Post on 22-Dec-2015
transcript
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SENIOR OUTCOMES SEMINAR
(BU385)
ECONOMICS (cont)
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BASIC CONCEPTS IN ECONOMICS II
•Nominal, real, and potential GDP
•Recessions
•Types of unemployment•Standard stabilization policy versus Supply-side Economics
•Growth policy
•Equilibrium of aggregate demand and supply
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BASIC CONCEPTS IN ECONOMICS II
•Real interest rate and real wage
•Inflation
•Presence and absence of trade-offs between inflation and unemployment
•Fiscal policy
•Monetary policy
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Gross Domestic Product (GDP)
• Final goods and services• Nominal and real• Domestic economy• Produced over a year
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Gross National Product (GNP):
GDP - + = GNP
Final goods & services produced
by foreign
producers
Final goods & services produced
by Americanproducers
abroad
For the U.S. economy, GDP ≈ GNP
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Deflators of GDP
Consumer Price Index (CPI) = Nominal GDP/Real GDP
More comprehensive deflator =
Consumer Price Index (CPI) + Producer Price Index (PPI)
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Logic of Computing Real GDP
Step 1. Compute Nominal GDP based on statistics of sales of final goods and services in market (current) prices
Step 2. Compute a deflator
Step 3. Compute Real GDP = Nominal GDP/ Deflator
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Logic of Computing Real GDP
The essence of the logic:
Only Nominal GDP is a directly observable variable.
Deflators and Real GDP are not directly observable variables. They are constructed based on the statistics of Nominal GDP.
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Difficulties with understanding deflators and real GDP
stem from the fact that elements of deflators and real GDP are not physically observable. They are economic models fitted by real-life statistics.
In sharp contrast, elements of nominal GDP are physically observable. A new edition of the old textbook, published in 2007, is a part of 2007 nominal GDP. However, one cannot physically observe this new edition when it is transformed – through deflation – into a part of 2007 real GDP
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Potential GDP
is a hypothetical real GDP produced under 4% unemployment and about 85% utilization of production capacities.
Potential GDP Actual real GDP
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The idea behind potential GDP
It is believed that the 4% unemployment rate is neutral towards inflation and recession:• it is high enough to prevent inflation• it is low enough to prevent recession.
Neutrality means that under 4% unemployment rate chances of inflation and recession are 50:50.
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The idea behind potential GDP
Neutrality means that under 4% unemployment rate chances of inflation and recession are 50:50.
Employment at 4% unemployment rate is called full employment
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Recessions
• Units of measurement: real GDP• Time units: quarters• Dynamics: reduction of absolute value of real GDP during a quarter
Definition:Recession is reduction of absolute value of real GDP during three consecutive quarters
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Interpretation of recessions
• Negative growth of real GDP.
• This negative growth can coexist with positive growth of nominal GDP.
• Elimination of surplus production capacities. These capacities are surplus relative to existing demand.
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Interpretation of recessions (cont)
• Elimination of surplus capacities tends to produce cyclical unemployment.
• In the U.S. economy, recessions tend to be progressively less harmful.
• Recessions happen in spite of all-out efforts to prevent them.
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Types of unemployment
Frictional: people who are fired/left on their own possess marketable skills, whichmake finding their new employment virtually assured.
At any moment of time (except recessions), approximately 50% of unemployed Americans
are frictionally unemployed.
Frictional unemployment is a major vehicle of mobility on the labor market.
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Types of unemployment
Structural: people who are fired because their functions are either eliminated or fulfilled through automated processes. Their skills are not marketable, and finding new employment is extremely difficult.
Due to their age, most of structurally unemployed experience major difficulties with acquisition of new skills.
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Structural unemployment
At any moment of time, structurally unemployed comprise between 25 and 40% of
unemployed Americans.
Structural unemployment is an important positive sign of economic development. However, on a family/personal level, structural unemployment is close to a tragedy.
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Cyclical unemployment
results from elimination of surplus capacities during recessions. For people with marketable skills, it could take a form of frictional unemp-loyment. For people without marketable skills, it could take a form of structural unemploy-ment.
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Stabilization policy
represents government programs whose goals are • to keep inflation at bay• to soften recessions.
Standard stabilization policy is implemented through increase/decrease in aggregate demand due to increasing/decreasing government expenditures.
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Standard stabilization policy for fighting inflation
P
AD, AS
P is absolute price level =deflator of GDP = index of inflation
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Standard stabilization policy for softening recession
P
AD, AS
P is absolute price level =deflator of GDP = index of inflation
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Trade-off between inflation and unemployment in the short run when
AS curve is relatively flat
P
AD, AS (real GDP=G)
P2
P1
G1 G2
Increase in inflation
P1 to P2
Increase in employment
G1 to G2
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Trade-off between inflation and unemployment in the long run
when AS curve is steep
P
AD, AS (real GDP=G)
P2
P1
G1G2
Increase in inflation
P1 to P2
Increase in employment
G1 to G2
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Trade-off between inflation and unemployment is
• Favorable in the short run when the AS curve is relatively flat
• Unfavorable in the long run when the AS curve is steep.
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Reagan’s supply-side alternative to standard stabilization policy
P
AD, AS (real GDP=G)
P1
P2
G1 G2
Decrease in inflation
P1 to P2
Increase in employment
G1 to G2
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Reagan’s supply-side alternative to standard stabilization policy (cont)
• Rightforward shift of AS curve is achieved through accelerated investments
• Accelerated investments are achieved through decrease in taxes and accelerated depreciation
• Supply-side alternative is based on the idea that changes in fiscal policy strongly influence
economic behavior
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Final results of Reagan’s supply-side alternative: increased employmentincreased incomes shift of AD curve rightward
P
AD, AS (real GDP=G)
P1
P2
G1 G2 G3
Increase in inflation
P2 to P1
Increase in employment
G2 to G3
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Final results of supply-side alternative: inflation remains on the previous level,
employment significantly increases
P
AD, AS (real GDP=G)
P1
P2
G1 G2 G3
Increase in inflation
P2 to P1
Increase in employment
G2 to G3
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Growth policy
An elementary description of the process of economic growth is given by production function
Yt=F (Kt, Lt, Ηt),
where Yt:= real GDP at year t, Kt :=fixed capital,Lt :=hours worked, Ηt:= technological progress (residual), t:=consecutive years.
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Growth policy
stimulates accumulation of Kt, increase in Lt, and acceleration of Ht such that Yt in production function
Yt=F (Kt, Lt, Ηt)
grows on average about 4% per year.
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Equilibrium of aggregate demand and supply
P
P*
AD, AS (real GDP)
AD(P*)=AS(P*)
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iR = iN – E[Inf],
where iR:=real interest rate,
iN:=nominal interest rate,
E[Inf]:= expected inflation
Real interest rate
Real interest rate is a price of credit adjusted for expected inflation
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Real wage rate
wN:=nominal wage rate (i.e. wage per hour)
wR:=real wage rate
wR= wN/CPI
Real wage measures the purchasing power of nominal wage
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Inflation
Inflation is a persistent increase in the absolute price level
Main causes:
• Excess demand (demand inflation)
• Excessive increase (wage inflation) in wages
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Inflation
Main consequences:
• Introduces arbitrariness into movements of relative prices deformations in investment processes arbitrariness in distribution of income from investments
• Very quickly becomes unmanageable and explosive
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Inflation
Main consequences (cont):
• Unmanageable and explosive inflation creates different expectations of the strength of inco-ming inflation between borrows (investors) and lenders (institutions of the saving system).
• These different expectations prevent signing of contracts between borrows and lenders b/c they cannot agree on a “fair” amount of nomi-nal interest rate charged for a loan.
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Inflation
Main consequences (cont):
• If the lending process by the U.S. saving system to the U.S. businesses is interrupted, the further development of the American industry is most seriously jeopardized. Reason: loans are the cheapest form of financing
the most popular form of financing of Ameri-
can businesses (up to 45-50% of all new financing).
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Inflation
Main consequences (cont):
• People on fixed income without adjustment to inflation suffer the most. This alone is a shame for any nation.
• Purchasing power (= exchange rate) of national currency is sharply reduced. Falling inflows of new capital to the country further reduce financing of businesses.
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Fiscal policy deals with taxation
of businesses & population
• Secure financing of the government budget. Expenses from this budget finance rightward shifts of AD curve (stabilization policy).
• Redistribute income in pursuit of some ideal of fairness. Currently, upper 50% of American households contribute around 90% of all tax recites. Upper 5% contribute around 30%.
Major goals:
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Monetary policy deals with regulation of the quantity of money in the domestic economy
• Emission of new banknotes by the government
• Issuance of new loans by banks through the creation of additional deposits
Two major factors of the quantity of money in the economy:
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Issuance of new loans by banks through the creation of additional
deposits
Open-market operations are the most powerful levers Fed uses to induce banks to increase lending during recessions and decrease lending during booms
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Equilibria on the market for money
iN
MS, MD
i*
i2
i1
i*initial equilibrium
I1 equilibrium after Fed induced banks to contract lending
I2 equilibrium after Fed induced banks to increase lending