U R I N GP R I C EL E V E L
[.conomics: ho of The str"rd-v.- hou' scarce resources are
DEMAND
. D e m a n d C u r y e ( S c h e d u l e ) : c u r v e ( t a b l c )s h o w i n g A i t h e q u a n t i t i e s f a g o o da c o n s u r r e rs u ' i l l i n g a n d a b l c o r'n to buy at alternative prices ,r.rir constant tastcs. p i n c o m e sr e l a t c d r i c e s . n d n u r n b e r f b L r y c r s . . a o . L a w o f D e m a n d : I n c r e a s en p r i c e( P ) c a u s e s e c r e a s e i d i n q u a n t i t y('Q ) d c r n a n d e d . . C h a n g e i n d e m a n d : C h a n g ei n t a s t e sp r i c c o f ' r c l a t c d ^ goocls.ir.rcorne. increasein nutnber of bu'n'ers: alters p l a n n c d c o n s u r n p t i o n t a l l p r i c e s .s h i f i i n g c u r v e t o a r i g l r t( i n c r c - a s c ) l e f i ( d e c r e a s e ) . or . C h a n g ei n q u a n t i t l ' d e m a n d e d :( - a t i s e d r t r * n I r r t c c b i r . c h a n g e n d r e s u l t s n m o r c n r c r .atl o n gc u r v e a . R e l a t e d p r i c e s : I n c l r " r c lp r i c e s o l c o t n p l e t n e n t s r o c n f s u b s t i t u t eis c l L r d i n gu t u r cc o n s L r m p t i o n .
. c . : . . ' . . r 1 - ' t lr n r ( ) n S o m p e t r n g u s e s . F-conomic Questions Include: \\ r.rt l: produced'.) I il,,rr r: lt produced'.) : \\:r,,lcls \\hat is produced'J t,R0I)T (--I-IO\ POSSIBILITY
. Price Inder: Aleragc lc-rel of priccs relatire to the ler,cl in a base time period. C clst of'a fireci basket averasLof'soods reportcd as a pcrcr-ntasc r)i'basc pcriocl cost. . G D P P R I C E I N D E X : A r n e a s u l c o t ' c h a n s c - si n t h c
)
FRONTIER:
I : r , ' . r l l " r n a t r rc c o r " n b i n a t i o n so f f i n a l g o o d s a n d ..': . r!c: that could be produced in a given tinte period , ' : : r . t l l . r r l i l a b l . - a n d l i r n i t e d r e s o u r c e sa n d t e c h n o l o g y . I l.i:lrrrlc-rrlpportunitV cost: Obtaining more production ,; ',11s'g1r1rd rL-quires reduction in the production (lost a , ' r n \ \ r t u l l l t \) o f ' o n e o r m o r e o t h e r g o o d s . - l . r ' , r t r l ' r n c r t - ' a s i n go p p o r t u n i t v c o s t m e a n s t h a t .:.:.lilIltg llrore of a good requires giving up e\er . r : = J I J l 1 1 r ' r l . u Otfst h e a l t e n ] a t i V eg o o d . 1 : I nsidc frontier: Unemnloved : ri l l l c l ! ' r l C \) . : t rpanding frontier: Increases in resources and ' . ' . : r i r o l o s r c i i la d v a n c e s . . t ..'.\)lrrrnl\ produccs only 2 goods (X.Y). Points on ' :::rc J !-ir\c r.\.B.C.D) represent different cornbinatiotts I goods $'hen all resources are used (full : r ) r l l r - r C S O u r C e sa r e not used Or used resources
A v e r a q ep r i c e o 1 ' a l l g o o c l s a n c l s e l v i c e s . C o n s u m e r P r i c e I n d e x ( C P I ) : A r r c a s u r c o f ' c h a n g e si n the ar'eraqeprice' of Llrbalrconsuller goods ancl sc-n icc's. ffl . Producer Price Inder (PPI): .A nrL-asrlrLo1'ehun-uc-s irr ill tlte arelagc pnce of'uoclrls borrglrt br ploclucer: (inclLrclcs cnrcle nratcrials: intenrrediatc gr.rods: inishccl goocls). f . Clost Of l.iring Adjustment (COt-A): ,\utomatic
n v
!
7
t a c i j u s t m c n t st r f ' r n c o r r . r co t h c r a t c o l ' i n l l a t i o n .
)
ME A S U R IN G FLA TIO N IN
. I n l l a t i o n : ( ' o n t i r t r r i n , gn c r c a s c i n t h c a r c r a g c l e r c l o f ' i p r i eC . o l ' ! r r t t t l : l t l l t l : C tr i ec : r r re I ' l i l l ) e. . D e l l a t i o n : ( ' ( ) n t l n u l n u c l c c r e a s ei n t h e a r e r a g e l e i c ' l o f p r i c c s t r l ' s o o r l s u n d s ! - r \ i c c s ( n c _ g a t i r ei n f l a t i o n r a t c ) 0\ cr tllle . . D i s i n l l a t i o n : F u l l u r gi n l l a t i o n r a t c . \ o t c t h a t p l i c c : u l c still incrc-asins . lnflation rate: bciriccu tinre nerioti one and tinre
D D '' x 1oo n c r i . t l t r i . i s .- . . . Tr pes of l nl'lation I . Supplrsicie nflatron r a . w a g e - p u s h - $ a Q ci' n c r e a s ee a d s o p n c L 'l u c r e a s e l t b . C ' o s t - p u s h i n c r c - a sic n o n - l a b o rc o s t s l e a d st o n
S U P PL Y
. S u p p h C u r v e :A c L r r v( t a b l c ) s h o w i n g eq u a n t i t i eo f a s e th priees gooda selleris rvillingandablcto sellat alterrtltire input at a givencostof production cietenriinecl constant bv prices. technologl,. nurnbcr sellers. and of . L a l l o f S u p p l y : I n c r e a s cn p r i c e( P ) c a u s e s r r c r e a s e r iu i q u a n t i t y( Q ) s L r p p l i e c l . C h a n g e i n s u p p l y : C i h a n g er n c o s t o l ' p r o d u c t i o n . t e c h n o l o g vp r i c c o f ' o t h e rp r o d u c e d o o d s :n u m b e ro f . c s e l l e r s l t e r sp l a n n e ds a l e sa t a l l p r i c e s .s h i f t i n gc u l v e a ) t o r i g h t ( i n c r e a s eo r l e f t ( d e c r e a s e ) . . Change in quantitv supplied:C'aused y ovr pric.' b n c h a n g e n d r e s u l t s n m o v e r n c na l o n - u u r r e . a i t c
- : : . . , r r n r L ' n to f r e s o u r c e s ) .I f t h e a l l o c a t i o n i s i n s i d e t h e -..: .,'. : 1 , ' :!:a l c l t t l \ . Good Y
pncr- lllcrL-ASc
MARKET QUILIBRIUM E
. E q u i l i b r i u m : I h e np r i c e p i s e s t a b l i s h ew h e r e d SUPPLY q u a n t i t yc l e m a n d e1 P e ) d quantrty upplied Qe). s ) 1 '"" Equilibrium . Properties Equilibrium: H€ of A MEASURING NEMPLOYMENT U L P>Pc. urplus s . Labor lbrce: [:nrploved r'[,'rremplovccl o DEMAND 2.P
Actual Investment
Y2 Y(equilibrium) Expenditure Multiplier: The multiple by which an initial change in aggregatespending will alter total cxpenditure after an infinite number of spending c y c l e s : ( lt ( l - M P C ) )o r ( l i M P S ) . Simplified Example: Given MPC : 0.8; Deflationary Gap - $300 million; assume interest rates do not (l) af-fect Investment (l) in Question: How much of an increase Investment is requiredto solvethe DeflationaryGap'? Answer: I x rnultiplier- $300 m I*x(l]MPS)-$:OOm l*-5300mxMPS I * : $ 3 0 0m x ( l - M P C ) I*-5300mx(0.2) I*-560m Y1
. Similar to consumption.imports can be modeled:\'l - nr MPM(Y) whereM - total inrporls. - importswhenY (t m . M P M = m a r g i n a p r o p e n s i t yo i m p o r t l t . Import Multiplier:(l/(l-MPM))
AGGREGATE DEMAND: Total quantity of output demandedat altcmativeprice levels in a given time pcriocl. . Reasons why rt is downwardsloping: l.Real balances effect: Price changesaffect the real value of GDP. 2. Foreign trade elfect: Domesticprice increase lor.r'ers exports (X) and increasesimports (M). Goods alc more expensive here and cheaper abroad. Loucr exports and higher imports lower expenditureson l o c a lg o o d sa n d s e r v i c e s . 3. Interest-rate effect: Increase in prices causes an increase Money Demand. Increase demancl in in fbr money raisesinterestrates.which lower investments. loweringtotal expenditures. AE
AEr AEo
YYl-fr.J
P C + | 1 + G + X 1 - M(1 1 < P s i ( C + 1 6 + G + X 6 - M 6P 6 ) P C + 1 2 + G + X 2 - M(2 6 < P 2 i
E S GOVER NM E NT X P E ND IT U R E(G )
spending Federal. state.and local government . Two tvpes of G: by a. Direct purchases government. b. Transfer paymentswhich redistributesincome from o n e g r o u pt o a n o t h e r . $ 3 0 0m i l Adjustmentto GAPS 1.Keynesian View: Government intervention 2 . C l a s s i c aV i e w : N o g o v e r n m e nitn t e r v e n t i o n l
AEz
F OREIGN CT O R SE
L Exports (X ): Expenditures by foreigners on producedgoods. domestically by on 2. Imports (M): Expenditures domesticresidents goodsproducedin foreign countries. . Definition: The useof government spending(G) or taxes (T) to changethe level of total spendingin the economl'.
w h e r e l 1 > 1 6 > 1x1>xo>x2M2>Mo>Ml 2, ,
K EYN ESI A N Q UI LI B RIU M E
Achieved hen: w (AE) l. Output : Income (Y) -Aggregate expenditures From ( I ), we can get equilibriumlncomeor Output(Yx) Y-AE Y-C-l+G+X-M Y-a+MPC(Y)+I+G+X-M Y-MP('(Y):a+l+G+X-M Y( l-MPC):a+l+G+X-M Y * - [ ] , ' (1 - M P C ) ] [ a + l + 6 + a - Y 1 Approach 2. Injectionsi Leakages ( l - e a k a g e( S + T + M ) : I n j e c t i o n s l + G + X ) s Exoenditures
TYPESOF FISCALPOLICY
. Expansionarv Fiscal Policy: Increases government in spendingor reduction in taxes. Bigger budget deficit (G>T). New Deal was expansionaryfiscal policy. . Contractionarv Fiscal Policv: Decreases ln
government spending or increases in taxes. Smaller deficit or surolus (G - $ 1 0 0 . 0 0 0 ) 4.L - the broadest definition of money supplr. consisting of all short-term (matures less than or L equalto I year) financial assets. refersto liquiditl. 5 .C r e d i t C a r d i s n o t m o n e y : M o n e y i s a f i n a n c i a l asset belonging to individuals and a liabilitr to item made arailablutcr banks.Credit card is a savings b e b o r r o w e dC r e d i t i s n o t a n a s s e t . . . Financial lntermediar.v-: Banks lunction rs an intermediarybetweenlenders& borrowersby holding deposits and making loans. . Bank Reserves:Vault cash and deposits at Federal is Reserve.called federal funds. In general.reserves the amount of casha bank keepson hand to manageinflou s and outflows. Banks lend each other excessfunds at the are federalfunds interestrate. Somereserves requiredbr central bank as a ratio (proportion)of depositsa. a reserve against cash withdrawals. Erpected rule: the more liquid the asset. hi-eher reserl'erequirement. the the . Money Creation: L How banks create money: Banks create demand part of the money supply.when makin-e bank deposits, loans. 2. Money multiplier:the amount(dollars)of moneythatthe bankingsystemcan createfrom $l of ercessresenes. 3. Maximum money creation: a. Assumes public depositsall money received and doesnot add to cashleakage. reser\es. b. Assumesbanks lend or snendall excess c. Formula: i increse i n c r e a s en reserveratio^ excessreserves in money required " 4.Complex Money Multiplier: Measure of monev createdper dollar depositedin the banking svstem when peoplehold cash; u'herer in resen'es Formula: [( l+c)/(r+c)]x increase excess : requiredreserve not ratio: c :9/o of withdrar.l'als redeposited E x . r : 0 . 0 2 ; c : 0 . 4 ; i n c r e a s e n e r c e s sr e s e r v e s f i o b $ 1 , 0 0 0m o n e ys u p p l yw i l l i n c r e a s e y S 3 3 3 3 . 3 3 .
occurrence of the economic condition maker recognition of the situation.
and policy
2. Implementation Lag: If an act of congress required. it can take some time for congress debateand approvethe bill. 3. Effectiveness Lag: After the policy ls it implemented" can take time for the policy to have an impact on the economy (ex. in the late '90s, Greenspantned to anticipate inflationary tendencies by tightening the money supply interestrates]aheadof time). fincreasing
Lump-sum Tax The Consumption equation is transformed: C : a + M P C ( Y - T ) ; C - a + M P C ( Y )- M P C ( T ) . The tax multiplier: Atequilibrium,Y:AE Y consumption, - C AssumingC is the only expenditure MPC(T) Y:a+MPC(Y) Y-MPC(Y)-a-MPC(T) Y(I-MPC):a MPC(T) Y(MPS): a - MPC(T) Y : a(1/MPS) (MPC/MPSXT) This impliesthe Tax multiplier - MPC/MPS or MPC/( lMPC).
E D IF F ER EN TIA L FFE C T OF IN C R E A S IN G IAND G
Accumulateddebt of the federalgovernmenl. . Debt Service:the interestrequiredto be paid eachyear debt (currentdeficit & debt) on outstanding . Transferresourcesfrom bond holders to tax payers.No net change. . Future generations fiom tax payersto transferresources bond holders. . External Debt: U.S. government debt (Treasury and bonds) held by foreign households,businesses governments.Imposesa burden on future generations. . Crowding out investment leads to slower growth for future generations. If T and G are increasedby the same amount. the net in eflect on Y is the increase G. Explanation: The effect of each component on Y is multipliers.Assumingall other basedon their respective are components unchanged: A Y : ( 1 / (l - M P C ) ) G - ( M P C / (l - M P C ) )T AssumingS40-G:T, A Y : ( l / ( 1 - M P C ) )$ ' 1 0 ( M P C / ( l - M P C ) ) / 1 0 $ A Y : $ 4 0 [ (r / ( l - M P C ) ) - ( M P C / (l - M P C ) ) ] ) A Y - $ 4 0 [ (r - M P C ) | ( l - M P C ) ] AY - $40il1 W h e r eA : c h a n g e
$100.ooo)
The governmentcan 1.Accurate measureof variables: only estimate the sizes of MPC. MPM and other variables. exogenous 2. Govemment is not able to changeG or T quickly. as it is often subjectto legislationas well as checksand betweenthe Executiveand Legislativebodies. balances 3. Financingdeficits can haveoffsettingeffects. . Crowding out: Classical believethat economists when government finances a deficit. the are eft-ects not fully expansionaryicontractionary sellsbondsto financean realized.If government erpansionary fiscal policy. it is taking away funds fiom a possible private investment ([) in Thereforeincrease G is offset by undertaking. a decreasin I. e -1. Fiscal policv can conflict u'ith other goals. Ex. Def'lationarygap and large public debt. Solving the in gap clet)ationary may requirean increase G. Increasing (i hou'ever.further raises the budget deflcit (G i n t e r e s t r a t e i n c r e a s e- > I n v e s t m e n t -t' decrease ( lltcome:Output) decreasc 2.Expansionarv N'Ionetarv policr,: Money Supply i n c r c a s e - , , i n t e r e s t r a l e d e c r e a s e- > I n v e s t m e n t -.:' increase ( lncome:Output) increase' Notc: lt is inportant that nronctary policyurakersare condition of the real sectorand the a\l'arcof'thucurre-lrt policv. lag cll'cctiveness of' n'ronctarl, . K e t , n e s i a srt i n r u l u s r I . lntcrcsl ralcs - price paid fbr thc use of lloney 2 S p e n c l i n( I r r v e s t n r e n t s ) g -j I iqLridityTrap. The' portion of thc- rloney-denrand p c u l r e t l r a t i s h o l r z o n t a l : e o p l ea r e w i l l i n g t o h o l d o u n l i n r r t e d l n o u n t s 1 ' m o n e ya t s o m e ( l c l w ) i n t e r e s t a policf is ineffectivc. ratc. N'lonctary,
C o m b i n a t i o n f h i g h a n d a c c e l e r a t i nig f l a t i o na n d h i ' l h o n unemployment. Classicalerplanationof stagflatron: the governr.nL-nr If wantsto r-naintain get close to the 1.9 unemplolrncrrt or rate.it rvill increase or lessen (movement SRP( ; r G T up to a higher inflation rate. Howeveronce again the econonryil'ill be pushedtoward the naturalrate of' unenrployment accorrplished an SRPCI that sits by r o r h en g h t o f S R P C ] . INFLATION: Can be subject to Adaptive Expectatron.
expectations ofthe future based on what has happenecl rn
The FED is the United Statcs' Ccntral Bank lt s u p e r v i s e st h e f i n a n c i a l s y s t c r n . . Structure: Tu,el'n'e regional Fedcral Reservc banks super\ isecl by a Board ot' (ioverrrors in Washingtorr nonrinated to fired ternrs subjcct to senate approval. . F u n c t i o n : C ' o n s r e s s{ a v e t h c -F E D 6 c r p l i c i t f u n c t i o n s . I . ( o n c l t r c tr n o n c t a r v p o l i c , r ,('r t t o s l i r n p o r t a r t t f u u c t i o n ) . 2 . S u p el r i s c a n c l r e g r i l a t e l - i n a n c i a l i n s t i t u t i o n s . i . S c r r c -a s l c n t l e r o f l a s t r e s ( ) r tt o f i n a n c i a l i n s t t t u t i o r t s . ; 1 .P r o r i d c b a n k i n s s e r v i c e s t o t h e L i . S . ( l o v e r r t n r c ' u t . 5 . I s s t t ec o r n a n d c u r r c n c v . 6. Pror ide firrancial ,.:r'r iecs to eouiuicte iul banks. savitrgs e a n d l o a n a s s ( ) i a t i o n s .s a r i n - { s b a n k s . a n d c r e c l i tr r n i o n s . . \lO\F,'I.\RY POLI('\': Polici that afTcctsthc economv r e t l r r o r r r : l t r r r r t s:e i l t r t t , r r t c \ u p l ; l \ l n d a r r r i l a h l e l e i l i t . .l . F'ederal ()pr:n (F'O\lC ): \larket Committee ( onroosctl of 7 rrrr'nrbers of the Boalcl of (iovelnors l and 5 lrcrlclal Rescrre Bank prc-sidents.t is thc chief' polio-uraking bodv ot'thc FED. 'fools. . N4onc-tan' l. Reserve Requirenrent (r'atio): Prollortion ot clenosrtsthat ur.lst be held as rcscrvcs. 2. Discount Rate: Ratc-of intercst charged br, the Federal Reservc Lranksfitt' lencling fcservcs to privale banks. l\Iarket Fedcral Rcscrve 3.Open Operations: purchases and salcs oi'goverurnent bonds fbr thc -fhis p u r p o s r -o f a l t e r i n g b a n k r e s e r r . e s . is most ofien used by the Fed in contrtrlling monr-y srrpply. . Tight rnonev policv: (lou'ers N{S) I . IIigh reservelcquirerncnts r 2. tligh drscoLrnt ate 3 . C ) o e nn r a r k e t s a l e s . E a s i ' l n ( ) n e l p o l i c l ' : l i r r c r c a s c sI \ ' l S ) I. I-ou fescf\e reottirenrerrts 2. [-ou rliscount rate 3. f)pen urarket purcltasc-s . Dernand fbr \4ouey,: The quantitics of'nronel' people are il'illins ancl ablc to holcl at allcnrati','e intcr-cstr;rlc-(S). l . T r a n s a c t i o n s d e m a n d : \ 4 o n c v h el d f i r r t h e D u r t r o s e o f r t t a l ' i l t r c i c t r J r t r t t t i t t ' k c tp t t r el t l r e s . 2. Precautionarl' demand: N'{onev lrelcl fbr unexpected m a r k e t t r a n s a c t i o n so r e n r e r g e r r c i e s . -l.Speculative demand: Monev helii firr speculatilc purposcs. fir later l'inancialopportuuitics.
M O N A R IS T E R S P E C TIV E ET P (M | L T O N TE D MA N 'V tE W ) FR S
. \Jonetan policr can control inflation. . Inerease uronev suppll at a steady rate eqrral to grorvth (tl cet.lrtrlnr'. . [)o not attclnpt 1o f ine tune nlone], grou'th.
thepast). Sustained igh inflation: ccompanied y MS increa:e h A b and c'xpectations inflation. of D i s t r i b u t i o n a lE f f e c t s o f I n f l a t i o n : L lndir,iduals who can get higherrvages and sell goodslt higherprices,can still keepjobs and continueto sanr r e \ r e n u ef r o m s a l e s . w i l l b e n e f i t f r o n r s L r s l a i n c t l inflation. Indexing wages (such as cLln-cltt\ociitl security payments)to inflation pre\ents or rccluec. the bad efl'ects of inflation. Their rcal rnconre becortres independent is lcss affectedbr int'latitrrr or 2. Bonclholders:The l'alucof bondsclrop ilh intlatr,'n real u if rtotninal intercst rates are unchangecl. Thc'rc-ti'r'r' bondholders'wealth stafus depends hori tirstnonrrr.,.r on interest rates adjustto expectations inliation. of
FIGHTING STAGFLATION:
l. Classical: Run a recessior.t. This squL-r./.. i n f l a t i o n a r y e x p e c t a t i o n so u t o f t h e e c o n o n t r
(
z
Ill
I
n
i
Inflation and unemployment relationship: Thc thcory-u'hcn uncnlllovmcnt is lou'.peoplehavejobs. peoplehave wagcs. purchirsc's made. clerrrand increases. plices are incrcasc. lcadingto an increase inflation rates.When in is unenrpkiy'ment high. people are laid of}. rro income. denanclis lou,.pricesdecrease. then inflationratesdrop. Shortrun Phillips Curve (SRPC): Graphical reprc-sentation the negative relationship betwecn of irrflation and ur.rernplovrnent rate. I n fa t i o n l Rate
I n fl a t i o n Rate
SRPC2 u.=5.5
Jb
U
(
6.5
lowcr the inflation rate fl'om a. (3oo). cla\\l!.r,. '. prescribe a planned rcccssiol.t. L.ouerin-g uronc\ .r.1p1r
19 5 4 19 6 2
lvill
raise interest rates. lou,ering inr c:tnt.-nl .l:rt to more unemplovment. rll\ln-! lit-
contribute
unemploytnent rate to 6.5 but lo'"1'erin-u inllatrtrn ttr I -
N o t e . I I n t r l l t ) 6 f i . t l r c d o un u ' a r c l - s l o p i nP h i l l i p s c u r v e g was appal'cntln the eally '70s it appeared breakd0u,n. to \\'lre-n rrucrnploynrcnt high, inflation u,asalso high. uas
S R P ( - r s h i f t s t o S R P C r a n d s e t t l e sa t t h c n a r u n r l r . r r c , , : uncmployrnent - 5.5 at d. 2 . K e y n e s i a n : I n d u c i n g a r e c e s s i o n i s c o n t r o r c r ' \ l . r l. r : r r : unpopular. MS clecrcases inefficicnt. i Kevnesian Solution: Supplcmcntarr polrcr e. r l i i , : incomes policy.
I CON TROV E RS I E/S S S U ES
LONGRUN HILLIPS URVE: P C
l . lrr tltc lofle run. $ ltctt ,-i,^r.^
. S h o u l c l c c n t r a l b a n k s o n l y ' s e t r ) r o n e t a l ' \p o l r c l t o k c c p inllation lou'l . Shouldlrollctall policv be usedto stiruulitlc u eak cuorroun".) a . Should ccntral banks crintrol thc rnoncv sr4rplvor iuterert lltcjs.' . Ilou sl-rotrld nronev be rneasurerl'.) . T h e i r t : l ) ' s t o n t r o l ( ) l l n r o n c ) s r r p 1 . r l r . : p e c r f - i c a lo v t h c ln ct'tcctivcucss of expiirr.iortarr' policr'. clepc-ntlstrn tl.rc r o b u s t n c s so l ' t h c c s t i n r a t e ( e l ) a r a l r ) c t e i ' -" o o l t l r c l t r a n l as borro'nlcrsl