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Principles of Microeconomics Econ 202 504


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									Econ 202: Macroeconomic Principles
            Lecture Notes: Stratford Douglas
                           Fall 2006

    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
                      MARKET ECONOMY
                      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,
                     such as:
                     (1) Health
                          (a) Life Expectancy
                          (b) Low infant mortality
                          (c) Environmental standards etc.
                     (2) How much stuff people have.
                     (3) Literacy & Learning
                     (4) Mobility
                  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,
                     NOT MONEY!

              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
                            services available
                     (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!
              (George Box)

              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
                      controlled way.

              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
                     making unit.
                  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
                     available resources.
                           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

                                           Paint         Wallpaper

                        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
                 tradeable goods.

                   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.

           C. Applications

              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

           B. Demand

                 QUANTITY DEMANDED: The amount of a good that buyers will actually
                  seek to buy in a given time period.

              1. Quantity Demanded Depends on:
                     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.
                            Ceteris Paribus
                       Note: A change in price causes a movement along the
                            demand curve.
                  b) INCOME (+,-)
                       (1)   Quantity demanded of normal goods increases when
                             income increases.
                       (2)   Quantity demanded of Inferior goods decreases when
                             income increases.
                  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 (+)
                        Future prices
                        Future incomes
                  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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           C. SUPPLY

                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:
                    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 (+)
                 d) EXPECTATIONS
                         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

                    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?

              5. Examples
                    Move one at a time.
                    Move both.
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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.
                 EXCLUDED are:
                  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)
                     Double Counting

              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

                                                               Nominal GDP
              2. Calculating Real GDP: Real GDP =                           x100.
                                                               GDP Deflator
                                        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.
                                 Quantity of
                 Price of                            Nominal           Real   GDP
Year                             Coffee
                 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
                                 Quantity of
                 Price of                            Nominal           Real   GDP
Year                             Sugar
                 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
                  c) Pollution
                  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.
                             Seasonally adjust
                  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.
                     For example:
                                     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
               Coffee       Consumed
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:
                                               CPI2003  CPI2002
                  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:

              4. Differences between GDP Deflator and CPI
                  a) Imports count in CPI but not GDP Deflator
                          Including Oil
                  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

              2. Indexation
                  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”
                           Political Instability
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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
                   (5) regulation.
                  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
                   Russia, 114.
                                                              Botswana’s ranking
                   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
                 (many landlocked)
                  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.)
                      Educational facilities
              c) Promoting Technological Progress
                      Agglomeration
                      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
                      future times.
                      (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)
                                     Except perpetuities.
                      (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
                 (c) Dividends
                 (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),
                      NASDAQ, FTSE
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           2. Financial Intermediaries: Between savers & investors.
               a) Banks
                   (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
                         (c) Managers:
                             (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
                         (a) Diversity
                         (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
                   d) Equilibrium:

               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
                      Interest Deduction
                   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
                             government borrowing.
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                        D. Conclusions: Should the Government Balance its Budget?
                           (Chapter 18)

                           1. Pros
                                  a) Burden on future generations.
                                  b) Crowding out will raise interest rates and lower investment
                                  c) Current budget deficits are not like WWII deficits.

                           2. Cons
                                  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.
                                     (Ricardian Equivalence)
                                                   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
                  future sum.

                   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.
                            Examples:
                             $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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              3. Diversification
                  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
                      expected returns.

           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
                      fundamental analysis
                     Morningstar is an independent company that does fundamental
                      analysis also.

              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.
               b) Rationale:
                  (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
                  BUT NOW:

               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:
                  Questions about CPS Methodology:

              2. Measures:
                  a) Unemployment Rate =                       x 100 ( 5.6% in Jan04)
                                                   Labor Force
                      (1)   Labor Force = Unemployed + Employed ( 150 million)
                      (2)   Numerical Example
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                                                        Labor Force
           b) Labor Force Participation Rate =                          x 100
                                                       Adult Population
              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
                        paid job.
                  (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
                             transportation, etc.
                       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
                        f actories.

                  (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
              and race.
                 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
                      natural rate.
                   c) Note:
                              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
                   b) Causes
                         (1)   Sectoral Shifts: Geographical, Types of Industry
                               (a) Moving Costs
                               (b) Retraining Costs
                         (2)   Churning:
                               (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).
              b) Causes:
                  (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
                                            nonunion wages.
                                    (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
                                   (i)   Morale
                                   (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
                                         applicant pool
                                    (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
global marketplace.”

Related Washington Post Editorial
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XI.        The Monetary System
              Objectives:
               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
                             about them?
                   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
                      everyone agrees).

               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

              1. Organization
                  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
                            bond interest
                      (3)   Non-Profit; Excess earnings ($24.5B in 2002) go to
                            federal government
                  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
                            (a) Monitor
                            (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
                  a) Composition
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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
                      (2)    Significance:
                             (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
                 money supply

              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
Assets                                           Liabilities
Reserves $100.00                                 Deposits $100.00

              3. Fractional Reserve Banking
                  a) Banks hold only a fraction of their demand deposits as reserves
                  b) Example
                      Part a: Make a loan to Ms. Smith
                          Stop’n’Rob National Bank: 10% Reserves
Assets                                           Liabilities
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Reserves $ 10.00                               Deposits $100.00
Loans       90.00

                    Part 2: Ms Smith Opens a Checking Account
                        Stop’n’Rob National Bank: 10% Reserves
Assets                                         Liabilities
Reserves $100.00                               Deposits $190.00
Loans       90.00

              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
                           (minimum R)
                    (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
                        to banks
                            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
                       Bank runs
              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:
                      (1)   Spending
                      (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
                         V=                =
                              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
                         investment (DLF).
                      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

              2. Hyperinflation
                           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
                            inflation tax
                      (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
                     to inflation.
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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?
                         Consumer tastes
                         Prices here & abroad
                         exchange rates
                         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.
                  b) Examples:
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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
                           government deficit)
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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
                            by foreigners.

           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
                      (2)   Means:
                               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
                       foreign-made goods.
              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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           d) Example:
               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
               European goods?
                    Two possibilities:
                    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:
                 a) LF:
                     (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.

                 b) FX:
                     (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
              Roadmap:

                   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:
                    Money Supply

                   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)

                   19 49q2
                   19 51q2
                   19 53q2
                   19 55q2
                   19 57q2
                   19 59q2
                   19 61q2
                   19 63q2
                   19 65q2
                   19 67q2
                   19 69q2
                   19 71q2
                   19 73q2
                   19 75q2
                   19 77q2
                   19 79q2
                   19 81q2
                   19 83q2
                   19 85q2
                   19 87q2
                   19 89q2
                   19 91q2
                   19 93q2
                   19 95q2
                   19 97q2
                   20 99q2
                   20 01q2
                      03 2
                   19 47q

           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
                        are separate.
                  (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
                 a) Recall:
                                   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
                    (1) Wars
                    (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
                           conservation technology
                     (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.
              Summary Equation:
                                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
                                  year t-1
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                  Clearly, QS will rise when Pt
                            t                   rises.
                  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
                        increased pessimism.
                    (d) Increased protectionism (Smoot-Hawley)
              (3)   Remedy: Increased G due to New Deal and WWII
                       New Deal spending and government job creation did
                        not suffice
                       Massive WWII spending and morale boost ended the
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              b) Example: Recession of 2001
                  (1)   Facts:
                        (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: PM needed for transactions r
                        I
                      Exchange-Rate Effect: Pr  NCO  SFX
                        e, NX
                   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)
                  c) Graph

              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
                     each other)

              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

              2. Origins
                  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:
                           Keynesian
                  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 
                        =          a                      
           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
                                actual inflation.
                   (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
                                will fall.
                   (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
                            real GDP
                  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
                     inflation, and
               (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.


                                           Inflation Rate





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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
                           (a) Internet
                           (b) Computational advances
                           (c) Health
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              2. The Future
                  a) Greenspan is 77 years old (2004)
                  b) Deficit:
                  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.

              2. Pro
                  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
                             higher inflation
                       (2)   Inconsistency between announced policy and actual policy
                             leads to greater fluctuations of Unemployment rate than
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                                 “Time inconsistency of policy”

              3. Con
                  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 &
                     Paul Volcker)
                  d) How do you design a rule that will endure?

           B. Should the Government Balance its Budget?

              1. Deficit:

              2. Pros
                  a) Burden on future generations.
                  b) Crowding out will raise interest rates and lower investment
                  c) Current budget deficits are not like WWII deficits.

              3. Cons
                  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.
                     (Ricardian Equivalence)

           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?

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