Econ 202: Macroeconomic Principles
Lecture Notes: Stratford Douglas
Text: N. G. Mankiw, Brief Principles of Macroeconomics
When taxes are too high, people go hungry.
When the government is too intrusive, people lose their spirit.
Act for the people's benefit. Trust them; leave them alone.
(Lao Tze, China, 6th Century BC)
There is always a temporary tradeoff between inflation and
unemployment; there is no permanent tradeoff.
(Milton Friedman, 1968)
The long run is a misleading guide to current affairs. In the long
run we are all dead. Economists set themselves too easy, too
useless a task if in tempestuous seasons they can only tell us
that when the storm is past, the ocean will be flat.
(JM Keynes, 1933)
Economists have successfully predicted seven out
of the last five recessions.
(Paul Samuelson, 1987)
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I. Chapter 1: Ten Principles of Economics
ECONOMICS is the study of how people deal with scarcity.
Microeconomics vs Macroeconomics
1. Micro: How households and firms make decisions.
2. Macro: How the economy as a whole operates (inflation,
unemployment, growth, etc)
A. How People Make Decisions
1. People Face Tradeoffs
2. The Cost of Something is What You Give Up to Get It.
OPPORTUNITY COST: The best alternative you give up when you
make a choice.
3. Rational People Think at the Margin
4. People Respond to Incentives
B. How People Interact
5. Trade Can Make Everyone Better Off
Are the US and China Competitors, or partners?
Trade is voluntary on both sides, so it must make both sides
better off or it would not happen.
6. Markets Are Usually a Good Way to Organize Economic Activity
The INVISIBLE HAND.
Two Disadvantages of Central Planners vis a vis Markets:
(1) Less and worse INFORMATION than price provides.
(2) Less motivated than consumers and producers
themselves to satisfy consumers or cut production costs
7. Government Can Sometimes Improve Market Outcomes
MARKET FAILURE: Situation where unassisted market is
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C. How the Economy as a Whole Works
8. A Country’s Standard of Living Depends on its Ability to Produce
Goods and Services.
a) A country’s standard of living is measured by per-capita income,
which correlates positively with some important good things,
(a) Life Expectancy
(b) Low infant mortality
(c) Environmental standards etc.
(2) How much stuff people have.
(3) Literacy & Learning
b) Living standards grow with PRODUCTIVITY (amount of goods and
services produced by a worker in an hour).
c) Living standards reflect access to goods and services,
9. Prices Rise When the Government Prints too Much Money
a) Inflation: A general increase in prices.
(1) Money is used to obtain goods and services
(2) At a given time, there is a finite amount of goods and
(3) Price = $/good.
(4) If everyone gets more $, but the number of goods stays the
same, then prices rise.
(5) Standing up at a basketball game
b) Since government can control the money supply, it can control
the rate of inflation, but it doesn’t always do so:
10. Society Faces a Short-Run Tradeoff between Inflation and
a) Unemployment: Some job seekers are unable to find work.
b) Business Cycle: Fluctuations in output and unemployment
(1) In the short run, an increase in the amount of money
stimulates everybody to buy, which stimulates production,
which means more jobs.
(2) In the long run, desire to buy falls, less production, U
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c) Phillips Curve is a picture of this tradeoff between
unemployment and inflation.
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II. Chapter 2: Thinking Like an Economist
A. The Economist as a Scientist
Science is just “the refinement of everyday thinking” – Albert Einstein
B. Economic Models: All Models are Wrong. Some are Useful!
1. Economic Models are representations of reality that attempt to
improve our understanding of (and help us make predictions about)
choice and economic outcomes.
Models are built from assumptions that contradict reality in a
2. Why Model? TO UNDERSTAND AND PREDICT.
The art of Scientific model building:
Figure out which assumptions to make.
Test the conclusions of the model.
3. OUR FIRST MODEL: The Circular Flow
a) HOUSEHOLDS are groups of people living together as a decision
b) FIRMS are organizations that produce goods and services. They
hire input factors and sell outputs (products).
c) PRODUCT (OUTPUT) MARKETS
d) FACTOR (RESOURCE , INPUT) MARKETS : Land, Labor, Capital
4. Second Model: The Production Possibilities Frontier
a) Defn: The PPF is a graph that shows the various combinations
of output that the economy can produce, give the available
inputs and technology.
b) EFFICIENCY means the economy is getting all it can from
Attainable points, unattainable points.
Efficiency is found on the frontier.
“The cost of something is what you give up to get it.”
c) PPF shows Opportunity Cost
d) Shift of the PPF due to Growth, Technological Progress
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C. Economics and Policy
1. POSITIVE statements are descriptive. WHAT IS?
2. NORMATIVE statements are prescriptive. WHAT IS BEST?
3. SCIENCE addresses Positive questions.
4. “Practical men, who believe themselves to be quite exempt from
intellectual influences, are usually the slaves of some defunct
economist.” - J.M. Keynes
D. Why Economists Disagree
E. Appendix: Graphing Review
1. Positive and Negative Relationships
2. Calculating Slope
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III. Chapter 3: Interdependence and the Gains from Trade
A. Example: Paint and Wallpaper
H OU R S N E E D E D T O D O R OOMS F IN IS H E D IN 40
O N E R OOM H OU R S :
Paint Wallpaper Paint Wallpaper
S T E W AR T 2 hrs 8 hrs 20 rms 5 rms
M AR T H A 4 hrs 10 hrs 10 rms 4 rms
1. Opportunity Cost
O P P OR T U N IT Y C OS T OF
D OIN G O N E R OOM
W IT H
S T E W AR T
M AR T H A
2. Specialization and Trade
No Trade: STEWART might choose to paint 4, wallpaper 4;
MARTHA paint 5, wallpaper 2.
Total: 9P, 6W
With Trade: Stewart might choose to paint 12, wallpaper 2
Martha wallpapers 4.
Total: 12P, 6W.
Each specializes in what s/he does best.
What trades are possible?
B. The Principle of Comparative Advantage
1. ABSOLUTE ADVANTAGE : A producer has Absolute Advantage if she
is more productive (fewer resources per unit) at making all possible
OPPORTUNITY C OST again. What is the cost of wallpapering, per
room, in terms of painted rooms?
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2. COMPARATIVE ADVANTAGE : A producer has Comparative
Advantage in producing a good if his opportunity cost of producing it
is lower than his trading partner.
3. COMPARATIVE ADVANTAGE AND TRADE: Trade can benefit everyone
because it allows people to specialize in activities in which they
have a comparative advantage.
1. SECRETARY : 10 pgs/hr typing; $10/hr in next best job
LAWYER: 20 pgs/hr typing; $100/hr in next best job.
As long as the lawyer pays the secretary more than $10/hr and less
than $50/hr to type, both are better off.
2. US and Mexico Trade
Imports are produced abroad and consumed here.
Exports are produced here and consumed abroad.
US worker can produce 2 units hardware/hr or 10 software/hr
Mexican worker can produce 1 hardware or 2 software per hr.
If they trade between 2 and 5 units of software per hardware, both
US and Mexico are better off specializing and trading.
This is an economic model, and the real world is more complicated,
but it shows the basic flow.
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IV. Chapter 4: Supply and Demand
A. A MARKET is a group of buyers and sellers of a particular good or
QUANTITY DEMANDED: The amount of a good that buyers will actually
seek to buy in a given time period.
1. Quantity Demanded Depends on:
a) PRICE OF THE GOOD. THE RELATIONSHIP BETWEEN PRICE AND QD
IS SPECIAL, AND IS CALLED DEMAND:
LAW OF DEMAND: As the price of a good rises, if nothing
else changes the quantity demanded of that good will fall.
Note: A change in price causes a movement along the
b) INCOME (+,-)
(1) Quantity demanded of normal goods increases when
(2) Quantity demanded of Inferior goods decreases when
c) PRICE OF R ELATED GOODS (+,-)
(1) Complements (): Goods used with the good
(2) Substitutes (+): Goods used instead of the good
d) Tastes (?)
e) Expectations (+)
f) Population (Number of individuals) (+)
2. Shifts in the Demand Curve
A DEMAND CURVE shows the change in the quantity demanded
of a good when its price changes, holding constant all other
determinants of demand. “CETERIS PARIBUS”
When one of the other determinants changes, the curve shifts.
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The QUANTITY SUPPLIED of a good or service is the amount that
sellers will seek to sell in a given time period.
1. Quantity Supplied Depends On:
a) PRICE OF THE GOOD. THE RELATIONSHIP BETWEEN PRICE AND QS
IS SPECIAL, AND IS CALLED SUPPLY:
LAW OF SUPPLY: As the price of a good rises, ceteris
paribus, so will the QS of that same good.
Ex: Supply Curve and Schedule
Note: A change in price (ceteris paribus) causes a
movement along the supply curve.
b) INPUT PRICES used to produce the good ()
c) TECHNOLOGY (+)
Future Prices ()
e) NUMBER OF SUPPLIERS
2. Shifts in the Supply Curve
A SUPPLY CURVE shows the change in the quantity supplied of
a good when its price changes, holding constant all other
determinants of supply.
When any other determinant changes, the curve shifts.
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D. Supply and Demand Together
1. EQUILIBRIUM: A market condition in which QS = QD.
The balancing role of Price: EQUILIBRIUM PRICE
EQUILIBRIUM QUANTITY = QS = QD
2. REACHING EQUILIBRIUM
SURPLUS: Excess Supply: Price is “too high.”
SHORTAGE: Excess Demand: Price is “too low.”
LAW OF SUPPLY AND D EMAND: Price adjusts automatically to
reach market equilibrium.
3. Shifts of Curves vs Movements Along Existing Curves
4. Shifting Supply and Demand: Three analytical steps.
1) Which curve(s) shift? (S or D)
2) Which way does it shift? (Increase or decrease)
3) How does the shift affect equilibrium price?
Move one at a time.
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V. Measuring a Nation’s Income
A. Income and Expenditure in the Economy as a Whole
For the economy as a whole, income = expenditure.
- Each transaction has a buyer (expenditure) and a seller
Circular Flow again.
B. Measurement of Gross Domestic Product
Definition: GDP is the market value of all final goods and services
produced within a country in a given period of time.
1. “MARKET VALUE ” is used so we can compare apples & oranges.
2. “ALL” includes goods and services traded on legal markets.
a) Non-market goods and services (garden vegetables, bartered
goods, services within family)
b) Illegal goods and services.
3. “FINAL” means for sale to final consumers (though intermediate
goods kept in inventory by their manufacturers are part of
investment, which is in GDP)
4. PRODUCED means currently produced (not resold items).
5. WITHIN A COUNTRY as defined geographically, whether by citizens or
6. IN A GIVEN PERIOD OF TIME, usually quarterly or yearly.
Quarterly data are usually seasonally adjusted.
Quarterly data are often stated in annual terms.
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C. Components of GDP: Y = C + I + G + NX
Link to Bureau of Economic Analysis Data
Link to GDP Components Data
Link to GDP Components Spreadsheet
1. Consumption (C): Spending by households on:
a) Goods, including durable and non-durable goods (but not
houses, which are investment).
b) Services (including education).
2. Investment (I): Spending (mostly by firms) on capital equipment,
inventories, and structures.
Includes purchases of new housing (by households).
Inventory changes are included – this makes sure that goods
produced in a given year are counted for that year, regardless of
when they are actually sold.
3. Government Purchases (G): Spending on goods and services by
all levels of government.
Includes salaries of government employees.
Does not include TRANSFER PAYMENTS .
4. Net Exports (NX): Exports minus Imports.
If a consumer or business buys an imported good, it will
increase C but lower NX by an equal amount.
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D. Real vs Nominal GDP
1. GDP is Market Value, measured in dollars.
Inflation changes the value of dollars.
Nominal GDP is GDP expressed in current dollars (i.e., the raw
data, actual dollar figures spent at the time.)
Real GDP is expressed in constant dollars (i.e., what GDP
would have been, if prices had been the same as in the base
2. Calculating Real GDP: Real GDP = x100.
Value of GDP in Current-Year Prices
GDP Deflator = x 100
Value of GDP in Base-Year Prices
Example1: Suppose Coffee is the only good produced.
Price of Nominal Real GDP
Coffee GDP GDP Deflator
2001 $ .50 100 $ 50 $150 33
2002 (base) $1.50 200 $300 $300 100
2003 $ 2.50 150 $375 $225 167
Example2: Suppose Coffee and Sugar are both produced.
Price and Quantity of Coffee are as Shown in Example1
Price of Nominal Real GDP
Sugar GDP GDP Deflator
2001 $1.00 10 $ 60 $170 35
2002 (base) $2.00 40 $380 $380 100
2003 $3.00 20 $435 $265 164
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E. GDP and Well-Being: A Pretty Good Measure
1. Real GDP is well correlated through time and across countries with
life expectancy, literacy, low infant mortality, Olympic medals,
environmental cleanliness, etc.
2. Disaster increases GDP
3. Does Not Account For:
a) Non-market activity (eat out vs eat in)
b) Sunsets, love, peace
d) Distributional issues
e) Changes in Relative Valuation
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VI. Measuring the Cost of Living
A. The Consumer Price Index (Bureau of Labor Statistics)
1. How to Calculate the CPI
a) Fix the Basket
What does a typical consumer buy? Conduct a survey.
How much of each good & service does s/he buy?
b) Find the Prices
Conduct a survey of sellers.
c) Compute the Basket’s Cost
Sum prices x quantities to get the cost of the basket.
d) Choose a Base Year and Compute the Index.
Cost of a Typical Basket in 2004
CPI2004 = x 100
Cost of a Typical Basket in the Base Year
For a Typical Consumer:
Price Quantity of
Price of Q of Donuts Cost of Inflation
Year of Coffee CPI
Doughnuts Consumed Basket Rate
2002 $ .50 20 $1.00 10 $20.00
2003 $ .75 20 $1.50 10 $30.00
2004 $ 1.25 20 $1.00 10 $35.00
Link to CPI Spreadsheet
Producer Price Index (PPI) is computed the same way, but uses
a market basket for the typical firm.
2. Compute the Inflation Rate:
Inflation Rate for 2003 = x 100
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3. Measurement Problems
a) Substitution Bias: Quantities that a typical consumer will
purchase will change as relative prices change.
b) Introduction of New Goods increases the value of a dollar (e.g.
VCRs, PDAs, cellphones,
c) Changes in Quality – e.g, cars, houses, computers.
d) Volatility: Base CPI vs CPI including Energy & Food.
A radical view: RedefiningProgress.org
4. Differences between GDP Deflator and CPI
a) Imports count in CPI but not GDP Deflator
b) CPI uses a fixed basket (hardly ever changes)
GDP Deflator uses actual production
B. Using the CPI to Correct Economic Measurements for Inflation
1. Real Value Measurement
a) Real Value = [(Nominal Value)/(CPI)] x 100
b) Example: Consumer Income
a) Social Security
b) COLA’s – often negotiated by unions.
c) Tax Brackets
3. Real and Nominal Interest Rates
a) Example: 10% interest rate and 10% inflation
b) Real Interest Rate = Nominal Interest Rate – Inflation Rate
If the inflation rate goes higher than expected, who gains,
borrower or lender?
Why are long-term bonds riskier than short-term bonds?
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VII. Production and Growth
A. Economic Growth Around the World
Which country was richest at the beginning? The end? Which grew
fastest? Where does US stand?
B. Productivity: Its Role and Determinants
1. Why Productivity is So Important
Productivity is the amount of goods and services produced from
each hour of a worker’s time.
GDP is both income and output – they are identical!
2. How Productivity is Determined
a) Physical Capital: Equipment and Structures
b) Human Capital: Knowledge, skills, education, training,
c) Natural Resources: Inputs provided by nature (oil, farmland)
d) Technological Knowledge: Finding better ways of production.
See Jared Diamond, Guns, Germs, and Steel, 1998, (Click for
Summary): Why did Eurasia beat Africa and the Americas?
(1) Domesticable plants and animals
(surprising role of disease)
(2) East-West Axis
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C. Economic Growth and Public Policy
1. Savings and Investment
PPF: Consumer Goods vs Capital Goods
2. Diminishing Returns and the Catch-Up Effect
a) Diminishing Returns: As the quantity of an input increases, the
benefit from an additional unit of it decreases.
High savings rates lead to higher productivity and income,
but growth rates may decline
b) Catch-up Effect (Convergence): Countries that start off poor
grow more quickly than rich countries.
What does it mean when a product is the “fastest
3. Investment from Abroad
a) Foreign Direct Investment: Owned and operated by foreigners.
b) Foreign Portfolio Investment: Owned by foreigners, operated by
Increases the productivity of locals, but some of the income from
the increase goes to foreigners: Increases GDP more than
4. Education: Investment in Human Capital
How does the opportunity cost of educating farm children differ
from the opportunity cost of educating city children?
Education of women
Education creates positive externalities
5. Property Rights and Political Stability
a) Role of property rights in an economic system.
Enforcement of contracts
Government expropriation, taxation, corruption, lack of
“rule of law”
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b) Economic Freedom of the World Index
Individuals have economic freedom when property they
acquire without the use of force, fraud, or theft is protected
from physical invasions by others and they are free to use,
exchange, or give their property as long as their actions do
not violate the identical rights of others. An index of
economic freedom should measure the extent to which
rightly acquired property is protected and individuals are
engaged in voluntary transactions.
James Gwartney et al. 1996
“The cornerstones of economic freedom are personal
choice, voluntary exchange, freedom to compete, and
security of privately owned property.”
Measure economic freedom in five areas:
(1) size of government;
(2) legal structure and protection of property rights
(3) access to sound money
(4) international exchange
Hong Kong has highest rating, 8.7 of 10,
2nd Singapore at 8.6.
3rd: New Zealand, Switzerland, UK, & US tied 8.2.
Other top 10:
Australia, Canada, Ireland, and Luxembourg.
Other Rankings: Germany, 22; Japan and Italy, 36; France,
44; Mexico, 58; India, 68; Brazil, 74; China, 90; and
of 18 is by far the best among continental sub-Saharan
African nations. Chile, with the best record in Latin
America, was tied with four other nations at 22.
The bottom five nations were Venezuela, Central African
Republic, the Democratic Republic of Congo, Zimbabwe,
and Myanmar. (N Korea & Cuba data N/A).
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6. Free Trade
a) Legal Trade Barriers: Compare South Korea (outward-oriented)
to North Korea (inward-oriented)
b) Physical Trade Barriers: Compare Europe (good access to
seaports & trade) to African and South American countries
Azerbaijan, Kazakhstan: Blessed by geology, cursed by
7. Research and Development
R&D is a public good.
NASA and US economy
NSF, other funding for science & higher education
Patents and protection of property rights
8. Population Growth
a) Stretching Natural Resources (Thomas R. Malthus, An Essay on
the Principle of Population . . . ,1798)
Only check on population growth is “misery and vice.”
Modern Malthusians: Limits to Growth, Population
b) Diluting the Capital Stock
What happens to attractiveness of investment as
population increases? (Catch-up effect again.)
c) Promoting Technological Progress
More people mean more ideas
Resources are perception as much as physical things
(coal was just a rock until we did something with it)
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VIII. Saving, Investment, and the Financial System
The FINANCIAL SYSTEM matches people who save with people who
A. Financial Institutions in the US Economy
1. FINANCIAL MARKETS: Markets where savers directly provide funds to
a) The Bond Market (DEBT): Specific sums promised at specific
(1) A BOND is a certificate of indebtedness, or IOU, that
specifies the obligations of the bond’s seller (the borrower)
to the bond’s buyer (the lender).
Seller will pay specific sums at specific future times.
(2) Most Bonds Have:
(a) Principal amount (amount borrowed)
(b) Rate of interest (coupon rate)
(c) Date of maturity (date repaid)
(3) What determines the value of a bond?
(a) Term: Length of time until maturity.
Link: Here’s a cool Yield Curve Chart
(b) Coupon Rate: Periodical payments.
(c) Credit Risk: Likelihood of default.
“Junk bonds” have high credit risk.
(d) Tax treatment: Interest may be tax-free income.
(municipal bonds, issued by state & local govt).
Munis’ interest rates are lower than those of
other bonds of similar riskiness.
Whether or not a muni is a good investment
depends partly on your own marginal tax rate.
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b) The Stock Market (EQUITY): A piece of the action,
whatever it might turn out to be.
(1) A SHARE OF STOCK is a claim to a portion of the firm’s
profits. Stockholders are the firm’s owners.
Stockholders are last in line for repayment if the firm
goes belly up.
(2) Most Stocks pay DIVIDENDS (distributed profits)
(3) What determines the value of a stock?
SUPPLY and DEMAND, based on Expected Profitability
(a) Current Earnings
(b) Growth rate of earnings
(d) Probability of bankruptcy
(4) Stocks are sold on STOCK EXCHANGES
(eg NYSE, AMEX, NASDAQ).
(5) A STOCK INDEX is an average of a number of stock prices.
Dow Industrials, S&P 500, Russell 2000 (Midcaps),
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2. Financial Intermediaries: Between savers & investors.
(1) Pay depositors interest, charge higher interest to
(2) Allow depositors to write checks
b) Mutual Funds
(1) How a mutual fund works:
(a) Sells shares of the fund to Shareholders
(b) The fund is just a portfolio (i.e., a collection) of
stocks, bonds, etc, so the value of its shares moves
with the value of the portfolio
(i) decide what assets to buy and sell, and
(ii) charge fees (0.5% to 2%) to cover expenses,
including their own salaries.
(d) “Load” and 12b1 fees: Sales charges.
(2) Advantages of Mutual Funds over Direct Ownership
(b) Professional Management, stock-picking ability (?)
(i) cf Index funds
(ii) Efficient market hypothesis: The price of a
stock reflects all current information.
Money managers will buy a stock that’s too
cheap, and sell a stock that’s too expensive
So all stocks will be “fairly valued” at all times
So stock-picking ability is an illusion.
Note Distribution of Risk between lenders & borrowers in stocks vs
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B. Saving and Investment in the National Income Accounts
1. Saving vs Investing
a) Saving is income not spent.
b) Investment is money spent on capital goods.
2. Some Accounting Identities
Identities are true by definition.
a) Open Economy: Y = C + I + G + NX
b) Closed Economy (simplification of reality):
Y= C + I+ G
Y– C – G = I
S = Y– C – G = I
where S is national savings.
Thus SAVINGS EQUALS INVESTMENT in the
c) Public vs Private Saving
(1) Budget Surplus: Public Saving is positive (T > G)
(2) Budget Deficit: Public Saving is negative (T < G)
Private Saving = Y – T – C
Public Saving = T – G
National Saving is the sum of public and private saving,
S = Private Saving + Public Saving
which works as an accounting identity because
if we substitute in the above equation and cancel the T’s:
S = (Y – T – C) + (T – G)
S = Y– C – G
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Savings as Proportion of GDP
1958- 1964- 1970- 1976- 1982- 1988- 1995- 2001-
11-11 11-19 11-28 12-06 12-15 12-23 01-01 01-09
Gross Private Personal Business
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How does Savings always equal Investment? (It has to, but how?)
C. The Market for Loanable Funds
The MARKET FOR LOANABLE FUNDS is the market in which those who
want to save meet those who want to invest.
(This is an obvious simplification of reality)
1. Supply, Demand, and Price in the Market for Loanable Funds
a) Supply: Savings is the source of the supply of LF.
b) Demand: Investment is the source of demand for LF.
c) Price: The Interest Rate is the Price of LF
2. Policies that Affect the Loanable Funds Market:
a) Saving Incentives
(1) An Income Tax taxes all income, whether it is saved or
(2) Traditional IRA’s, 401(k)’s, allow deduction of savings.
(3) Effect on LF Market:
1) Which curve shifts?
2) Which way?
3) Effect on interest rates, total S & I:
(4) Other Considerations: Equity, effectiveness (elasticities)
b) Investment Incentives: Investment Tax Credit to Firms, Mortgage
c) Government Budget Deficits and Surpluses
Recall, government saving is part of S.
History of federal deficits, debt.
Crowding Out: A decrease in investment caused by
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D. Conclusions: Should the Government Balance its Budget?
a) Burden on future generations.
b) Crowding out will raise interest rates and lower investment
c) Current budget deficits are not like WWII deficits.
a) Problems caused by debt are overstated. (Debt service is small
relative to total income.)
b) Some government spending (e.g., education, roads) can
increase growth rates, and cutting it will be counterproductive.
c) To some extent, parents who leave money to their children may
offset the effects of increased government debt on them.
Government Budget Surplus
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Percent of GDP
Source: Congressional Budget Office
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IX. The Basic Tools of Finance
Finance involves Time and Risk.
A. Present Value and the Time Value of Money
1. Compounding: Process by which interest earned on a deposit earns
interest in the future.
Example: If you save Y dollars today, its Future Value n years from
now at at interest rate of r, is:
FV(Y, n, r) = Y x (1 + r)n
Rule of 72: Investment doubles in approx 72/(interest rate) years
(Ex: $100 will be $200 in 12 years at 6% interest)
2. Present Value of a Future Sum: The amount of money today that
would be required to produce (at prevailing interest rates) a given
Or, it is the amount that you would take today in exchange for giving
up the right to get X dollars, n years from now.
a) If r is the interest rate, then the amount X to be received in n
years has a present value of
PV(X, n, r) =
(1 + r)n
X = Dollars to be received
r = Interest rate (for example, 5% interest i = .05)
n = Numbers of years until you receive X.
Note the effect of risk.
$110 one year from today, at 10% interest.
Powerball: Take 25 equal installments, or half today.
Bowie Bonds: $55 million 10-year Bonds David Bowie
issued & Prudential Insurance Co. bought in 1997.
Collateral is royalties from 25 of Bowie's albums.
Bowie agreed to the deal so he could raise the
money to buy out the rights to his songs from his
former manager. This means he now controls 100%
of his copyrights.
James Brown did something similar in 1999.
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b) The present value of a perpetuity of X dollars per year is .
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B. Managing Risk
1. Risk Aversion
a) Risk Aversion means a preference to avoid uncertainty.
If you are risk averse, then you will happily give up a deal in
which you might gain or lose, in favor of one in which you
are certain of getting the average.
Example: Which would you prefer:
(a) I pay you $10, or
(b) We flip a coin and I pay you $20 if it’s heads.
(c) We flip a coin and I pay you $110 if it’s heads, or you
pay me $90 if it’s tails?
b) Thus, for a RISK AVERSE person, the “disutility” of losing $1
exceeds the “utility” of winning $1.
2. Markets for Insurance
a) In an insurance contract, you pay a fee to a company to take on
(1) Car, life, fire, etc.
(2) Insurance doesn’t reduce risk; it just reallocates it more
b) Two problems:
(1) Adverse Selection: Someone at risk is more likely to buy
Example: Health insurance is about $300/month on
average (Kaiser Family Foundation, 2004)
(2) Moral Hazard: Once you are insured, you are more likely
to take a risk.
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a) Diversification is the reduction of risk achieved by replacing one
big risk with lots of smaller, uncorrelated risks. \
Ex: Earthquake insurance sold solely in San Francisco, vs
“Don’t put all your eggs in one basket.”
b) Asymptotic decline of risk as a stock portfolio is diversified:
10 stocks are about half as risky as one.
Adding another 10 stocks reduces risk another 13%.
Additional diversification doesn’t reduce risk much.
c) Diversification reduces exposure to idiosyncratic risk (i.e., risks
that affect only one company) – not aggregate risk.
4. Tradeoff between Risk and Return
Taking on higher aggregate risk (i.e., taking money out of
Treasury bills and putting it into the stock market) increases your
C. Asset Valuation
1. The Value of an Asset (Stock or Bond) is the discounted present
value of all future cash flows from it.
2. Fundamental Analysis: Compare the Value of a company to the
Price of its stock.
a) Get Price from the Internet.
b) Accounting statements and future prospects indicate Value:
(1) Dividend history
(2) Price/Earnings and Earnings Growth Rates
(3) Business management and prospects: Competition,
customer loyalty, debt level, etc.
Value Funds base their buying and selling largely on
Morningstar is an independent company that does fundamental
3. Technical Analysis: Study the recent pattern of prices and
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Growth Funds base their buying and selling largely on technical
4. Efficient Markets Hypothesis
a) Efficient Markets Hypothesis: Asset prices reflect all publicly
available information about the value of an asset.
(1) Thousands of professionals are constantly doing
fundamental analysis and buying and selling stocks.
(2) At the market price, buying pressure (i.e., belief the stock
is undervalued) just equals selling pressure (i.e., belief the
stock is overvalued)
What happens to a stock’s price if the pros find out
that its profits will rise 10%?
c) The price is informationally efficient – i.e., it reflects all
information in a rational way.
d) Stock prices will therefore follow a random walk: Future
changes will be impossible to predict.
e) Index funds beat 80% of managed funds 1992-2002
5. Market Irrationality See this article for a nice summary of reasons to
doubt the Efficient Markets Hypothesis.
a) Keynes: Stock markets are driven by “animal spirits.”
b) Warren Buffett: "I'd be a bum in the street with a tin cup if the
markets were efficient."
c) Bubbles: Tulips, Internet, etc.
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X. Unemployment and its Natural Rate
A. But First, Check Landmarks:
1. Chapter 10 is the Last of Four Chapters on the Real Economy
Chapter 7: K and L: Key ingredients of Income & Growth
Chapter 8: K: How Savings and Investment affect output.
Chapter 9: K: Tools for Savers and Investors
Chapter 10: L: Labor Market and Unemployment
Coming Up After Chapter 10:
a) Chapters 11 - 12: Money, Banking, and Inflation
b) Chapters 13-14: Trade and Foreign Exchange
c) Chapters 15-17: Models of the Business Cycle
Is both a Personal & Societal Problem
Impact on Standard of Living
Multidimensional: Geographical, Long Run, Short Run
B. Measuring Unemployment
1. Current Population Survey (CPS): Bureau of Labor Statistics
(Dept of Labor) monthly survey of 60k households:
West Virginia Stats: http://www.wvbep.org/bep/empstats.shtm
Questions about CPS Methodology:
a) Unemployment Rate = x 100 ( 5.6% in Jan04)
(1) Labor Force = Unemployed + Employed ( 150 million)
(2) Numerical Example
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b) Labor Force Participation Rate = x 100
approximately 66% overall in US.
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3. Everyone Falls into One of These Categories:
a) LABOR FORCE (civilian) composed of Subcategories:
(1) EMPLOYED: Spent some time in the previous week in a
(2) UNEMPLOYED: On temporary layoff or looking for a job.
b) NOT IN THE LABOR FORCE: Not employed, and not looking, eg
full-time students, homemakers, discouraged workers. “Not ILF”
MARGINALLY ATTACHED WORKERS (about 1/5 the size of
unemployed) who currently are not working or looking for
work, but have looked recently and would like to work
Includes DISCOURAGED WORKERS (1/5 OF MAW’S)
who would like to work, but have given up looking)
Others cite problems with child care or
Others who are not in the labor force (retirees, fulltime
students, children, military, disabled, institutionalized, etc)
c) Examples: In which category is each of these people?
(1) Steve worked forty hours last week at the Discount Den.
(2) Last week, Elizabeth worked 10 hours at Black Bear and took a class at WVU. She would prefer a full -time job.
(3) Roger lost his job at Weirton Steel. Since then he has been try ing to f ind a job at other local
(4) Cindy is president of Coopers Rock Foundation, a f ull time job that she does as a v olunteer,
without pay .
(5) Linda has a new baby . Last week she neither held a job nor looked f or a job.
(6) Linda’s f ather cannot work because he hurt his back y ears ago in the mines.
(7) Scott has a Ph.D. He worked f ull-time deliv ering pizzas last week. He has applied f or jobs with
three companies and f iv e univ ersities. As soon as he gets an of f er, he’ll quit his current job.
(8) Mary -Helen has been out of work f or a f ull y ear. She would take a job if it was of f ered, but no
local companies are hiring. She is not activ ely searching f or work.
4. Participation and Unemployment Rates vary systematically by age
Blacks have higher unemployment rates than Whites.
White and Black Males similar in participation rates
Black Females: higher participation rates than WFs
Youth: Lower participation, higher unemployment
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Overall, in the last 30 years participation rates have risen among
women & teens, & dropped among 55+ year olds.
5. Unemployment Patterns Through Time
a) Natural Rate of Unemployment: The rate around which the
unemployment rate fluctuates. (~ 5.5%?)
b) Cyclical Unemployment: The deviation of unemployment from its
Most unemployment spells are short (< 15 weeks)
40 – 50% of the unemployed are long-term unemployed.
C. Reasons for Unemployment
The Ideal Labor Market Would Always Clear . . .
1. . . . Or Would It? Frictional Unemployment (See this article)
a) Frictional Unemployment: Unemployment that is due to the time
that it takes for workers to find suitable new jobs
(1) Sectoral Shifts: Geographical, Types of Industry
(a) Moving Costs
(b) Retraining Costs
(a) New hires found unsuitable to employers.
(b) New jobs found unsuitable to new hires.
(3) Information flows are imperfect
(a) Jobs finding workers and vice versa
(b) Quality uncertainty by both hirer and hiree
c) Government Policy
(1) Increase Information flow: Employment Bureaus
(2) Reduce Retraining Costs: Community Colleges, Vo-Tech
(3) Unemployment Insurance:
Cushions unemployment for a limited time (typically
half your old salary for half a year)
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Only applies if you were involuntarily dismissed;
about half of unemployed.
Makes it easier to find “the best” job available
Reduces incentive to find a new job.
2. Labor Markets that Don’t Clear: Structural Unemployment
a) Structural Unemployment is due to there not being jobs for
everyone who wants one (QSLabor > QDLabor).
(1) Sectoral Shifts Again. Cease to be a purely frictional
problem if transition costs are prohibitive:
(a) Specialized skills
(b) Time to payback for human capital investment
(c) Moving costs
Bigger problem for older workers
(2) Sticky Wages
(a) Minimum Wage Laws:
(i) Raise income for low-wage workers
(ii) Raise unemployment rates for low-wage
(iii)Greatest impact is on least educated,
minorities, and youth.
(b) Unions and Collective Bargaining
(i) Unions are worker associations that bargain
with firms over wages & working conditions
(ii) Prevalence of Unions:
16% of current (2001) US workforce
about 30% of US workforce 50 years ago,
% is much higher in many European countries.
Biggest unions are now in services
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(iii) Union wages are 10% to 20% higher than
(iv) Higher wages may, and often do, result in lower
employment, especially in the long run.
(v) Effect of unions on unemployment depends on
the market power & size of employers.
(3) Efficiency Wage Theory: Employers may maintain wages
above short-run equilibrium in order to:
(a) Keep workers healthier
Mankiw Claims this is irrelevant to US labor
(b) Reduce turnover & associated costs
(i) Search, Hiring, & Training Costs
(ii) Loss of experience
(iii) Most Desirable Workers Self-Select & Leave
(c) Increase worker effort
(ii) Workers fear unemployment (pool of
unemployed creates a threat)
Marx: “Reserve army of the unemployed”
(d) Improve worker quality
(i) Higher offer wages increase the quality of the
(ii) Final choice is random, but with an improved
chance of getting a superior worker
Example: Bill has a reservation wage of $10; Ted
has a reservation wage of $2.
According to this report on Labor Market Recovery (St Louis Fed):
Jobless recovery is due to increased productivity and slow growth in
demand for goods & services, not foreign competition
Greenspan’s Omaha Speech:
“The loss of jobs over the past three years is attributable largely to rapid declines in the demand
for industrial goods and to outsized gains in productivity that have caused effective supply to
outstrip demand. Protectionism will do little to create jobs; and if foreigners retaliate, we will
surely lose jobs. We need instead to discover the means to enhance the skills of our workforce
and to further open markets here and abroad to allow our workers to compete effectively in the
Related Washington Post Editorial
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XI. The Monetary System
1. Think about money in a new way
2. Learn about the Fed
A. The Meaning of Money
Money allows trade to be roundabout, and therefore more efficient.
1. The Functions of Money
a) Medium of Exchange: Buyers give it to sellers to purchase
goods and services
b) Unit of Account: Yardstick for debts and posting prices.
Recall Comparative Advantage tables – what is so hard
c) Store of Value: An item that can be used to transfer purchasing
power from the past to the future.
2. The LIQUIDITY of an object is how easy it is to convert it to money.
Money is the most liquid object
Less liquid items may be a better store of value.
3. The Kinds of Money
a) Commodity Money has intrinsic value.
Silver Certificates, cigarettes, salt, Jolly Ranchers.
Yap: Stone wheels and beer.
b) Fiat Money: Valuable because the government says it is (and
4. Money in the US Economy
a) M1 = $1.35Trillion. Includes:
(1) Currency (~$700B)
(2) “Demand Deposits”
(Checking Account Balances) (~$650B)
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b) M2 = $6.5 Trillion. Includes:
(1) M1 Plus:
(2) Savings Deposits (~$3.5T)
(3) Money Market Mutual Funds (~$700B)
(4) Some other minor items
c) M3, MZM (money of zero maturity- part of M3).
d) What about credit card allowable balances?
Point: Money includes a lot of things besides cash.
B. The Federal Reserve System
The Fed: Central Bank of the United States
a) Founded in 1914, Federal Reserve Act of 1913
(1) Created by Congress, but independent
(2) Income from fees of member banks, and from government
(3) Non-Profit; Excess earnings ($24.5B in 2002) go to
b) Seven on the Board of Govenors including Chairman Alan
Greenspan (Reagan Appointee)
14 year, staggered terms
c) Twelve Regional Banks
d) Two Main Functions (also does research):
(1) Regulate Banks, Maintain their Stability
(b) Clear Checks
(c) Lend money to banks
(2) Monetary Policy
(a) Regulate the Money Supply
(b) Money Supply
2. The Federal Open Market Comittee
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(1) Board of Governors
(2) NY Fed President
(3) 4 other Fed Regional Bank Presidents on a rotating basis
b) Function: Control the Supply of Money
(1) Open-Market Operations: Sale and purchase of govt
(a) Sale of Bonds Decreases the Money Supply
(b) Purchase of Bonds Increases the Money Supply
(a) Inflation is the result of too much money
(b) Short-Run Tradeoff Between Inflation &
C. Banks and the Money Supply
1. Recall: “Demand Deposits” (checking accounts) are part of the
2. Banks Create No Money if They Hold 100 Percent Reserves
a) Reserves: Deposits held by the bank, not lent out.
Reserves = Required Reserves + Excess Reserves
b) Reserve Ratio:
c) Assets and Liabilities
Mr. Jones deposits $100 in
Stop’n’Rob National Bank: 100% Reserves
Reserves $100.00 Deposits $100.00
3. Fractional Reserve Banking
a) Banks hold only a fraction of their demand deposits as reserves
Part a: Make a loan to Ms. Smith
Stop’n’Rob National Bank: 10% Reserves
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Reserves $ 10.00 Deposits $100.00
Part 2: Ms Smith Opens a Checking Account
Stop’n’Rob National Bank: 10% Reserves
Reserves $100.00 Deposits $190.00
c) Banks Create Money
In the real economy, Ms Smith may be at a different bank,
but the result is the same for M1.
Create money, not wealth (note: liabilities increase at the
same time assets do - for both the bank and the
4. The Money Multiplier
a) Recycling Money
b) The Money Multiplier is the amount of money the banking system
generates with each dollar of reserves (ratio of deposits to
c) Money Multiplier = 1/R =
5. The Fed’s Tools:
a) Open Market Operations:
(1) To the extent the proceeds from Fed purchases are
deposited, they increase the money supply by an amount
determined by the money multiplier.
(2) Most used, easiest
b) Reserve Requirement
(1) Defn: Regulation prescribing the minimum amount of
reserves that must be held for each dollar of deposits
(2) Bank Runs
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(3) Reserve Requirement should affect the money multiplier
c) The Discount Rate
(1) Defn: The interest rate the Fed charges on loans it makes
Through the “discount window.”
Discount window is also used to help troubled banks
(2) Lower discount rate means more reserves, means more
(3) This affects the Federal Funds Rate - the interest rate at
which banks lend at the Federal Reserve to other banks.
Federal Funds Rate
6. Problems in Controlling the Money Supply
a) Fed can’t control the amount households deposit in banks
b) Fed can’t control the amount banks choose to lend
Reserve Requirement is just a minimum
Fed can cope with these problems if it’s vigilant.
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XII. Money Growth and Inflation
Inflation is a rise in the overall level of prices. Deflation is also
possible, but it hasn’t happened recently.
This chapter looks at the causes and costs of inflation.
A. Money Supply and Demand
1. The Level of Prices and the Value of Money
a) Inflation concerns the value of money, not the value of goods and
b) If the price of a basket of goods rises,
the price of a basket of money falls:
Value of Money Value of Reese’s Cup
4 Reese cups per Dollar (1/4) Dollar per Reese Cup.
2 Reese cups per Dollar (1/2) Dollar per Reese Cup.
c) Value of Money = 1/P
2. Money Supply, Money Demand, and Monetary Equilibrium
a) Money Supply: Controlled by the Fed.
b) Money Demand:
Peoples’ desire to hold wealth as liquid assets (money):
(1) Convenience of obtaining more money
(2) Interest Rates, but
(3) Price Level is the KEY variable. (Measured by CPI.)
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3. The Effects of a Monetary Injection
a) The Fed Buys Some Bonds From the Public
b) Four Questions:
(1) Which curve shifts?
(2) Which way?
(3) What is the effect on the value of money?
(4) What is the effect on the Price Level?
4. How Does the Economy Move to the New Equilibrium?
a) Fed injects money
b) Public has too much money, tries to get rid of it by:
(2) Lending (bonds, savings accounts)
c) Both actions D for goods & services, which prices.
But adding money does nothing to increase the amount of
goods & services available.
d) As Price level rises, QD of money increases
B. The Classical Theory of Inflation
1. The “Classical Dichotomy” and Monetary Neutrality
a) Two types of Economic Variables (David Hume):
(1) Nominal Variables: Measured in money
(2) Real Variables: Measured in physical units
b) Absolute prices are Nominal variables;
Relative prices are Real variables because they show how one
good can be traded for another.
c) Monetary Neutrality: Changes in money supply do not
significantly affect real variables.
Money is a yardstick; affects measurements, not reality.
This is probably true only in the LONG RUN.
2. Velocity and the Quantity Equation
a) The VELOCITY OF MONEY is the rate at which money changes
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Nominal GDP P x Y
Money Supply M
b) The QUANTITY EQUATION relates the money supply, the velocity of
money, the price level, and real GDP:
M xV =P xY
Matters because V is relatively stable, and Y is not affected by
changes in P.
c) Five Steps to the Quantity Theory of Money:
(1) V is stable over time.
(2) So if the fed raises M by 5%, P x Y must also rise by 5%
(3) Y (Real GDP) is determined primarily by factor supplies
and technology. Money neutrality implies no effect of M on
(4) Therefore any changes in nominal GDP (P x Y) caused by
a change in M must come from changes in P.
(5) Therefore whoever controls the money supply can control
inflation. (5% M) (5% P)
Milton Friedman: “Inflation is always and everywhere a monetary
In Dollars and Deficits, Friedman notes that after the Russian
revolution, the Bolsheviks introduced a new currency. They
printed huge amounts of it and it became almost worthless. At
the same time some of the older Czarist currency still circulated
and maintained its value in goods. It appreciated enormously in
terms of the new money. Why? This money was not redeemable.
Nobody expected the Czarist government to return. Why did this
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currency hold up? "Because," says Friedman, "there was
nobody to print any more of it."
If the Fed tries to achieve zero inflation, should M be held unchanged?
Example: Suppose M = $500B, PxY = $10Trillion, Y = $5T
P = __________
V = __________
If Y rises by 5% , and M is unchanged, what happens to nominal GDP? _______________ How much should M grow to keep P constant? ______
How might you increase V?
3. The Fisher Effect: A 1% rise in the inflation rate will cause a 1%
rise in the nominal interest rate.
a) Fluctuations in the nominal interest rate are caused mostly by
changes in inflationary expectation
b) The real rate of interest is determined by real factors, including
the time preferences of the public (SLF) and the return on real
c) Fischer Equation:
Nominal Interest Rate
= Real Interest Rate + Expected Inflation Rate
Measuring the Real Interest Rate (approximately):
Real Interest Rate = Nominal Interest Rate Inflation Rate
4. The Inflation Tax
a) Governments sometimes print money to pay bills
b) This is a hidden “tax” on anyone who holds money.
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C. The Costs of Inflation
1. Note: Inflation, by itself, Does Not Affect the Purchasing Power of
Wages and other earnings
a) Wages rise along with inflation, because labor is a service (and
inflation raises prices of all goods & services).
Inflation changes absolute prices, not relative prices.
b) Many people believe the “inflation fallacy” that inflation reduces
the value of their wages, in and of itself.
c) Note that it is not a fallacy to anyone whose nominal income is
not affected by inflation (either through the market or by
American Revolution, then the Confederacy
Weimar Republic of Germany (1919-23)
Recently, Argentina (1980’s), Yugoslavia (1991-94)
In 1991, the dinar was revaluated at 10,000 to 1.
In 1992, the dinar was revaluated at 10 to 1.
In 1993, the dinar was revaluated at 1,000,000 to 1.
In 1994, the dinar was revaluated at 1,000,000,000 to 1.
3. True Costs of Moderate Inflation:
a) Shoeleather Costs: Resources wasted when people reduce
money holdings due to inflation
(1) Inflation causes people to hold less money, due to the
(2) Therefore people subject to inflation change their money to
and from another store of value more often.
b) Menu Costs: The cost of having to alter prices more often due
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c) Inflation may not be uniform (some prices are stickier than
others), which can cause Relative-Price Variability and
consequent Misallocation of Resources
d) Inflation-Induced Tax Distortions
(1) Tax “Bracket Creep” Raises Taxes (this is largely fixed by
(2) Taxing Illusory Income Reduces the Incentive to Save:
(a) Capital Gains
(b) Nominal Interest Income
This problem isn’t addressed in the tax code.
e) Confusion and Inconvenience
f) Unexpected Inflation Redistributes Wealth from Creditors to
Wizard of OZ
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XIII. Open-Economy Macro: Basic Concepts
A. The International Flows of Capital and Goods
Two Markets: Two Net Flows that BALANCE
1. Goods & Services Market (“Current Account”): Net Exports
a) Trade Flows
(1) Exports are goods produced here and sold abroad.
(2) Imports are goods produced abroad and sold here.
b) NET EXPORTS (NX) = Exports – Imports.
aka TRADE BALANCE,
(1) Trade Surplus: NX > 0, or Exports > Imports.
(2) Trade Deficit: NX < 0, or Exports < Imports.
(3) Balanced Trade: NX = 0, or Exports = Imports.
c) What affects the trade balance?
Prices here & abroad
incomes here & abroad
transportation costs, trade barriers & subsidies.
d) For the US, International Trade is:
(1) Increasingly Important as Percent of GDP
Exports = 5% in 1970, 10% in 2000, 12% in 2004.
Better Communications & Transportation;
Lighter goods, More Services in trade,
Lower Tariffs (GATT, NAFTA, WTO)
(2) Increasingly Unbalanced: Trade Deficits Higher
Imports 17% of GDP in 2004
2004 Trade Deficit ($617.7B) = 5.3% of GDP.
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1960- 1964- 1968- 1972- 1976- 1980- 1984- 1988- 1993- 1997- 2001-
03-25 05-03 06-11 07-20 08-28 10-06 11-14 12-23 01-31 03-11 04-19
Q: Where does Santa live?
2. Asset Market (“Capital Account”): Net Capital Outflow
a) Capital Flows are Purchases and Sales of Assets:
(1) Foreign Portfolio Investment: Purchases of FINANCIAL
assets by foreigners (stocks, bonds, currency, etc.)
(2) Foreign Direct Investment: Purchase – or creation – of
PHYSICAL assets by foreigners (factories, office buildings,
real estate, etc)
b) US NET C APITAL OUTFLOW = US purchases of Foreign Assets
minus Foreigners’ Purchase of US Assets
aka NET FOREIGN INVESTMENT
3. Accounting Identity: Net Exports = Net Capital Outflow
NX = NCO
or, in other words
Exports – Imports = Americans’ Foreign Inv. – Foreigners’ Inv. in US
Note this is an identity, so it is always true by definition.
a) Why? Every transaction is an exchange. Either it’s a:
(1) Good (export) exchanged for a good (import) or a
(2) Good (export or import) exchanged for an asset.
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(1) Ford sells a truck to Russians for rubles
NX because the truck goes overseas
NCO because Ford gets foreign assets (rubles)
Say Ford exchanges rubles for dollars at Russian bank.
This causes no change in NCO because:
Reduced Russian holdings of American assets ($)
Offsets the decrease in US holdings of rubles.
(2) Sony exports playstations to US, buys Columbia Pictures
with the dollars
4. Saving, Investment, and International Flows
a) Recall: Y is Income, and also is Production (GDP)
(1) Y = C + I + G + NX
Y – C – G = I + NX
(2) Saving (S) is income (Y) minus private consumption (C)
and government expenditures (G):
S = Y– C – G
S = I + NX
If NX = 0 (e.g., closed economy), then S = I.
b) Open Economy: Since NX = NCO,
S = I + NX,
which implies that
S = I + NCO
Savings are either invested domestically or abroad.
If Saving is smaller than Investment, a trade deficit results
c) Recall that part of Savings is the government budget surplus:
S = Private Saving + Government Saving
= (Y – C – T) + (T – G)
and therefore government deficits reduce saving.
Therefore trade deficits can result from either too much
investment, or too little saving (perhaps caused by a
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Recall that the government ran large deficits in the late
1980’s, which turned to surpluses in the mid 1990’s
Mankiw says trade deficits of the 1980’s were driven by high
budget deficits while trade deficits of the 1990’s were driven by
high investment. (Grasshopper vs Ant)
When we were not saving enough, we got foreigners to
contribute to our investment.
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One effect is that over 40% of the national debt is now held
B. International Prices: Real and Nominal Exchange Rates
1. The Nominal Exchange Rate is the price of one country’s currency,
expressed in units of another country’s currency.
Or, it is the rate at which you can exchange one currency for
Example: $1.33 / € is the same as €0.75 / $
2. Changes in the Nominal exchange rate:
a) A currency with a rising value (i.e., rising nominal exchange rate)
is said to appreciate.
The Euro appreciates if its exchange rate rises to $1.50
b) A currency with a declining nominal exchange rate is said to
The dollar depreciates if its exchange rate falls to €0.67
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3. The Real Exchange Rate is the rate at which the goods and
services in one country can be exchanged for goods and services in
So, if I buy $100 worth of wheat in the US, how many Euros can I
sell it for? Suppose that
US Price (P) of wheat is $10/bu
European price (P*) of wheat is €5/bu
Exchange rate (e) is €0.75 per dollar
You could buy 10 bu of wheat for $100,
You could buy €75 for $100 and use it to buy 15 bu of wheat
So the real exchange rate is 1.5 bu of European wheat per bu
of American wheat.
Real Exchange Rate of the Dollar = e P / P*
= .75 10/5 = 1.5
e is the dollar's nominal exchange rate,
P is the US price
P* is the price of the same good in the foreign country.
Normally, you calculate real exchange rates based on the price
P of a market basket, not a single commodity.
C. Purchasing Power Parity (PPP)
1. PPP theory says that a unit of a currency should be able to buy the
same amount of goods and services in any country.
So if PPP holds, in the wheat example, the $100 should be able
to buy the same amount of wheat in Europe or the US.
2. PPP Logic: Arbitrage
a) Arbitrage is the process of taking advantage of price
differences in different markets.
Buy €75 for $100
buy 15 bu of wheat in Europe for €75,
sell the wheat for $150 in the US, with which you
buy €112.50, with which you
buy 22.5 bu of wheat in Europe, which you
sell it for $225 in the US, with which you
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buy €168.75, with which you
buy 33.75 bu of wheat in Europe, which . . .
The above increases the supply of dollars to Europe,
which lowers the exchange rate, and the dollar will
depreciate until arbitrage is no longer profitable.
Alternatively, it increases the demand for wheat in Europe
(P*) and increases the supply of wheat in America (P)
until arbitrage is no longer profitable.
b) In general, the ability to arbitrage leads to the law of one price,
which is the same as PPP: The price of a standard good will be
the same, regardless of which market you purchase it in.
3. Implications of PPP Theory:
a) If PPP holds, the real exchange rate is always 1.
eP/P* = 1
b) If PPP holds, the nominal exchange rate reflects the different
price levels in the different countries.
e = P* / P
c) Inflation makes a country’s currency depreciate.
More on the Big Mac Index
4. Limitations of PPP Theory:
a) Many goods are not easily traded - e.g., Big Macs
b) Even easily traded goods may not be good substitutes
(American and German cars).
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XIV. A Macroeconomic Theory of the Open Economy
If PPP can’t explain real exchange rates, what does?
What kinds of policies can affect the trade deficit?
The model below takes both GDP and the price level as given.
A. Supply and Demand for Loanable Funds and Foreign Currency
1. The Market for Loanable Funds
a) Recall, in Chapter 8 Loanable Fund Supply and Demand
(1) Determined in the LF Market:
(a) Real Interest Rate (Price of LF)
(b) Savings and Investment (Quantity of LF)
(2) Supply and Demand in LF Market:
(a) Savings is Supply
Slopes Upward because a higher interest rate
causes a higher opportunity cost of today’s
(b) Investment is Demand
Slopes Downward because a higher interest
rate means fewer investments are worthwhile.
(3) How is Chapter 14 Different from Chapter 8?
(a) Chapter 8 Simplifications:
(i) One market only (LF).
(ii) Closed economy, so S = I.
(b) Chapter 14 Complications:
(i) LF Market Linked to the FX market.
(ii) Open Economy, so S = I + NCO
b) Implications of S = I + NCO
(1) Always true (by definition):
Saving = + Capital
A dollar saved is either invested at home, or invested
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If US domestic savings are less than Investment,
NCO will be negative (foreign inflows of capital will
pay for US investment)
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c) Open-Economy Market for Loanable Funds
Determines LF and Real Interest Rate
(1) Demand for LF is I plus NCO:
If US Real INTEREST RATES RISE . . .
I falls because fewer investments are worth it
NCO falls because domestic bonds pay more
. . . then Quantity Demanded of LF falls.
(2) Supply of LF is still domestic Savings
(3) At the EQUILIBRIUM INTEREST RATE, Savings supplied will
just equal the desired Investment plus desired NCO:
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2. The Foreign-Currency Exchange (FX) Market
NX = NCO
Foreign Exchange Market determines Real Exchange Rates (price
variable) and Dollars Exchanged for Foreign Currency (quantity
a) NX is Demand for Dollars in Exchange for Foreign Currency
Dollars demanded to pay for US exports.
Slopes Downward because an increase in Real Exchange
Rates makes US goods more expensive relative to
b) NCO is Supply of Dollars in Exchange for Foreign Currency:
Vertical because NCO is not affected by real exchange
rates; Instead, it is determined by the real interest rate in
the LF market.
c) Equilibrium occurs when the Real Exchange Rate is just high
enough to balance the demand for dollars from foreigners
buying US goods with the supply of dollars from Americans
buying foreign assets
If real exchange rate is too high, NCO > NX.
If real exchange rate is too low, NCO < NX.
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I am the US and you are France. I sell you my pen for a dollar.
Let's look at my NX and NCO:
Assume that there are no other sales or purchases of
goods and services, so NX = $1.
To get the dollar, you buy it with Euros.
US NX translates into (foreign) demand for dollars in
the FX market.
Why would Americans pay dollars for Euros if they don’t want
1) Americans want Euros for their own sake. (They like
the pictures on the Euro, or are planning to buy
German cars next year, or think they are likely to
2) US investors want to buy another French asset, say
the Eiffel Tower, now selling for €0.75. Now, $1 will
buy exactly the amount of Euros needed to buy the
Eiffel Tower, €0.75. So, US investors supply
dollars on the FX market to buy foreign capital
Euros and the Eiffel Tower are both French capital assets
In either case, the €.75 flows back to the US in payment for
my pencil, so the acquisition adds to US NCO
American NCO translates into dollar supply in the FX
e) Note: S&D in this FX market model are artificially defined:
Americans buying imports create “negative demand” for
dollars on the FX Market
Foreigners buying American assets create “negative
supply” of dollars
Key is that we’ve now defined a D FX that slopes downward, and
a SFX that is vertical, when the current real exchange rate is the
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B. Equilibrium in the Open Economy
1. Net Capital Outflow Links the LF and FX Markets
Recall the TWO MARKETS:
LF: S = I + NCO in equilibrium
FX: NCO = NX in equilibrium
Note that NCO IS IN BOTH MARKETS:
LF: NCO is part of Demand (I + NCO)
The domestic real interest rate is the opportunity cost of
investing in foreign assets.
FX: NCO is Supply
To buy foreign assets investors must exchange dollars for
the foreign currency.
NCO Depends on the US Real Interest Rate
Higher US interest rates make US assets more attractive
relative to foreign assets.
2. Slopes of Curves:
(1) Demand slopes down because: investors compare interest rates on borrowed funds to returns available on
(2) Supply slopes up because: Interest rates are the opportunity cost of consuming today rather than later.
(1) Demand (NX) slopes down because: Depreciation makes exports cheaper and impor ts more
(2) Supply (NCO) is vertical because: You can always buy a smaller number of foreign
asset shares if your currency depreciates; all that matters is the return on the dollar invested, not the number of shares yo u
get for the dollar.
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3. Simultaneous Equilibrium in Two Markets
C. How Policies and Events Affect an Open Economy
Which curve shifts? Which way? How are P & Q affected?
1. Government Budget Deficits
a) Negative Public Savings mean lower Savings
(Lower Supply in the LF market)
Causes higher real interest rates r (P), lower investment
and savings LF (Q)
b) Higher real interest rate r means lower NCO
c) Lower NCO means Lower Supply in the FX Market
Causes a higher real exchange rate (P) from 1 to 2,
fewer dollars exchanged (Q).
Creates a trade deficit.
2. Trade Policy and Protectionism
a) Tariffs and Quotas increase the demand for dollars in the FX
market (because they reduce the demand for yen)
This increases the exchange rate from 1 to 2.
b) Tariffes & Quotas don’t change the NCO, so they can’t change
NX (effect is “microeconomic” i.e., it causes increased imports
of something else due to stronger dollar).
So no change in the LF market.
3. Capital Flight
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a) Outward shift in NCO due to political instability, or loss of
confidence for another reason
b) Increase in Demand for LF
Causes interest rate r.
c) Increase in Supply in FX market
Causes exchange rate
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XV. Short Run Economic Fluctuations
We have looked at determinants of prosperity in the long run:
Productivity, Investment, Trade.
We have looked at the determinant of absolute prices in the long run:
Heading into murky waters: THE BUSINESS CYCLE.
PPP, Classical Dichotomy don’t hold in the short run. What does?
Quarterly Real GDP Change (Annual Rate)
A. Three Key Facts about Economic Fluctuations
1. Economic Fluctuations are Irregular and Unpredictable
Keeps Presidential politics random.
2. Most Macroeconomic Variables Fluctuate Together.
Growth rate of Real GDP is generally used to determine if we're
in a recession, and as a thermometer of the economy.
GDP, Personal Income, Profits, Consumer Spending,
Investment Spending, Industrial Production, Retail Sales, home
sales, auto sales, stock indexes, etc.
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Some “lead”, some “lag”, some (Investment in particular) are
more volatile than others.
3. As Output Falls, Unemployment Rises
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B. Explaining Short Run Economic Fluctuations
1. How the Short Run Differs from the Long Run
a) Long Run: Classical Theory Reigns.
(1) Classical Dicohotomy: Nominal variables, Real Variables
(2) Monetary Neutrality: Money affects nominal variables, but
not real variables.
b) Short Run: Aggregate Demand and Aggregate Supply Reign
(1) Nominal and real variables are intertwined.
(2) Money can affect output.
2. The Basic Model of Economic Fluctuations
a) Two variables of interest:
(1) Price Level (CPI)
(2) Output (GDP).
b) Aggregate Demand Curve shows the relationship between the
price level and the quantity of goods and services desired by
households, firms, and government.
c) Aggregate Supply Curve shows the relationship between the
price level and the quantity of goods and services that firms
choose to produce and sell.
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C. The Aggregate Demand Curve
1. Why the AD Curve Slopes Downward
Y = C + I + G + NX
Each type of spending contributes to AD.
b) C, I, and NX All Increase when the Price Level Falls:
(1) Consumption: The Wealth Effect
Consumers hold money, which becomes more
valuable as P falls, which makes them wealthier, and
hence more willing to spend on Consumption.
(2) Investment: The Interest-Rate Effect
As P falls, households need less money, so they try
to lend it, which makes interest rates fall.
As interest rates fall, Investment spending rises.
(3) Net Exports: The Exchange-Rate Effect
As US interest rates fall (due to lower P, explained
above), US NCO rises, increasing the supply of
dollars on FX markets.
Exchange rate falls, NX rises.
All this is ceteris paribus (in particular, M is fixed).
2. Shifting the AD Curve
a) AD Shifts Due to Consumption Shifts
(1) Decrease in desire to Save causes increase in C.
(2) Tax Cuts will increase C.
b) AD Shifts Due to Investment Shifts
(1) Improved technology for investment goods
(2) Changes in optimism, pessimism about the future
(3) Tax breaks (Investment Tax Credit)
(4) Changes in Money Supply that affect the interest rate.
c) AD Shifts Due to Government Spending Changes
(2) Capital projects (roads, canals, etc)
(3) Social Programs, Education
d) AD Shifts Due to Changes in Net Exports
(1) Foreign countries’ recessions, booms.
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(2) Changes in exchange rates due to central bank actions
D. The Aggregate Supply Curve
1. Aggregate Supply is Vertical in the Long Run
a) Depends on Labor, Capital, Natural Resources, Technology
b) In the long run, Classical Dichotomy & Money Neutrality say
AGGREGATE PRICE does NOT affect REAL GDP.
c) The GDP at which AS is vertical is Full-Employment Output,
corresponding to the Natural Rate of Unemployment
2. Shifting the Aggregate Supply Curve in the Long Run
a) AS Shifts Due to Labor Shifts
(1) Immigration, emigration, plagues
(2) Changes in Natural Rate of Unemployment:
Increases in minimum wage
Increases in unionization
Unemployment insurance changes
b) AS Shifts due to Capital Shifts
(1) Increases in capital stock (investment)
(2) Destruction of capital stock (war, disaster)
(3) Improvements in human capital (education)
c) AS Shifts Due to Natural Resource Shifts
(1) Discovery of new resources,
(2) Changes in imported resources (oil) availability & price
d) AS Shifts Due to Technology Shifts
(1) Improvements in resource extraction, utilization, or
(2) Computers and other technological labor-enhancing
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3. Long Run Growth and Inflation using AD and AS
4. Why AS Slopes Upward in the SHORT RUN: Misperceptions about
a) The Sticky-Wage Theory
(1) If all prices rise faster than wages, (perhaps due to long-
term labor contracts), then
(2) Labor becomes cheaper.
(3) When Labor becomes cheaper, output increases.
b) The Sticky-Price Theory
(1) Some sellers don’t mark their own prices up when the
aggregate price rises (perhaps due to "menu costs")
(2) The real (relative) prices of these laggards fall.
(3) Lower-than-intended prices stimulate sales, which causes
more hiring, more production
c) The Misperceptions Theory
(1) Sellers mistake aggregate price increases for relative
price increases of their own goods,
(2) So they increase output.
Natural Actual Expected
QS = Qt
t + a(Pt Pt )
where a is some positive number, and
Pt is the year t price level that was predicted in
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Clearly, QS will rise when Pt
Hence, the AS curve slopes upward in the short run.
5. AS Shifters in the SHORT R UN
a) Anything that shifts the AS curve in the Long Run
b) An Increase in Expected Future Aggregate Prices shifts AS
Leftward, as it will tend to cause wages to be higher today.
Note that the whole reason that AS is different in the SR
and LR is that someone is not taking full account of
Therefore, as inflationary expectations change, the
economy moves back to LR AS (natural rate of U)
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E. Two Causes of Economic Fluctuations
1. A Shift in Aggregate Demand
In the Short Run, a decrease in the price level due to a shift
in AD reduces output (because short run AS slopes
In the Long Run, a decrease in AD will affect only the price
level, not output (because long-run AS is vertical: Classical
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a) Example: Great Depression & World War II
(1) Great Depression Facts:
(a) Real GDP Fell 33% 1929-1933
(b) Unemployment rose from 3% to 25%
(c) Prices fell 22%.
(d) Similar Effects Worldwide
(2) Why? AD Shift
(a) Money Supply declined 28% due to bank panics,
runs, closures, and lack of Fed response
(b) Stock prices fell 90%, reducing wealth and C.
(c) Investment declined due to financial problems and
(d) Increased protectionism (Smoot-Hawley)
(3) Remedy: Increased G due to New Deal and WWII
New Deal spending and government job creation did
Massive WWII spending and morale boost ended the
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b) Example: Recession of 2001
(a) GDP never fell in any single year
(b) Unemployment 3.9% October 2000, 4.9% August
2001, 6% April 2002
(2) Three shocks to AD:
(a) End of dot-com bubble
(b) September 11
(c) Corporate Accounting Scandals (Enron, Worldcom)
(3) Policy: Stimulate AD with tax cuts, interest rate cuts
2. A Shift in AS
a) Intended Supply-Side effect of tax cuts
b) Stagflation of the 1970’s
Stagflation is a combination of recession (stagnation) and
Long Run AS fell due to increase in oil prices
c) Effect of Oil Shocks, and accommodation
Accommodation occurs when policymakers stimulate AD
to offset falls in AS
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XVI. Monetary Policy, Fiscal Policy, and Aggregate Demand
Monetary Policy: Rate of Growth of the Money Supply
Fiscal Policy: Government Spending and Taxes
A. How Monetary Policy Influences Aggregate Demand
Recall why the AD Curve has a Negative Slope. If Aggregate Prices
Wealth Effect: P reduced value of wealth held as money,
Interest-Rate Effect: PM needed for transactions r
Exchange-Rate Effect: Pr NCO SFX
The Interest-Rate Effect is the most important for the US.
1. The Theory of Liquidity Preference (Keynes):
The interest rate adjusts to make Money Supply and Money Demand
(Real vs nominal r doesn’t matter for present purposes. Assume
inflation is constant.)
a) Money Supply: From the Fed manipulating banks’ reserves.
b) Money Demand
(1) Liquidity is the ease with which an asset is converted into
(2) Money is useful as a medium of exchange, so people want
to hold some for transactions.
(3) The INTEREST RATE is the opportunity cost of holding
(4) Therefore, the higher the interest rate, the lower the
quantity demanded of money.
c) Equilibrium in the Money Market: Interest rate at which the
Quantity Supplied of money equals the Quantity Demanded of
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Recall the relationship between bond price and interest
(1) Consider if the interest rate is above equilibrium
(2) Consider if the interest rate is below equilibrium
Note that the interest rate is determined in the LF Market
in the Long Run, but Liquidity Preference (money market
effects) drives short-run changes – before price
expectations can adjust.
2. The Aggregate Demand Curve Slopes Downward:
Revisiting the Interest Rate Effect
a) P Money Demand (MD shifts outward),
b) MD Interest Rate r
c) r I GDP demanded.
Note: This is a movement along the AD curve (not a shift of the
curve because it is caused by a change in P.
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3. Changes in the Money Supply will SHIFT the AD Curve:
a) MS r
b) r I AD (a shift in AD)
4. The Role of Interest-Rate Targets in Fed Policy
a) M is hard to measure exactly, but r can be measured.
b) Fed targets the Federal Funds Rate (which is what banks lend
5. The Fed reacts to Stock Market “Exuberance” or Despondence
Keynes called it “animal spirits”
Current Fed Policy
B. How Fiscal Policy Influences Aggregate Demand
1. Say G increases by $80B
a) Multiplier Effect: Increase in G will be magnified because it has
expansionary effects on C and I as well.
GDP may increase by more than $80B
b) Crowding Out: Increase in G will increase the deficit
GDP may increase by less than $80B
2. The Multiplier Effect
a) A Formula for the Spending Multiplier
(1) An additional dollar of G is income to whoever gets it, who
spends part of it, which makes that part income to
someone else, and so on.
Whatever isn’t spent in each round is saved.
(2) The Marginal Propensity to Consume (MPC) is the
amount of an additional dollar of income that a person will
spend on consumption.
"The fundamental psychological law upon which we are entitled to depend with great
confidence, both a priori from our knowledge of human nature and from the detailed
facts of experience, is that men are disposed, as a rule and on average, to increase
their consumption as their income increases, but not by as much as the increase in
their income. (That is: dPCE/dDPI is positive and less than one)." – JM Keynes,
General Theory of Employment, Interest, and Money, 1936
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(3) The Government Expenditure Multiplier is
Multiplier = 1/(1 MPC)
(4) Example: Say a typical person will spend 80 cents of an
additional dollar of income. Then MPC = .8 and the
multiplier is 5.
In this case, the Multiplier Effect of $80B of increased
G is 5 x 80B = $400B
b) The multiplier also applies to autonomous increases in:
C (due to a tax cut perhaps),
NX (due to lowering trade barriers perhaps)
I (due perhaps to increased optimism)
c) The multiplier also works for autonomous decreases.
3. Crowding Out
a) Increase in G increases MD, which raises r, which lowers I.
b) This counteracts the multiplier effect to some extent.
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4. Changes in Taxes
a) Tax rate changes increase C, and sets off both multiplier and
crowding out effects.
b) Permanent tax cuts are more stimulative than temporary ones,
since they increase income permanently
GHW Bush’s 1992 reduction of withholding was
completely ineffective, because it didn’t reduce taxes at all.
C. Using Policy to Stabilize the Economy
1. The Case FOR Active Stabilization Policy
a) Government has tools to control short-run changes in
b) Business cycles lows are lower than necessary, and highs are
higher than necessary, due to “animal spirits.”
c) Why not do something about it?
2. The Case AGAINST Active Stabilization Policy
a) Fiscal policy is driven by politics, not data analysis or economic
Bias toward higher spending, lower taxes.
Legislation takes time.
b) Lags in effects of monetary policy are both unknown and
Faulty steering wheel.
3. Automatic Stabilizers: Countercyclical “thermostats”
a) Income tax collections automatically rise and fall with income.
b) Welfare, unemployment insurance.
c) Argument against balanced budget amendment.
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XVII. The Tradeoff Between Inflation and Unemployment
A. The Phillips Curve
1. The Phillips Curve is a negatively sloped curve that expresses the
short-run tradeoff between Inflation and Unemployment
a) A.W. Phillips
(1) Phillips Career
(a) Kiwi, POW/Japan, Miner, Electrical Engineer, LSE
(b) Phillips Machine: Hydraulic model of the economy
(2) Phillips Curve is an Empirical relationship:
"The Relation Between Unemployment and the Rate
of Change of Money Wage Rates in the United
Kingdom, 1861-1957," Economica 1958.
Years with low unemployment have high inflation
rates, and vice versa.
b) Paul Samuelson, Robert Solow, American Economic Review,
"Analytical Aspects of Anti-Inflation Policy"
(1) Found a Phillips Curve relationship in the US.
(2) Suggested that Phillips Curve offered policymakers a
“menu” of inflation and unemployment rates.
3. Aggregate Demand, Aggregate Supply, and the Phillips Curve
a) Phillips Curve Corresponds to AD Shifts against a stable,
upward sloping AS Curve:
b) Example: Two Possible Outcomes at a Given Time
c) Implication: Government can use Monetary Policy and Fiscal
Policy to make the Menu Choice.
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B. Shifts in the Phillips Curve: The Role of Expectations
1. The Long Run Phillips Curve: The Classical Model Strikes Back
a) Milton Friedman, American Economic Review, 1968
“The Role of Monetary Policy.”
Edmund Phelps published supporting articles.
b) Recall the Classical Dichotomy & Monetary Neutrality
(1) Nominal and Real Variables
(2) Monetary policy can’t influence real variables.
(3) Unemployment is caused by job search, efficiency wages,
unions, other labor market frictions and constraints, which
are unaffected by monetary policy.
c) Long-Run Phillips Curve is Vertical
(1) Increase in M Increases Aggregate Demand
(2) Aggregate Supply is Vertical, so P rises but U is
(3) Unemployment quickly returns to the Natural Rate of
(4) A Vertical AS curve implies a Vertical Phillips Curve and
the following Policy Implications:
Policy should try to lower the Natural Rate.
Policy should not try to affect cyclical fluctuations.
Try to shift LR AS and reduce market frictions and
constraints, don’t try to shift AD.
2. Expectations and the Short-Run Phillips Curve
Friedman & Phelps appealed to theory; Samuelson, Solow
appealed to data. Which is more convincing?
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a) Friedman & Phelps said there might be a short-run tradeoff, but
it doesn’t hold in the long run
b) Short Run Phillips Curve Equation
(similar to the one we saw in Chapter 15):
Unemployment Natural Expected Actual
Rate Rate Inflation Inflation
where a is a positive constant.
(1) If actual inflation exceeds expected inflation,
unemployment will fall
Phillips curve has a negative slope, with respect to
(2) Once people adjust their expectations to actuality,
unemployment will rise again to the natural rate.
Adjustment in inflationary expectations (upward)
shifts the SR Phillips Curve (rightward).
(3) Notice, the net effect of the shift in expectations is that
inflation will have risen, and will stay high, unless:
(a) Policymakers restrict money supply to cut actual
(b) Which will cause higher short-run unemployment
(c) As expectations adjust in the long run unemployment
(4) Note: There is no natural rate of inflation – inflation
persists, and follows expectations.
3. The Natural Rate Hypothesis: Unemployment eventually returns
to its natural rate, regardless of the rate of inflation.
a) In 1968, Friedman and Phelps predicted that stimulation of the
economy would not work in the long run
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b) "Natural Experiment:"
Vietnam War, Great Society, rapid increase in M2 after 1968
c) See the breakdown – shift of the Phillips Curve by 1972.
d) This seemed to confirm Friedman & Phelps’ analysis
C. Shifts in the Phillips Curve: The Role of Supply Shocks
1. Oil Shock: 1973 Yom Kippur War, Arab Oil Embargo
RealOilPrice (WTI, 2005 Dollars)
2. A Supply Shock is an event that directly affects producers’ costs,
shifting the AS curve and hence the Phillips Curve
a) Result: Higher Inflation and Higher Unemployment
b) Policy Choice: Fight Inflation or Fight Unemployment?
c) US Result: Anti-Unemployment Policies confirmed price rises,
led to higher inflationary expectations.
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By 1980, Inflation was 9%, Unemployment was 7%, Jimmy
Carter was toast.
D. The Cost of Reducing Inflation
1. Fed Chairman Paul Volcker, 1979-1987,
a) Inflation was close to 10% in 1979
b) Volcker chose to fight inflation immediately after gaining office:
Tough talk, backed with political will
2. Conflicting Opinions about the “Sacrifice Ratio”:
a) Sacrifice Ratio is the percentage of annual GDP that must be
sacrificed for a 1% reduction in inflation
b) Some said it was about 5
c) A new theory suggested it was much lower.
3. Rational Expectations and the Possibility of Costless Disinflation
Lucas, Sargent, Barro, early 1980's.
a) Rational Expectations: The theory that people use all
information available – including information about government
policies – when forecasting the future.
People anticipate the money supply M will grow faster than
b) Firms strike "inflationary bargains" (esp. wage contracts) when
they anticipate future inflation
These inflationary bargains confirm, and therefore in
some sense cause, future inflation.
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c) Thus, Inflationary Expectations result from people thinking the
government is going to pursue an inflationary policy
The only way that changes in M can affect U is if someone
is confused or constrained.
The slope of the Phillips Curve results largely from
incorrect expectations about future inflation.
d) Thus, if the government makes it clear that it is going to reduce
the rate of growth of M:
(1) People will automatically lower their expectations of
(2) Inflation will fall without unemployment rising (much).
e) So the sacrifice ratio could be zero!
(1) There was a sacrifice in 1981-1983.
But it was less than expected.
(2) Volcker announced loudly that he was going to reduce the
rate of growth of money – but not everyone believed him.
Note points A, B, and C above.
Expectations adjusted with some lag.
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E. Current Events
1. Greenspan Era: 1987 – Present
a) 1986: Oil Prices Plummeted (positive AS Shock)
b) Generally, careful handling of the money supply
(1) Money policy induced a small recession in 1991-1992
(2) Inflation fell and stayed down, around 2%
(3) 2001: dot-com, stock market bubble, 9/11
Unemployment Rate Graph
c) Inflationary expectations are low
d) Favorable Supply Shocks:
(1) Oil Prices
(2) Maturation of baby boom
(3) More fluid labor markets
(4) Technological progress
(b) Computational advances
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2. The Future
a) Greenspan is 77 years old (2004)
c) Inflation may reawaken
(1) Oil Prices
(2) Monetary Policy:
Federal Funds Rate:
Inflation Adjusted Bond:
XVIII. Five Debates
A. Should Monetary Policy be Made by Rule or Discretion?
1. The Issue: The FOMC makes monetary policy. Some say it should
be forced to follow a fixed rule.
Often Proposed: Increase M by 3% per year (usual rate of
growth of Real GDP)
Why? MV = PY
Modifications possible to allow feedback from increases in U.
a) Discretion can give latitude for incompetence and abuse of
(1) Abuse of Power: The Political Business Cycle
(2) Incompetence: The Great Depression
b) Leads to More Inflation and Unemployment Than Desirable
(1) Temptation to exploit Phillips Curve tradeoff leads to
(2) Inconsistency between announced policy and actual policy
leads to greater fluctuations of Unemployment rate than
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“Time inconsistency of policy”
a) Current system allows flexibility.
b) Has served us well in recent years.
(1) Most people broadly approve of Fed’s job performance
(2) See injections at 9/11, and 1987 (22% drop)
c) Little evidence for political business cycle (see Jimmy Carter &
d) How do you design a rule that will endure?
B. Should the Government Balance its Budget?
a) Burden on future generations.
b) Crowding out will raise interest rates and lower investment
c) Current budget deficits are not like WWII deficits.
a) Problems caused by debt are overstated. (Debt service is small
relative to total income.)
b) Some government spending (e.g., education, roads) can
increase growth rates, and cutting it will be counterproductive.
c) To some extent, parents who leave money to their children may
offset the effects of increased government debt on them.
C. Should Government Policymakers Try to Stabilize the Economy?
D. Should the Central Bank Aim for Zero Inflation?
E. Should Tax Laws be Reformed to Encourage Saving?