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Macroeconomics - Introduction

Macroeconomics
Macroeconomics is the branch of economics that studies the overall workings of an
economy, such as total income and output; aspects of the economy are viewed in
aggregate. For instance, when referring to labor in macroeconomics, the focus is on all
workers within an economy, not the choices of an individual worker.

BASICS

Introduction
The information presented within Section A: Basics, is preliminary material and will not be
tested directly on your upcoming exam. However, we recommend reviewing this material as
you will need to know it in order to understand the more advanced topics discussed later.

Gross Domestic Product (GDP) and Gross National Product (GNP)


Gross Domestic Product (GDP) and Gross National Product (GNP) are the two most
common measures of a nation's economic output.

Gross domestic product is defined as the value of all goods and services produced within a
nation during a particular period of time (typically a year). Market prices are used to
determine value and only "final" goods and services (those consumed by the end user) are
included.

Gross National Productmeasures the income of all of a nation's citizens, even if that income
was earned abroad. Amounts that foreigners earn within the nation's boundaries are not
included.

Gross Domestic Product (GDP)


Two different approaches are used to calculate GDP. In theory, the amount spent for goods
and services should be equal to the income paid to produce the goods and services, and
other costs associated with those goods and services. Calculating GDP by adding up
expenditures is called the expenditure approach, and computing GDP by examining income
for resources (sometimes referred to as gross domestic income, or GDI, is known as the
resource cost/income approach.

Expenditure Approach
The expenditure approach utilizes four main components:

Consumption (C) - These are personal consumption expenditures. They are typically
broken down into the following categories: durable goods, non-durable goods, and services.
Investment (I) - This is gross private investment; it is generally broken down into fixed
investment and changes in business inventories.

Government (G) - This category includes government spending on items that are
"consumed" in the current period, such as office supplies and gasoline; and also capital
goods, such as highways, missiles, and dams. Note that transfer payments are not included
in GDP, as they are not part of current production.

Net Exports - This is calculated by subtracting a nations imports (M)from exports (X).
Imports are goods and services produced outside the country and consumed within, and
exports are goods and services produced domestically and sold to foreigners. Note that this
number may be negative, which has occurred in the U.S. for the last several years. Net
exports for the U.S. were minus $606 billion during calendar year 2004 (as per Bureau of
Economic Analysis, U.S. Department of Commerce June 29, 2005 press release).

Formula 4.1

GDP = C + I + G + (X - M)

Resource Cost/Income Approach


To calculate Gross Domestic Income (GDI), first consider how revenues received for
products and services are used:

1. Pay for the labor used (wages + income of self-employed proprietors)


2. Pay for the use of fixed resources, such as land and buildings (rent);

3. Pay a return to capital employed (interest);

4.Pay for the replenishment of raw material used.

Remaining revenues go to business owners as a residual cash flow, which is used to


replenish capital (depreciation), or it becomes a business profit. So with the resource
cost/income approach, GDP (or GDI) is calculated as wages, rent, interest and cash flow
paid to business owners or organizers of production.

So GDP by resource cost/income approach = wages + self-employment income + Rent +


Interest + profits + indirect business taxes + depreciation + net income of foreigners.

Formula 4.2
GDI = wages + self-employment income + Rent + Interest + profits
+ indirect business taxes + depreciation + net income of foreigners

The above formula is probably hard to memorize, so at least try to remember this
relationship - GDI = wages + rent + interest + business cash flow

Total GDP figures should be the same by either method of calculation. But in real life, things
don't always work out this way. Official figures usually have a category called "statistical
discrepancy", which is needed to balance out the two approaches.
Nominal vs. Real GDP, and the GDP
Deflator
The main difference between nominal and real values is that real values are adjusted for
inflation, while nominal values are not. As a result, nominal GDP will often appear higher
than real GDP.

Nominal values of GDP (or other income measures) from different time periods can differ
due to changes in quantities of goods and services and/or changes in general price levels.
As a result, taking price levels (or inflation) into account is necessary when determining if
we are really better or worse off when making comparisons between different time periods.
Values for real GDP are adjusted for differences in prices levels, while figures for nominal
GDP are not.

The GDP Deflator


The GDP deflator is an economic metric that converts output measured at current prices
into constant-dollar GDP. This includes prices for business and government goods and
services, as well as those purchased by consumers. This calculation shows how much a
change in the base year's GDP relies upon changes in the price level.

If we wish to analyze the impact of price changes throughout an economy, then the GDP
deflator is the preferred price index. This is because it does not focus on a fixed basket of
goods and services and automatically reflects changes in consumption patterns and/or the
introduction of new goods and services.

Real GDP for a given year, in relation to a "base" year, is computed by multiplying the
nominal GDP for a given year by the ratio of the GDP price deflator in the base year to the
GDP price deflator for the given year.

Example:
Suppose we wish to calculate the real GDP for the year 2001 in terms of 1996 dollars. The
value for (note that these values are for illustration purposes only) 1996 price deflator is 100
and the 2001 price deflator is 115. The 2001 GDP in nominal terms is $10 trillion dollars.

Then: Real GDP year 2001 in 1996 dollars =$10 trillion × (100 / 115) = $8.6 trillion

Limitations of GDP and Alternative


Measures
There are many limitations to using GDP as a way to measure current income and
production. Major ones include:

·Changes in quality and the inclusion of new goods - higher quality and/or new products
often replace older products. Many products, such as cars and medical devices, are of
higher quality and offer better features than what was available previously. Many consumer
electronics, such as cell phones and DVD players, did not exist until recently.
·Leisure/human costs - GDP does not take into account leisure time, nor is consideration
given to how hard people work to produce output. Also, jobs are now safer and less
physically strenuous than they were in the past. Because GDP does not take these factors
into account, changes in real income could be understated.

·Underground economy - Barter and cash transactions that take place outside of recorded
marketplaces are referred to as the underground economy and are not included in GDP
statistics. These activities are sometimes legal ones that are undertaken so as to avoid
taxes and sometimes they are outright illegal acts, such as trafficking in illegal drugs.

·Harmful Side Effects - Economic "bads", such as pollution, are not included in GDP
statistics. While no subtractions to GDP are made for their harmful effects, market
transactions made in an effort to correct the bad effects are added to GDP.

·Non-Market Production - Goods and services produced but not exchanged for money,
known as "nonmarket production", are not measured, even though they have value. For
instance, if you grow your own food, the value of that food will not be included in GDP. If
you decide to watch TV instead of growing your own food and now have to purchase it, then
the value of your food will be included in GDP.

Alternative Measures of Domestic Income


Other than GDP and GNP, there are alternative measures of domestic income, such as
national income, personal income and disposable personal income.

National Income
National income is computed by subtracting indirect business taxes, the net income of
foreigners, and depreciation from GDP. It represents the income earned by a country's
citizens. National income can also be computed by summing interest, rents, employee
compensation (wages and benefits), proprietors' income and corporate profits.

·Personal income represents income available for personal use. It is computed by making
various adjustments to national income. Social insurance taxes and corporate profits are
subtracted from national income, while net interest, corporate dividends and transfer
payments are added.

·Disposable personal income (or disposable income) is income available to people after
taxes; i.e., it is personal income less individual taxes.
Components of Marginal Product and
Marginal Revenue
I. Components of Marginal Product and Marginal Revenue

Marginal Product
The marginal product is the change in output that occurs when one more unit of input (such
as a unit of labor) is added.

Marginal Revenue
Marginal revenue is the increase in total revenue that occurs with the production of one
more unit of output.

Value of Marginal Product


For a particular resource, the value of marginal product (VMP) is the resource's marginal
product multiplied by the product price.

Marginal Revenue Product


The marginal revenue product of a resource is defined as the increase in a firm's total
revenue attributable to employing one more unit of that resource. The increase in output
due to adding one more resource unit is called the marginal product. The marginal revenue
product is calculated as the marginal product times the marginal revenue.

The Relationship Between MRP and Demand


Due to the law of diminishing returns, we expect that both the marginal product and the
marginal revenue product for an input will decline as more of the input is deployed.

A firm seeking to maximize profit will increase employment of a variable input unit until the
MRP of that input is just equal to what it pays for the input. This rule will be followed by price
takers and price searchers.

As the price of an input goes up, fewer units of that resource will generate the MRP needed
to entice the firm to employ that resource. The demand curve for a resource will be
downward sloping, as shown in figure 4.1 below:

Figure 4.1: Results of Regulating Price and Output


Values for the demand curve will depend upon the price of the good being produced, the
productivity of the resource in question, and the amount of other resources used by the firm.

A profit-maximizing firm will continue to employ units of a resource as long as the MRP
associated with the unit exceeds the firm's cost. If we assume the units of each resource
are perfectly divisible, then the following conditions will apply to a firm with 3 production
inputs (A, B, and C).

MRPa=Pa

MRPb =Pb

MRPc= Pc

Pa is equal to the price (or wage rate) of resource A, Pb is equal to the price (or wage rate)
of resource B, and Pc is equal to the price (or wage rate) of resource C.

Suppose resource A represents highly skilled labor and resource B represents labor with
low skills. If a firm can get 100 units of additional output by purchasing $500 worth of highly
skilled labor and only 50 additional units of output by hiring $500 worth of labor with low
skills, then per unit costs will be reduced by hiring the highly-skilled labor. Expenses can
always be reduced by substituting resources with relatively high marginal product per dollar
spent for resources that have a relatively low marginal product per dollar. This substitution
will continue to occur if per unit costs are to be minimized until the following relationship is
achieved:

MRPa = MRPb = MRPcinan


-------- -------- --------
Pa Pb Pc

Note that this relationship also implies that if skilled laborers are three times as productive
as unskilled labor, then firms will be willing to pay skilled laborers three times as much as
unskilled labor.
The Demand and Supply of Financial
and Physical Capital
Physical vs. Financial Capital
The term physical capital applies to the stock of buildings, equipment, instruments, raw
materials, semi-finished and finished goods in inventory, and other physical objects used by
a firm to produce its goods and/or services.

Financial capital includes the resources used to purchase those physical objects; those
resources come from savings. Interest represents the price of capital; the actual market
interest rate will be the rate at which the supply of capital is equal to the quantity of capital
demanded.

Comparing the Future Marginal Revenue Product of Capital with Future Capital
Prices
A firm needs to examine the future marginal revenue product of capital when making a
decision to employ more capital. The firm converts the value of those future income streams
to a value in the present. Present value is the current worth of a future income stream,
discounted to reflect the fact that a dollar in the future is worth less than a dollar today. The
general form of the present value calculation is:

Formula 4.2

present value = future value / (1 + r)

Where: "r" represents the relevant interest rate

Note that if future value stays the same, and interest rates decrease, future value increases.
As interest rates decline, more investments of capital become profitable to the firm, and the
quantity of capital demanded will increase.

Main Influences on the Demand & Supply of Capital


The main influences on the demand for capital are:

·the interest rate


·expectations concerning future business conditions - if firms believe that future business
conditions will be poor, they will be less likely to make investments

The main influences on the supply of capital are:

·the interest rate


·income - as incomes increase, people generally save a larger proportion of their income
·expectations about future income - if people expect their income to decline, then they will
tend to save more now so as to even out their consumption. College students will tend not
to be savers, as they usually expect their future incomes to be significantly higher than the
present.

The equilibrium interest rate will tend to fluctuate over time. Population changes,
technological changes, and expectations are some of the factors that will influence the
demand and/or supply for capital.

Renewable and Non-renewable Resources


Renewable natural resources (a form of physical capital) are those resources that tend to
be replenished by nature. Examples include water or solar energy. Non-renewable natural
resources are not available (for practical purposes) once they are used. Examples include
natural gas, oil, and coal.

The basic principle regarding the equilibrium for non-renewable natural resources is that the
price of the resource today should be equal to the present value of the next period's
expected price for the same resource. Essentially, the prices for a non-renewable resource
are expected to increase at a rate equal to the interest rate.

Suppose an oil producer expects prices for oil to be lower in the future. A profit-maximizing
oil producer would try to sell as much oil in the present, and then invest the proceeds. If the
price of oil is expected to increase at a rate greater than the interest rate, then the oil
producer should let as much oil as possible stay in the ground.

Keep in mind that prices for non-renewable resources do not exactly follow this pattern
because the future is always uncertain. Technological changes and political uncertainties
are some of the many factors that make forecasting price changes difficult.

Economic Rent and Opportunity Cost


I. Economic Rent

Economic Differences of Small and Large Incomes


These differences are best explained by the concept of marginal revenue product, which we
discussed earlier in the chapter. Remember that marginal revenue product of a resource is
defined as the increase in a firm's total revenue attributable to employing one more unit of
that resource. The increase in output due to adding one more resource unit is called the
marginal product. The relationship between additional resources and output implies that
skilled laborers are three times as productive as unskilled labor, and therefore, firms are
willing to pay skilled laborers three times as much as unskilled labor.

Keeping this in mind, workers with large incomes are associated with a high marginal
revenue product, while those with small incomes are associated with a low marginal
revenue product. For example, a star baseball pitcher (skilled labor) will have a high
marginal revenue product, while a dishwasher (unskilled labor) will have a low marginal
revenue product. Very few people are qualified to pitch in Major League Baseball, while
there are many people qualified to wash dishes.
Economic Rent and Opportunity Costs
Economic rent is the difference between what an owner of a factor of production (such as
land, capital or labor) receives and the opportunity cost for that owner.

Let's suppose the factor of production is labor. In this example, the laborer receives $20/per
hour for their job, and the minimum salary they'd be willing to work for (opportunity cost) is
$16/per hour. This $4/hour difference is the laborer's economic rent. In the case of the
superstar baseball pitcher, most of the salary earned may be economic rent. Most of a
wages of a dishwasher is opportunity cost, since these types of jobs pay minimum wage.If
the factor of production is a plot of land, the supply curve would be perfectly vertical, since
there is no way for the landowner to supply additional land. In this case, all money received
is economic rent.

The size of economic rent received by a owner of a factor of production is determined by


the elasticity of supply for that particular good or service.

 If the elasticity of supply is neither elastic nor inelastic, the supply curve will slope
upward and the supplier's income would be split between economic rent and
opportunity cost.
 If the elasticity of supply is inelastic, the supply curve would be perfectly vertical and
the supplier's entire income would be comprised of economic rent. For example, if
the supply were a particular plot of land, or a
 If the elasticity of supply is elastic, the supply curve would be perfectly horizontal,
and the supplier's entire income would be comprised of opportunity cost.

rent paid each month to live in an apartment, or to lease a car is not the same. Remember that economic rent is simply a component o

Monitoring Cycles, Jobs, and Price


Level
I. The Business Cycle

Phases of the Business Cycle


Economies usually have long-term secular trends, such as a certain rate of expansion for
the labor force and/or the general population. One feature of market economies is that
economic activity sometimes rises above the long-term trend line, while at other times it falls
below.

Figure 4.2
A business peak, or boom, occurs when unemployment is low, incomes are high and
businesses are operating at full capacity. When aggregate economic conditions began to
slow, the business cycle is said to be in a contraction, or recessionary phase. Sales begin to
fall, and unemployment starts to rise. The low point of the contraction phase is called the
recessionary trough. The business cycle begins the expansionary phase after the low point
is reached and business conditions began to improve. Business sales improve, and the
unemployment rate begins to decline. Another boom will follow, and the cycle will begin
anew.

Conditions during the low point are referred to as a recession. Many economists define a
recession as being a decline in Gross Domestic Product over two or more quarters. Severe
recessions (both in length of time and severity of the contraction) are referred to as
depressions.

Key Labor Market Indicators


The civilian labor force is defined as those who have jobs or are seeking a job, are at least
16 years old and are not serving in the military. A person who does not have a job, is
available for work and is actively seeking work is considered to be unemployed.

Key labor market indicators include:

 The Labor Force Participation Rate - This rate is calculated by dividing the number
of people in the civilian labor force by the total civilian population of those 16 years
old or older.
 The Unemployment Rate - This is computed by dividing the number of unemployed
by the number of people in the civilian labor force. That number is multiplied by 100
and expressed as a percentage. Part-time workers are considered to be employed.
 The Employment/Population Ratio - This ratio is calculated by dividing the number of
job-holding civilians who are at least 16 years old by the total number of people in
the civilian population within the same age group. This ratio will tend to go higher
during economic booms and lower during recessions.

There are several issues with calculating the unemployment rate. The handling of
discouraged workers is one point of contention. This phrase describes workers who are
without a job but are not actively seeking a job because they have gotten discouraged about
their job search. Such people would not be officially counted as unemployed, although this
is a point of contention. Another area of dispute has to do with the inclusion of part-time
workers as employed. Some believe that they should not be counted as employed,
especially those who would prefer to work full-time. Due to definitional disputes with the
unemployment rate, many economists prefer to use the employment/population ratio, which
uses numbers that are easily measured and are well defined.

Generally unemployment is higher during a recession. Employment usually does not pick up
until after the economy is coming out of a recession; it is usually regarded as a "lagging
indicator" for the health of the economy.

GDP, Real Wages and Aggregate Hours Worked


We cannot simply look at the number of people with jobs when examining the total quantity
of labor in an economy. Some workers only have part-time jobs, while others work more
than the standard work-week. Aggregate hours, which is the total number of hours worked
by all employees, is a better measure of the quantity of labor.

The number of aggregate hours worked should increase with GDP. Data pertaining to
aggregate hours in the United States is maintained by the U.S. Department of Labor Bureau
of Labor Statistics.

Changes in real wage rates can be calculate by dividing nominal wages by the GDP
deflator. Data for real wages in the United States is also maintained by the Bureau of Labor
Statistics.

Types of Unemployment
The creation of "full employment" is a common economic policy goal. However, full
employment does not imply zero unemployment. A dynamic economy will always have
some unemployment; this is not necessarily harmful. Types of unemployment are often
broken down as follows:

·Structural Unemployment - Changes occur in market economies such that demand


increases for some jobs skills while other job skills become outmoded and are no longer in
demand. For example, the invention of the automobile increased demand for automobile
mechanics and decreased demand for farriers (people who shoe horses).

·Frictional Unemployment - This type of unemployment occurs because of workers who


are voluntarily between jobs. Some are looking for better jobs. Due to a lack of perfect
information, it takes times to search for the better job. Others may be moving to a different
geographical location for personal reasons and time must be spent searching for a new
position.

·Cyclical Unemployment - This occurs due to downturns in overall business activity.

As previously noted, full employment does not equate to zero unemployment. Some
unemployment is normal in a market economy and is actually expected as part of an
efficient labor market. Full employment is defined as the level of employment that occurs
when unemployment is normal, taking into account structural and frictional factors.

The natural rate of unemployment is that amount of unemployment that occurs naturally due
to imperfect information and job shopping. It is the rate of unemployment that is expected
when an economy is operating at full capacity. At this time in the U.S., the natural rate of
unemployment is considered to be about 5%.

The Consumer Price Index & Inflation


Inflation
Inflation is defined as an increase in the overall price level. Please note that inflation does
not apply to the price level of just one good, but rather to how prices are doing overall. A
consumer facing inflation that occurs at the rate of 10% per year will able to buy 10% less
goods at the end of the year if his or her income stays the same. Inflation can also be
defined as a decline in the real purchasing power of the applicable currency.

Consumer Price Index (CPI)


The CPI represents prices paid by consumers (or households). Prices for a basket of goods
are compiled for a certain base period. Price data for the same basket of goods is then
collected on a monthly basis. This data is used to compare the prices for a particular month
with the prices from a different time period.

Example:
The inflation rate is computed by subtracting the CPI of last year's prices from the CPI value
for this year, dividing that difference by last year's CPI value and then multiplying by 100.

So if the value of the price index for the current year is equal to 165, and last year's value
was 150, the rate would be calculated as:

Inflation rate = (165 - 150) X100= 10


150

CPI Sources of Bias


The CPI is not a perfect measure of inflation. Sources of bias include:

·Quality adjustments - quality of many goods (e.g., cars, computers, and televisions) goes
up every year. Although the Bureau of Labor Statistics is now making adjustments for
quality improvements, some price increases may reflect quality adjustments that are still
counted entirely as inflation.

·New goods - new goods may be introduced that will be hard to compare to older
substitutes.

·Substitution - if the price goes up for one good, consumers may substitute another good
that provides similar utility. A common example is beef vs. pork. If the price goes up, and
the price of pork stays the same, consumers might easily switch to pork. Although the CPI
will go higher due to the price increase in beef, many consumers may not be worse
off. Also, when prices go up, consumers may effectively not pay the higher prices by
switching to discount stores. The CPI surveys do not check to see if consumers are
substituting discount or outlet stores.

Aggregate Supply & Aggregate


Demand
The Aggregate Supply Curve
The aggregate supply curve shows the relationship between a nation's overall price level,
and the quantity of goods and services produces by that nation's suppliers. The curve is
upward sloping in the short run and vertical, or close to vertical, in the long run.

Net investment, technology changes that yield productivity improvements, and positive
institutional changes can increase both short-run and long-run aggregate supply.
Institutional changes, such as the provision of public goods at low cost, increase economic
efficiency and cause aggregate supply curves to shift to the right.

Some changes can alter short-run aggregate supply (SAS), while long-run aggregate supply
(LAS) remains the same. Examples include:

 Supply Shocks - Supply shocks are sudden surprise events that increase or
decrease output on a temporary basis. Examples include unusually bad or good
weather or the impact from surprise military actions.
 Resource Price Changes - These, too, can alter SAS. Unless the price changes
reflect differences in long-term supply, the LAS is not affected.
 Changes in Expectations for Inflation - If suppliers expect goods to sell at much
higher prices in the future, their willingness to sell in the current time period will be
reduced and the SAS will shift to the left.
The Aggregate Demand Curve
The aggregate demand curve shows, at various price levels, the quantity of goods and
services produced domestically that consumers, businesses, governments and foreigners
(net exports) are willing to purchase during the period of concern. The curve slopes
downward to the right, indicating that as price levels decrease (increase), more (less) goods
and services are demanded.

Factors that can shift an aggregate demand curve include:

 Real Interest Rate Changes - Such changes will impact capital goods decisions
made by individual consumers and by businesses. Lower real interest rates will
lower the costs of major products such as cars, large appliances and houses; they
will increase business capital project spending because long-term costs of
investment projects are reduced. The aggregate demand curve will shift down and to
the right. Higher real interest rates will make capital goods relatively more expensive
and cause the aggregate demand curve to shift up and to the left.
 Changes in Expectations - If businesses and households are more optimistic about
the future of the economy, they are more likely to buy large items and make new
investments; this will increase aggregate demand.
 The Wealth Effect - If real household wealth increases (decreases), then aggregate
demand will increase (decrease)
 Changes in Income of Foreigners - If the income of foreigners increases
(decreases), then aggregate demand for domestically-produced goods and services
should increase (decrease).
 Changes in Currency Exchange Rates - From the viewpoint of the U.S., if the
value of the U.S. dollar falls (rises), foreign goods will become more (less)
expensive, while goods produced in the U.S. will become cheaper (more expensive)
to foreigners. The net result will be an increase (decrease) in aggregate demand.
 Inflation Expectation Changes - If consumers expect inflation to go up in the
future, they will tend to buy now causing aggregate demand to increase. If
consumers' expectations shift so that they expect prices to decline in the future, t
aggregate demand will decline and the aggregate demand curve will shift up and to
the left.

Short and Long-run Macroeconomic


Equilibrium
In the short-run, an unanticipated decrease in aggregate demand will lead to an excess
supply of resources, which will lead to a decline in resource prices. Unemployment will
increase, prices will go down and output will be reduced. Over a longer period of time, lower
resource costs will cause a shift to the right in aggregate supply. The economy will move to
producing a level of output consistent with full employment (as was the case before the
decrease in aggregate demand), but at a lower price level.
An unanticipated increase in aggregate demand will, in the short-run, lead to an output level
that is greater than what is consistent with full employment. This occurs because price
levels are different that what was anticipated by resource providers. There will be less
unemployment than the "natural rate" of unemployment. There will be upward pressure on
resource prices and interest rates, which will, over the long-run, result in a decrease in
aggregate demand. Resource providers will make adjustments to the new price levels and
output will decline to what is consistent with full employment. A new market equilibrium will
occur at a higher price level. So in the long-run, inflation (higher prices) will be the major
effect of the increase in aggregate demand.

In the short-run, an unanticipated decrease in SAS will lower the availability of resources.
This will lead to an increase in resource prices, which will in turn cause the aggregate
supply curve of goods and services to shift up and to the left. A reduced level of output will
be produced at higher prices. If the cause of the unanticipated decrease in SAS is
temporary, then there should be no changes in prices or output over the long-run. If the
cause is more important, then the long-run supply curve will shift to the left. The economy
would produce a lower level output at higher prices.

An unanticipated increase in aggregate supply will, in the short-run, lead to a shift to the
right in SAS. Output and income will expand beyond what is consistent with full employment
at a lower price level. If what produced the increase in aggregate supply is only temporary,
the SAS curve will return to normal levels and prices and output will be as before. If what
produced the change is permanent, then both SAS and LAS will shift to the right. There will
be a greater amount of output, at lower prices.

Self-Correcting Mechanisms
Three aspects of a market economy that help to stabilize the economy and lessen the
impact of economic shocks include:

1.Changes in Resource Prices - If the economy is operating at less than full employment,
there will be downward pressure on prices for labor and other resources. That effect will
stimulate short-run aggregate supply. If the economy is operating above full employment,
prices for labor and other resources will get bid up, and short-run aggregate supply will be
reduced.

2. Change in Real Interest Rates - During recessions, business demand for capital funding
declines, causing a lowering of real interest rates. The lower interest rates in turn stimulate
consumers to buy large items and cost of business investment projects are reduced, which
stimulates business investment spending. Economic booms lead to higher interest rates,
thereby lowering demand for consumer durable goods and funding for business investment
projects. Therefore, interest rate movements work to stabilize aggregate demand.

3.Relative Stability of Consumption - The permanent income hypotheses states that


household consumption is mainly a function of expected long-range (permanent) income.
Since long-run income has more of an impact on spending than temporary changes in
current income, consumption spending stays relatively the same across business cycles.
During economic boom times, consumers will increase their savings; during a recession,
temporary declines in income will induce households to draw on their savings so as to
maintain a level of consumption in line with their expected long-run incomes.

Economic Theories
Classical vs. Keynesian Economics
Under classical economic theory, an economy will always move towards equilibrium at full
capacity and full employment. Aggregate demand will adjust to full potential GDP, assisted
by flexible wages and prices. Desired savings are kept equal to desired investment by
responses to interest rate changes.

British economist John Maynard Keynes took the viewpoint that spending induces
businesses to supply goods and services. If consumers become pessimistic about their
futures and cut down on their spending, then business will reduce their production. He
rejected the classical viewpoint that unemployment would be resolved by flexible wage
rates; instead, wages are viewed as being "sticky" when downward pressures exist.
Business will produce only the quantities of goods and services that government,
consumers, investors and foreigners are expected to buy. If the planned expenditures are
less than what would be associated with production at full employment, then output will be
less than the economy's full potential.

The Four Components of the Keynesian Model


There are four components of planned aggregate expenditures in the Keynesian model:
consumption, investment, government spending and net exports. Some basic assumptions
about the Keynesian model should be noted. When the economy is operating at full
employment capacity, then only the natural rate of unemployment is extant. Wages and
prices are not flexible until full employment occurs; at that point, increases in demand will
only cause prices to go higher.

 Consumption - Keynes believed that consumption expenditures are mainly


influenced by the level of income. As income increases, consumption will increase
but not by as much as the increase in income. The relation between consumption
and income is known as the consumption function.
 Investment - This category includes spending on fixed assets such as machinery,
and changes in inventories of raw materials and final goods. Keynes believed that in
the short run, investment spending is not a function of income.
 Government - As with investment, planned government expenditures are not a
function of income.
 Net Exports - Exports remain constant and imports increase as aggregate income
rises, so net exports (exports minus imports) will tend to go down as aggregate
income goes up.

Formula 4.3

Aggregate Demand = C + I + G + (X - M)
In the Keynesian model, equilibrium is achieved when the value of current production
equals planned aggregate expenditures. At that point, there is no incentive for firms to alter
their production plans. If expenditures exceed the value of output, business inventories will
be drawn down. Firms will need to expand production in order to replenish inventories and
meet the higher level of demand. If demand exceeds production, business inventories will
rise and production will be cut back until inventories are at normal levels.

Note that equilibrium can occur at levels of output which are below the level of output
consistent with full employment.

Figure 4.3: Aggregate Expenditures

In the graph above, AE0 represents aggregate expenditures that would occur at different
price levels. The 45 degree line, AE=GDP, represents the points where equilibrium occurs.
Equilibrium occurs at point (P0,Q0), where output is less than can be achieved at QF, the
output associated with full employment.

Ideally, planned aggregate expenditures will shift to a line such as AE 1. At that point, full
employment is achieved.

From a Keynesian view, market economies are viewed as being inherently unstable: they
are prone to booms and busts. Changes in demand, magnified by multiplier effects, tend to
cause wild swings in the economy. Fluctuations in private business investment are the
largest cause of the economy swinging to different levels of output.

Monetarists believe that fluctuations in the money supply are the chief source of fluctuations
in real economic output and that the major cause of inflation is excessive growth in the
money supply.

According to the monetarist view, economies will usually operate at full employment.
Aggregate demand is mainly influenced by changes in the money supply. Fluctuations in
aggregate demand will be diminished if growth in the money supply is kept at a steady rate.
Monetarists concur with the Keynesian viewpoint that wages are "sticky" when downward
pressures exist.
Money, Banks, and the Federal
Reserve
I. Basics

Money is a part of everyone's life, and we all want it, but do you know how it gains value
and how it is created? Check out the following link for more:

The following page will prime you for the topics discussed in this chapter:
What Is Money?

What Are the Functions of Money?


Money has three basic functions.

 It acts a medium of exchange. If money did not exist, we would have much more
complicated lives. If you wished buy bananas, you would need a barter arrangement
where another party valued something you had and could also provide you with
bananas. Anything can serve as money (ie. Coins, cigarettes, shells) as long as
someone else will accept it as a medium of exchange.

 Money is a way to store value. Although many things (land, gold, etc.) can serve as
a store of value, money has one large advantage in the sense that it can quickly be
converted into other goods. One problem with using money as a way to store value
is that some forms of money do not pay interest. Another problem is that inflation
destroys the value of money over time.

 Money is also used as a unit of account. The values and costs of goods, services,
and assets can be expressed as a unit of money. Prices expressed as money are
used to help consumers make choices among numerous goods and services.

What is the Money Supply?


The supply of money is the amount of money available in a country; it is measured in many
ways. The two most frequent ways to measure money are referred to as M1 and M2.

M1 is the narrowest definition of the money supply. It includes:

 cash (currency) in circulation


 checking accounts (demand deposits) - both non-interest earning and interest-
earning
 travelers' checks

M2 includes:

 all components of M1
 money market mutual funds
 deposits in savings accounts
 time deposit of less than 100K at depository institutions (banks, credit unions,
savings and loans)

Using Commodities as Money


Problems that arise when using commodities include requiring a double coincidence of
wants (does the person you want food from want your cigarettes?) and the difficulties in
making price comparisons.

y" means anything that can be used in exchange for goods or services. It is not referring to currency (in the form of coin
d services.

The Banking System


Types of Institutions
There are three major types of depository institutions:

1.Commercial banks

2.Thrift institutions such as credit unions, savings and loan associations (S&Ls), and
savings banks. Credit unions are cooperative organizations, usually restricted to employees
of a particular firm or government entity. The savings banks and S&Ls have historically
focused their loan activities to the real estate mortgages.

3.Money market mutual funds offer bank-like features. Shareholders of these funds are
allowed to write checks against these funds. However, these funds do have restrictions. The
mutual funds specify minimum check amounts such as $250.

Their main economic functions include providing liquidity, lowering the cost of borrowing
money, and pooling the risk associated with lending money.

All of these institutions make money by charging more for loans than what they pay for
deposits, and they are all subject to substantial regulation. Major areas of concern for
regulation include reserve requirements, capital requirements, lending rules, and deposit
rules. For example, in the past, only commercial banks could offer checking accounts, and
savings banks could only offer saving accounts. Those restrictions were relaxed in the
1980s.

Money market mutual funds have been a major force in providing competitive interest rates
to short-term depositors. Technological innovation has been a major force in providing new
services to customers. For example, crediting interest on a daily basis was not feasible
before the advent of modern computer technology.

The Fractional Reserve Banking System


A fractional reserve banking system exists when the amount of reserves banks must keep
on hand is less than the amount of their deposits. In the U.S., banks must keep a fraction of
their assets as bank reserves - cash plus deposits with the Federal Reserve, which is the
nation's central bank. Banks issue loans with the funds that are not held in reserve; in doing
so, they expand the nation's money supply.

The Required Reserve Ratio


The required reserve ratio is the percentage of a particular liability category (to the bank),
such as savings accounts, that must be held as reserves. If someone deposits $10,000 at a
bank and there is a 20% reserve requirement, the bank must keep $2,000 as reserves and
can loan out only $8,000. If the reserve requirement is 10%, the bank could loan out $9,000.
The $9,000 that is loaned out can be deposited at the original bank or at another bank; 90%
of that $9,000, which is $8,100, can then be loaned out. This process continues until the
amount of money supply generated is equal to $10,000 × (1 / .1) = $100,000.

The Actual and Potential Deposit Expansion Multipliers


The potential deposit expansion multiplier is the reciprocal of the required reserve ratio. If
the required reserve ratio is 5% (.05), the potential deposit expansion multiplier is equal to 1
/ .05 = 20.

The actual deposit expansion multiplier is less than the potential deposit expansion
multiplier for two reasons:

·Banks may not loan out all available funds (i.e. they may have excess reserves, which are
reserves that exceed required reserves)

·Recipients of loans may not deposit the proceeds; they may instead decide to hold them as
currency

Goals and Targets of the U.S. Federal


Reserve
What is monetary policy?
Monetary policy is the control of the money supply (and sometimes credit conditions) to
achieve or satisfy macroeconomic goals.

A country's central bank controls the nation's money supply, enacts monetary policy and
acts as a clearinghouse between banks. The Federal Reserve is the central bank in
the U.S.; in Canada, the central bank is the Bank of Canada.
The central bank has three tools to control the nation's money supply:

1. Setting of Reserve Requirements - In general, banks will use their reserves to


make loans and turn a profit. In doing so, they increase the nation's money supply.
Increasing (decreasing) the reserve ratio decreases (increases) the amount of funds
available to loan, thereby decreasing (increasing) the nation's money supply.
2. Open Market Operations - The Federal Reserve can purchase or
sell U.S. government securities on the open market. When they purchase (sell)
government securities, it increases (decreases) the nation's money supply. The
monetary base is equal to bank reserves (vault cash plus reserves held at the
Federal Reserve), plus money in circulation. The nation's money supply is a multiple
of the monetary base. The Federal Reserve's open market operations directly impact
the size of the monetary base.
3. The Discount Rate - The discount rate is the interest rate charged by the Federal
Reserve to banks that borrow money from them. Typically this is done in order to
meet temporary shortages of reserves. Note that banks do not automatically have
the right to do so. An increase (decrease) in the discount rate will discourage
(encourage) banks from letting reserves go to very low levels, thereby tending to
decrease (increase) the money supply.

So if the central bank wishes to pursue an expansionary monetary policy, it will lower
reserve requirements, purchase government securities on the open market and/or decrease
the discount rate.

A restrictive monetary policy implies that the central bank will increase the reserve
requirements, sell government securities and/or increase the discount rate.

Problems Associated with Measuring an Economy's Money Supply


·Changes in Checking Accounts - The introduction of interest-earning checking accounts
and money market mutual funds (some with check-writing privileges) have made M1 money
supply figures for the 1980s and later not comparable to figures for private years

·Debit Cards - Debit cards transfer funds from the cardholder's checking account when
used for purchases and may induce some people to hold less cash.

·Holding of the U.S. dollar Outside of the U.S. - The amount of currency held by people
outside of the U.S. has greatly increased. These holdings are difficult to measure. The
impact is greater on M1 than M2 because currency accounts for a relatively smaller portion
of M2.

· Greater Availability of No-load Mutual (Stock and Bond) Funds - It is now easier for
investors to purchase mutual funds without paying an up-front commission (load). These
holdings are not counted in M1 or M2. Many mutual funds companies let investors cash out
or move their stock and/or bond holdings to a money market account over phone or on the
internet.
Money, Interest, Real GDP, and the
Price Level
I. The Supply and Demand of Money
People hold money:

 To conduct transactions
 For precautionary reasons, such as to meet emergencies, such as unexpected
medical bills
 As a store of value

Holding money has an opportunity cost in the sense that the money could be invested
elsewhere and earn interest. Even if the money is held in an interest-earning checking
account, a higher rate of interest could be earned by purchasing financial instruments such
as bonds.

As the rate of interest goes higher, the opportunity cost of money increases. So as interest
rates go up (down), people will be less (more) willing to hold money.

The supply of money is usually determined by the Central Bank (Canada) or the Federal
Reserve (U.S.) and the targeted supply of money is not directly related to the interest rate.

A graph for the supply and demand for money, as a function of the interest rate, would
appear similar to figure 4.4 on the following page.

Figure 4.4: The Supply and Demand for Money

Note that this demand curve assumes other relevant factors are held constant. If the
quantity of goods produced increases and/or the price level increases, the demand for
money will increase. This causes the demand curve to shift to the right. If economic activity
declines and/or prices go down, then demand for money will decrease.
Changes in the availability of financial instruments are also changing the demand for money
over time. The widespread availability of credit cards has reduced the amount of money that
households need to keep on hand.

Determining Interest Rates


Interest rates are determined by the interaction of the quantity supplied and the quantity
demanded of money. The quantity supplied of money is determined by the actions of the
central bank and the banking system. Suppose that the interest rate is too high in the sense
that the quantity of money supplied is greater than the quantity of money demanded. People
will respond by purchasing bonds, in which case money will be reduced. The greater
demand for bonds will push interest rates down, towards equilibrium.

Short and Long-run Effects of Money on Real GDP


·Short-Run, Anticipated - If individuals correctly anticipate inflation, in the short-run an
expansionary (restrictive) monetary policy will increase (decrease) prices. Real output and
employment will remain the same. Nominal interest rates will increase while real interest
rates will stay the same.

·Long-Run, Anticipated - Expansionary (restrictive) monetary policy will increase


(decrease) the rate of inflation and increase (decrease) nominal interest rates. Real interest
rates, employment levels and real output are not affected by monetary policy.

·Short-Run, Unanticipated - Unanticipated expansionary monetary policy, assuming the


economy is not at full employment, will somewhat increase prices, increase real output and
reduce real interest rates. Unanticipated restrictive monetary policy will increase real
interest rates, decrease the inflation rate, reduce employment and reduce output. This type
of policy is appropriate when the economy is operating at greater than full employment.

·Long-Run, Unanticipated - Expansionary monetary policy will lead to higher inflation and
nominal interest rates while real interest rates, real output and real employment will not be
positively impacted. An important point to remember is that, in the long run, inflation is the
primary effect of expansionary monetary policy.

The Equation of Exchange


The Quantity Theory of Money
The quantity theory of money proposes that the quantity of money and price levels increase
at the same rate in the long run. This concept is demonstrated by the equation of exchange.

The Equation of Exchange


The equation of exchange is comprised of the money stock, M, multiplied by the velocity of
money, V. The velocity of money is the number of times money turns over (spent as part of
a final good or service) during the year.
Therefore, we get the expression:

Formula 4.4

M × V= P × Q = Total Spending or GDP

P represents the price level, and Q represents the quantity of goods and services produced.
This equation is referred to as the equation of exchange. It is the basic equation used
by monetarists - economists who believe that fluctuations in the money supply are the
chief source of fluctuations in real economic output and that the major cause of inflation is
excessive growth in the money supply.

If quantity and velocity are basically constants, increasing the money supply will just lead to
an increase in prices (inflation). The Quantity Theory of Money holds that in the long run,
because quantity and velocity are not changed by the money supply, a percentage increase
in the money supply will lead to a corresponding increase in the price level. However, if
monetary policy can influence velocity or quantity, monetary policy can be useful.

The equation of exchange can be converted into the demand for money function:

Formula 4.5

Md = (P × Q) / V = Y / V

Where Md is the demand for money and Y is nominal GDP. From the monetarist's
viewpoint, the demand for money is related to nominal GDP, not interest rates (the
Keynesian viewpoint).

Inflation
Determining Inflation

Inflation vs. Price-Level


The term price-level refers to the prices that must be paid in order to acquire a basket of
good and services. The phenomenon of inflation refers to a continual rise of the price-level.
When inflation occurs, the purchasing power of a unit of money (the dollar in the United
States) is declining.

The inflation rate is calculated by comparing the price level in one time period to the price
level of a previous period. Suppose the price level is currently 110, and the price level of the
previous year is 100. The annual rate of inflation would then be 10%.

The inflation rate in general can be stated as:


Formula 4.6

Inflation Rate = ((P1 - P0) / P0) X 100

P1 is the price level of the later time period, and P0 is the price level of the previous time
period.

Causes of Inflation

Two main types of impulses for inflation in an economy include:


·Demand-pull - aggregate demand rising more rapidly than aggregate supply

·Cost-push - there is a decrease in aggregate supply

Factors creating a demand-pull inflation include an:

·Increase in government spending

·Increase in the supply of money

·Increase in the price level in the rest of the world - if prices increase in other countries,
residents of those countries will want to buy goods from domestic producers; i.e., exports
will increase

The main factors which induce a cost-pull inflation include an:

·Increase in wage rates

·Increase in raw material costs

Demand-pull inflation represents an increase in aggregate demand, which will shift the
aggregate demand curve to the right. Cost-push inflation will involve the aggregate supply
curve shifting to the left.Both result in higher price levels.

Unanticipated Inflation
Unanticipated inflation in the labor market will cause workers to work for less wages then
what they would knowingly work for. Employers may get higher profits due to the higher
prices. The result will be a transfer of income from workers to employers. There is also a
possibility that employment will be higher than "full employment".

Unanticipated inflation in the financial capital market also begets a transfer of income. In
this case, borrowers gain at the expense of lenders. The amount of borrowing and lending
will not be optimal, as lenders will unwittingly loan out too much funds.

Anticipated vs. Unanticipated Inflation


Inflation that comes as a surprise to most people is called unanticipated inflation. If changes
in price levels are widely anticipated, then that inflation is referred to as anticipated inflation.
In general, steady rates of inflation can be anticipated successfully by economic decision
makers.

There are many harmful consequences to inflation. Some of the consequences include:

 Individuals Apply their Efforts to Protecting Themselves from Inflation Instead of to


Production - People will spend a great deal of time and money acquiring information
about how to protect themselves (and/or profit) from inflation. Capital flows towards
speculative assets such as gold and art objects, instead of productive investments
such as buildings and machinery and the incentive to speculate instead of work
increases.
 Inflation Increases the Risk of Investments - Wild fluctuations in price levels make
forecasting future earnings more difficult; this tend to discourage investment.
 The Information Delivered by Prices is Distorted by Inflation - Some price changes
are restrained by long-term contracts, while others respond quickly to changes in the
general price level.
 Unanticipated inflation can change relative prices. These distorted prices may
provide poor signals to producers and resource suppliers.

Phillips Curve
Tradeoffs Between Unemployment and Inflation (the Phillips Curve)
The Phillips curve depicts an inverse relationship between inflation and the rate of
unemployment. In other words, higher rates of inflation imply lower rates of unemployment.
The relationship is named after the British economist A.W. Phillips, who wrote an influential
article about it.

That inverse relationship held true during the 1960s. During the 1970s, however,
the U.S. economy experienced "stagflation" - high unemployment and high inflation.

Unexpected rises in the inflation rate decrease the "real" wages of workers operating under
long-term employment contracts. This stimulates employment as real-wage costs to
employers are reduced. Underestimates of inflation induce job seekers to take job offers
they may not otherwise take. The job offer given may seem very good (if inflation is not
taken into account) and it will be quickly taken. A worker who understands that inflation is
eroding his or her real wages would not be so quick to take the job offer.

Once works begins to anticipate inflation, there is no long-term reduction in the


unemployment rate. In the short-term, if inflation is higher than expected, there will
temporarily be a reduction in unemployment. If inflation is lower than expected,
unemployment will be higher than normal.

Figure 4.5: Modern Phillips Curve with Expectations


In the graph above, Un is the natural rate of unemployment.

When integrating expectations and the Phillips curve, we find that:

 Expansionary fiscal and monetary policy leads to inflation, without a permanent


reduction in unemployment below the natural rate.
 If inflation is greater (less) than anticipated, unemployment will be below (above) the
natural unemployment rate
 If the inflation rate remains the same (does not increase or decrease), then the
actual rate of unemployment will move towards the natural rate of unemployment.

The following lessons were learned from the work with Phillips curves:

 Expansionary macro policy does not reduce the rate of unemployment, at least in the
long run.
 Stable prices help keep unemployment low - stable prices are low unemployment
are not conflicting goals.

Impacts of Inflation on the Nominal Interest Rate


The nominal interest rate of a bond or loan is simply the stated or named interest rate.
The real interest rate is the nominal interest less current or expected inflation.

If economic participants expect higher inflation, they will alter their economic behavior.
Lenders will be less willing to make loans or will demand higher nominal rates of interest in
order to compensate for the perceived risk of inflation. Borrowers will seek more loanable
funds in anticipation of higher prices. The net result will be higher nominal interest rates.

Increases in the money supply will lead to higher price levels, unless there is a
corresponding increase in real output. Lenders will demand higher nominal interest rates so
as to compensate for the expected inflation.
Fiscal Policy Basics
Basics

What is fiscal policy?


Fiscal policy is the use of government taxation, spending and borrowing to satisfy
macroeconomic goals.

Potential GDP
The GDP that results from an economy operating at full employment with full utilization of
capital is called potential GDP.

A reduction in after-tax wages will occur with the enactment of an income tax. The supply
curve of labor will therefore shift up and to the left. The new equilibrium quantity of labor
hired will be less than what would have occurred with potential GDP. There will be a
"wedge" between before-tax and after-tax wage rates. Taxes on expenditure increase the
size of the "wedge" and further reduce employment.

Keynesians argue that if output is less than what would occur at full employment, fiscal
policy should be used to stimulate aggregate demand.

There are three major ways in which fiscal policy affects aggregate demand:

1.Business Tax Policy - Business taxes can change the profitability of businesses and the
amount of business investment. Lowering business taxes will increase aggregate demand
and business investment spending.

2.Government Spending - Government can directly increase aggregate demand by


increasing its spending.

3.Tax Policy for Individuals - Lowering taxes will increase disposable personal income
and increase consumption spending.

From the Keynesian viewpoint, fiscal policy should be used to increase aggregate demand
when an economy is operating at below full-employment levels. Ideally, the economy will be
guided to output at the level of full employment.

If aggregate demand exceeds aggregate supply and output is at full-employment levels,


fiscal policy should be used to reduce aggregate demand. This will push the economy to a
point of noninflationary equilibrium.

The Supply Side Model is an economic theory holding that bolstering an economy's ability
to supply more goods is the most effective way to stimulate economic growth. Supply-side
theorists advocate income tax reduction because it increases private investment in
corporations, facilities, and equipment.
The Laffer curve shows the relationship between tax rates and tax revenue.

Figure 4.6: The Laffer Curve

This graph shows that as the tax rate increases from zero, the amount of tax revenue
collected will increase. At point T*, however, increases in the tax rate lead to decreases in
the tax revenue collected. High tax rates also produce a loss to society in the sense that
productive economic activity is being discouraged.

Governments would like to be at point T*, because it is the point at which the government
collects maximum amount of tax revenue while people continue to work hard. This would
theoretically be the point at which potential GDP is maximized.

Supply-side economists believe that high marginal tax rates, such as those experienced in
the U.S. in the 1970s, diminished aggregate production without raising substantial amounts
of additional tax revenue. Tax cuts during the 1980s (the Reagan presidency) are believed
to have induced strong increases in supply, particularly with regards to high-income
earners. Supporters of the 2001 U.S. tax cuts, which reduced the top marginal tax rates,
believe that the cuts have increased economic growth through better supply-side incentives.

Tax policy also has consequences at a global level. Ireland has significantly reduced its
personal and corporate tax rates; during the 1990s its growth rate was much higher than the
rest of Europe. There is an association with high European tax rates and slow rates of
economic growth.

Effects of Fiscal Policy


Investment sources include:
·Private saving
·Government saving
·Borrowing from foreigners

Capital markets are influenced by fiscal policy in two ways:


·Government spending and tax policy will generate either a budget surplus or a deficit,
which will in turn mean that the government sector will either contribute towards financing
investment or "crowd out" private investment.
·Tax policy will affect the amount saved. Taxes on interest earned will decrease the
incentive to save and create a wedge between the after-tax interest earned by savers and
the interest rate paid by firms.

Generational Effects of Fiscal Policy


Current fiscal policy impacts the amount of taxes that future citizens will pay. If the
government runs up long-term budget deficits, then future generations will need to pay
higher taxes in order to pay the interest. Similarly, future generations will pay lower taxes if
the government creates budget surpluses. Economists have created systems which
examine the lifetime taxes and benefits associated with generations or age groups. Those
systems are referred to as generational accounting.

A government that chronically runs deficits will, at some point in time, have to address that
imbalance. This fiscal imbalance will need to be addressed with higher tax revenues and/or
reduced government spending.An imbalance is also created when the government benefits
received by one generation exceed the taxes paid by that generation. For example, initial
recipients of Social Security in the United States received far more benefits than they paid
in taxes. Such imbalances are referred to as generational imbalances.Future generations
will need to pay more taxes, or receive less benefits, in order to address this imbalance.
Fiscal policy therefore transfers benefits according to age; it also determines how much
each generation will pay the government.

The Multiplier Effect


The marginal propensity to consume (MPC) is equal to ΔC / ΔY, where ΔC is change in
consumption, and ΔY is change in income. If consumption increases by eighty cents for
each additional dollar of income, then MPC is equal to 0.8 / 1 = 0.8.

The expenditure multiplier is the ratio of the change in total output induced by an
autonomous expenditure change.

investment spending are considered to be autonomous while consumption is not because it is a function of income.

Some consumption is considered to be autonomous. Even with no income, some


consumption will occur (savings will need to be used). So the consumption function could
be expressed as C = α + (β × Y), where α represents consumption that occurs regardless of
income, β is the marginal propensity to consume and Y is income.
Why is there a multiplier effect?
Suppose a large corporation decides to build a factory in a small town and that spending on
the factory for the first year is $5 million. That $5 million will go to electricians, engineers
and other various people building the factory. If MPC is equal to 0.8, those people will
spend $4 million on various goods and services. The various business and individual
receiving that $4 million will in turn spend $3.2 million and so on.

If the marginal propensity to consume is equal to 0.8 (4 / 5), then the multiplier can be
calculated as:

Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

As a result of the multiplier effect, small changes in investment or government spending can
create much larger changes in total output. A positive aspect of the multiplier effect is that
macroeconomic policy can effect substantial improvements with relatively small amounts of
autonomous expenditures. A negative aspect is that a small decline in business investment
can trigger a larger decline in business activity and, thereby, create instability.

The previously mentioned formula for calculating the multiplier is a simplified one. Leakages
(money spent, but not on domestic goods or domestic services) reduce the size of the
multiplier. Examples of leakages include taxes and imports.

Another important point is that the multiplier effect takes time to work; months must pass
before even half of the total multiplier effect is felt. Also, keep in mind that the multiplier
effect can cause idle resources to be moved into production. If unemployment is
widespread, then there should be little impact on resource prices.

Discretionary Fiscal Policy and


Automatic Stabilizers
Discretionary Fiscal Policy
Discretionary fiscal policy is made more difficult due to lags in recognizing the need for
changed fiscal policy and the lags that occur with enacting the changed fiscal policy.
Implementing the modified fiscal policy usually requires legislative action, which takes a
long time to implement. There is a concern that fiscal policy changes may be ill-timed,
however. For example, an expansionary fiscal policy may be enacted when the economy is
already recovering from a recession. Fiscal policy does have an advantage over monetary
policy in the sense that increased government spending leads to an immediate increase in
aggregate demand. The effects of a tax cut may be more moderate and have more of a
time lag because individuals may not immediately spend their increases in disposable
income that resulted from the tax cut.
Ideally, fiscal policy will be used to increase aggregate demand during recessions and to
restrain aggregate demand during boom times. Poorly timed fiscal policy could actually
increase inflation and accelerate declines in the economy when the economy has already
started to slow down.

One difficulty with proper timing is that forecasting economic activity is not an exact science.
There is usually a lag between the time fiscal policy changes are needed and the instance
that the need to act is widely recognized. There can also be a substantial amount of time
between the time of recognition and the time that fiscal policy changes are actually enacted.
Lastly, another difficulty with achieving proper timing is that the impact of a change in fiscal
policy may not be felt until six to twelve months after the change has occurred.

Automatic Stabilizers
Automatic stabilizers, without specific new legislation, increase (decrease) budget deficits
during times of recessions (booms). They enact countercyclical policy without the lags
associated with legislative policy changes. Examples include:

·Corporate Profits - Taxes on corporate profits go up substantially during boom times, and
decline rapidly during times of recession.

·Progressive Income Taxes - Progressive taxation push people into higher income tax
brackets during boom times, substantially increasing their tax bill and reducing government
budget deficits (or increasing government surpluses). During recessions, many individuals
fall into lower tax brackets or have no income tax liability. This increases the size of the
government budget deficit (or reduces the surplus).

· The Unemployment Insurance (UI) Program - This program provides payments to


greater numbers of people as unemployment increases during times of recession. At the
same time, the taxes that contribute to UI will go down as employment decreases. These
two effects will cause the government budget deficit to increase. During boom times, the
program will automatically produce surpluses (or reduce deficits) as fewer benefits are paid
due to lower unemployment and tax revenues increase due to greater employment.

Monetary Policy and Price Level


Stability
Stable Prices vs. Sustainable Growth in real GDP
Price level stability refers to the concept that price levels are stable enough so that people
do not feel compelled to take inflation into account when making economic decisions. Many
economists believe that measured inflation in the range of 0 up to 2 or 3 percent a year is
actually zero inflation. There may be quality improvements in goods that are not reflected in
the official measurement of inflation; this reflects a price level measurement bias.
Price level stability is only a means to a higher goal. That goal is a rising standard of living,
which depends upon sustainable growth in real GDP. Whether or not that growth is
sustainable depends upon other factors such as technological advances, availability of
natural resources, the willingness of people to work, the willingness of people to invest, and
political stability. Monetary policy helps to create a stable environment which favors
investment and saving.

Achieving Price Level Stability


The Federal Reserve can quickly affect short-term interest rates, such as three-month T-
bills and rates on savings deposits. However, the impact of monetary policy on longer-term
interest rates is more moderate and more difficult to predict. Longer-term interest rates are
more influenced by the supply and demand for investment funds, as opposed to monetary
factors. Secondly, the impact of inflation must be taken into account. For example, suppose
an expansionary monetary policy is perceived to be inflationary. The impact of that policy on
longer-term interest rates, such as real estate mortgages, will be to raise them.

Expansionary Monetary Policy


An expansionary monetary policy, if inflationary effects are not anticipated, should lower
interest rates, particularly short-term ones. It will also have the effect of reducing velocity, as
the opportunity cost of holding money is reduced. Eventually the lower interest rates will
induce more personal and business spending to occur so that aggregate demand will
increase. This process could take several quarters. Eventually the increased demand will
cause nominal and real interest rates to go higher, which will increase the velocity of
money. At that point the impact of the expansionary monetary policy will be further
amplified.

Expectations of Monetary Policy


Expectations impact perceptions about inflation and the timing of those perceptions. The
effectiveness of expansionary monetary and fiscal policy with regards to increases in output
and employment is reduced by expectations. The reduction in output caused by restrictive
monetary and fiscal policy will be moderated by expectations, as economic participants will
more quickly anticipate the lowering of overall price levels.

Demand curves for labor and capital slope downward to the right. With other factors held
constant, employers will only hire more workers if real wage rates have decreased and
capital expenditures will increase only if real interest rates have declined.

Expansionary monetary and fiscal policy often assumes that workers will accept lower real
wages and that investors will accept lower real rates of return. It is the willingness of
workers to accept wages that are lower than what they would normally demand, and the
willingness of investors to accept lower real interest rates than normal that causes
employment and real production to increase. Nominal wages and interest rates remain the
same; inflation is doing the job of cutting real wages and interest rates. Therefore, in order
for employment and production to increase, inflation must increase so that real wages and
interest rates can go down. This relationship is described by the original Phillips curve,
which shows that inflation accompanies lower rates of unemployment.

As long as the public does not understand that inflation has increased, the economy can be
moved according to the Phillips curve relationship.

Why would it take time for the public to recognize and adapt to the new rate of
inflation?
One reason is that some workers may not be able to do anything about it. They may be
locked into multi-year labor agreements that do not permit negotiation until the expiration of
the labor agreement. Investors and employees might also be subject to money illusion -
their attention could be focused on their nominal wages and nominal interest rates, and they
may not realize that real wages and interest rates are declining. At some point in time,
however, they will recognize that their real buying power (from wages and interest income)
has gone down.

Also, they may not immediately see that inflation is occurring. Not all prices go up during
times of inflation, so it may hard to see the big picture.

Eventually, the public will understand and adapt to the new inflationary environment and
they will seek raises in wages and interest rates in order to bring them back to their old
income levels. The economy will move to a long-term equilibrium position in which output
and employment return to points where they were before the monetary and fiscal stimulus
occurred. The major change will be that prices will be at a higher level.

This makes sense, as we should not expect major benefits to occur just from printing more
paper money or running larger government deficits!

Expectations essentially reduce the time that government policymakers can fool the public
into accepting cuts in real wage and real interest rates and, therefore, the positive effects of
financial and monetary stimulus are moderated.

New Monetarist vs New Keynesian Feedback Rules


There are two famous new feedback rules for monetary policy. Those rules are:

 The Taylor rule is a Keynesian feedback rule that focuses on short-term interest
rates. The rule takes into account the target inflation rate, the difference between
actual inflation and the target inflation rate, and the difference between real GDP and
potential GDP.
 The McCallum rule is a monetarist rule that emphasizes the growth rate of money.
It states that the Federal Reserve should target a monetary base growth rate equal
to the target inflation rate plus the ten-year moving average of the real GDP growth
rate minus the four-year moving average of the monetary base velocity.

The major differences between the rules are:

·Targeting an interest rate versus monetary growth (as usual for Keynesians versus
monetarists!).
·The Taylor rule provides for a response to fluctuations in real GDP, while the McCallum
rule does not.