)you're
             Cincomeof Y = 35: through spending. That is, S = Y - C; S =
                = 6 + after
             S = -a 21
                = - 27 (1
             C35 6 + + = 8 - b)Y
             S = -6
             C = 27 + 0.4Y
             S = -6 + 0.4(35)
             S = -6 + 14
             S= 8
   Economics Gone Wild!
              Alternatively, we can recognize that for a wholly private economy, it
              is always true that Y = C + S. That is, your income has to be equal
              to the part of it that you spend plus the part of it that you don't spend.
               By the now if we were dealing with a mixed economy, we I.
              We can way, write the equilibrium condition as C + S = C + would
Lesson         write as our accounting spending = C both T. That is, us the
              Subtracting consumptionidentity: Y from+ S + sides givesyour
               income has to be equal to the for of it that you spend plus the
              alternative equilibrium conditionpart a wholly private economy: S = I.
VIII          This means that if S = 8, then that amount needs to be borrowed and
               part of it that you don't spend plus the part that you don't even see-
               -because the government took it as taxes economy to be in
              spent by the investment community for the before you were given
               your (after-tax) equilibrium.
              macroeconomic income. In this case, the alternative equilibrium
               would be S + T = I + G.


             An income-expenditure equilibrium requires that income be equal to
             expenditures. For this wholly private economy, we can write the
             equilibrium condition as Y = C + I. We know that for an income of
             35, consumption spending is 27. So we can write: 35 = 27 + I.
             Therefore I = 35 - 27 = 8.




   Economics Gone Wild!
Lesson
VIII




               We're shown C + I of income is the income that satisfies the
                         Y = a level
               The equilibrium wholly private economy (no government spending;
               equilibrium condition Y = C + I. So, we simply make use of all we
                          in which consumption spending is given by the equation
               no taxes) Y = 30 + 0.6Y + 34
               C = 30 + 0.6Y and about
                         Y 0.6Y investment solve for is
               know about -C and = 64 I and spendingY: 34.
                          0.4Y = 64
                          Y = 160



   Economics Gone Wild!
Lesson
VIII




                         Alternatively, we can write the saving equation and evaluate
                    There's an easy way and a hard way to get this answer--and
                           for an income pretty easy.
                    evenitthe hard way isof Y = 160: First, if we know that the
                         S = -a in equilibrium and we know that investment is
                    economy is+ (1 - b)Y
                         S = saving must
                    34, then -30 + 0.4Y be 34, too. So, S = 34.
                         S = -30 + 0.4(160)
                         S = -30 + 64
                         S = 34


   Economics Gone Wild!
Lesson
VIII




                 Again, there's an easy way and an almost-as-easy and
                Alternatively, we can write the consumption equationway. First,
                 if people for an income 160 160:
                evaluate itare earning Y =of Y =and saving S = 34, then they
                 must + spending the difference: C = 126. That is, we simply
                C = 30be 0.6Y
                 make + 0.6(160)
                C = 30 use of the identity: Y = C + S.
                C = 30 + 96
                C = 126



   Economics Gone Wild!
                          Can you say whether or not the
                           labor force is fully employed?
             We can't say. We take the so-called "going wage" as the wage rate
Lesson       that if the current demand for labor some earlier period the given
             Onlycleared the labor market during happens to intersectwhen the
             economy was at the macroeconomic health. That very wage
             supply of laborin goodgoing wage (a possible but notgoinglikely is
VIII         circumstance, according to Maynard Keynes) would thethe economy
             still going--even if the demand for labor has fallen (and
             corresponding income (Y = WN) be full-employment income. = 160 is
             is in recession). In recessionary conditions, the income of Y
             equal to going wage rate times the quantity of worker-hours currently
             demanded at that wage rate.




   Economics Gone Wild!
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Lesson
VIII




              Macro Theories


   Economics Gone Wild!

				
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