BU204 10 Finley Joey Unit 9

Running head: LABOR MARKETS, UNEMPLOYMENT, AND INFLATION & 1

Labor Markets, Unemployment, and Inflation & Inflation, Disinflation, and Deflation

Joey D. Finley

Kaplan University

Macroeconomics

BU204

Fazlul Miah

May 03, 2011

LABOR MARKETS, UNEMPLOYMENT, AND INFLATION & 2

Labor Markets, Unemployment, and Inflation & Inflation, Disinflation, and Deflation

1. Define any key terms that you feel are important in answering the following question as they are defined in the textbook and explain, in your own words what those definitions mean (5 points), and then thoroughly analyze each of the following changes in the market for loanable funds to answer the these questions Use the diagrams below, resizing them as necessary, to illustrate your analysis in explaining what happens to private savings, private investment spending, and the rate of interest if the following events occur. Assume the economy is closed (no transactions are made with foreign countries).

a. Aggregate demand curve: a curve that shows the quantity of goods and services that households, firms, and the government want to buy at any price level.

b. Aggregate supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at any price level.

c. Model of aggregate demand and aggregate supply: the model that most economists use to explain short run fluctuations in economic activity around its long run trend.

d. Equilibrium: where Supply and Demand meet. Equilibrium in the labor market changes as:

i. The capital stock or natural resources increases.ii. The technology increases and

iii. Population and immigration grows.

a. The government reduces the size of its deficit to zero (10 points).

R

Q

E1

R2

Q

E2

Q3

D

D2

SDecrease in government spending


i. Aggregate demand curve shifts left. Aggregate supply curve is constant. Demand shift to left means less demanded at every price.

ii. If the government wants to reduce its deficit to zero, there would be a decline in the want for loanable funds, from D1 to D2, equal to the reduction in the size of the deficit. The graph for a. shows amount Q1, Q2, & Q3 represents the amount by which the government reduces its deficit. Responding to less demand, the interest rate falls from R1 to R2.

iii. The drop in interest rates (R) will increase private investment spending from Q3 to Q2 and decrease private savings from Q1 to Q2 in graph for a.

b. At any given interest rate, consumers decide to save more. Assume the budget balance is zero (10 points).

i. Aggregate demand curve is constant. Aggregate supply curve shifts right. Supply shift to right means more supplied at every price.

ii. If consumers decide to save more, there will be a raise in the supply of loanable funds. That increase is expressed by the rightward shift of the supply curve from S1 to S2. The increase in the supply of loanable funds reduces the equilibrium interest rate from R1 to R2.

iii. Responding to the decreased interest rate, private investment spending would increase from Q1 to Q2 in the graph for b.

R

R2

Q1 Q2

E1

E2


c. At any given interest rate, businesses become very optimistic about the future profitability of investment spending. Assume the budget balance is zero (10 points).

i. Aggregate demand curve shifts right. Aggregate supply curve is constant. Demand shift to right means more demanded at every price.

ii. Increased investment spending at any given interest rate leads to an increase in the demand for loanable funds.

iii. Increase demand for loanable funds shifts the demand curve from D1 to D2 and raises the equilibrium (E1E2) interest rate from R1 to R2. Responding to a higher interest rate, private savings will increase from Q1 to Q2 in the graph for c.

2. Define any key terms that you feel are important in answering the following question as they are defined in the textbook and explain, in your own words what those definitions mean (5 points), and then thoroughly analyze each situation to answer the following questions.

Using aggregate demand, short-run aggregate supplies, and long-run aggregate supply curves, explain the process and causes by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Use the diagrams below, resizing them as necessary, to illustrate your analysis. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output?

i. SRAS curve: 1 of 2 graphically display of the supply-side of the aggregate market.

ii. LRAS curve: The other display long-run aggregate supply curve.iii. Long Run equilibrium: The long run AS coincides with equilibrium

in the labor market. a. There is a decrease in households’ wealth due to a decline in the stock market (15 points).

R1

R2

Q1 Q2

E2

E1


1. 2. 3.

i. Graph 1: Household consumption drops as wealth declines. This decreases spending at any given price level (the AD curve shifts in) and reduces the prices they are willing to pay for goods. The falling price level along with given wages raises the costs of hiring workers and output declines in equilibrium.

ii. Graph 2: Equilibrium price and output drop from E1 to E2. The falling price level combined with fixed wages will raise the relative or real wage as the economy goes into a recession. The relatively low demand for labor in the recession will put downward pressure on the nominal wage rate.

iii. Graph 3: The falling cost of production reduces the prices that firms demand for their production via the SRAS curve shifts right. Wages will fall until the labor market equilibrium return relative wages to their long-term levels. The new long run equilibrium is at E2.

b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases (15 points).

1. 2. 3.

E1

E2

E

E2


i. Graph 1: When households have more disposable income, they increase spending. This shifts out demand for goods and increases the prices they are willing to pay for goods. The higher prices of goods reduce the cost of labor. Falling real wages induce firms to increase production.

ii. Graph 2: The equilibrium moves from E1 to E2. When firms are producing a lot of output, labor demand is high. Wages feel upward pressure, raising costs. The costs of production are passed along to customers which in turn reduces equilibrium demand.

iii. Graph 3: Eventually, wages rise far enough that the excess demand for labor is in equilibrium and real wages return to their equilibrium level and the economy returns to potential output in Graph 3.

3. Define any key terms that you feel are important in answering the following question as they are defined in the textbook and explain, in your own words what those definitions mean (5 points), and then thoroughly analyze each situation to answer the following questions.

An economy in a hypothetical country is in long-run macroeconomic equilibrium when each of the following aggregate demand shocks occurs. What kind of gap—inflationary or recessionary—will the economy face after the shock, and what type of fiscal policies, giving specific examples, would help move the economy back to potential output?

a. A stock market boom increases the value of stocks held by households (10 points).

1. 2.

i. As people see the values of their portfolios increasing, they will increase their spending (the wealth effect). This shifts the AD curve to the right, and will cause and inflationary gap. To close the gap, the government could use contractionary fiscal policies would help move the economy back to potential output.

P1

P2

Q1

Q2

Inflationary Gap Q Q

P2

P3


ii. Increasing the value of stocks cause people to feel richer and results in the economy facing a POSITIVE demand shock in which consumers will spend more and cause an inflationary gap in output from ideal potential output.

iii. The Government should institute a contractionary fiscal policy that involves increasing taxes, reducing transfer payments and reducing spending.

iv. Contractionary fiscal policy decreases aggregate demand to close inflationary Gap

b. Firms come to believe that a recession in the near future is likely (10 points).

1. 2.

i. If firms become concerned about a recession in the near future, they will decrease investment spending and aggregate demand will shift to the left. The economy will face a recessionary gap. Policy makers could use expansionary fiscal policies to move the economy back to potential output.

ii. Because businesses think a recession is coming, they cut back in production to prevent inventories for growing too large and start to lay-off workers. This causes a drop in demand. This causes the economy to face a NEGATIVE demand shock, which will result in lowering of output below ideal potential output, which is a recessionary gap.

iii. The Gov’t should institute an expansionary fiscal policy that involves spending more, decreasing taxes and increasing transfer payments.

iv. Expansionary fiscal policy increases aggregate demand to close Recessionary Gap.

P1

P2

P1

P

Q Q Q Q1

Recessionary


c. Anticipating the possibility of war, the government increases its purchases of military equipment (10 points).

1. 2.

i. If the government increases its expenditures, the aggregate demand curve will shift to the right. The economy will face an inflationary gap. Contractionary fiscal policies can be used to move the economy back to potential output. The government would have to decrease its acquisitions of nondefense goods and services, increase taxes or trim down transfers.

ii. If the government starts purchasing war goods, this will increase the total demand within the economy. The economy will experience a POSTIVE demand shock, resulting in an inflationary gap, where output is above ideal potential output.

iii. The Government should institute a contractionary fiscal policy to “cool” the economy, by reducing spending, increasing taxes, and decreasing transfer payments.

d. The quantity of money in the economy declines and interest rates increase (10 points).

1. 2.

i. Higher interest rates rise will cause investment spending to decrease and the aggregate demand curve to shift to the left. A recessionary gap will result. Policy

P1

P2

P1

P2

Q1 Q2 Q QInflationary Gap


makers could use expansionary fiscal policies to move the economy back to potential output.

ii. If the supply of money is too small within the economy and interest rates rise, then the people will have less money with which to demand products and services. This will result in lower demand. The economy will experience a NEGATIVE demand shock where borrowing becomes more expensive and difficult, thereby reducing spending and causing a decline in output below ideal potential output, a recessionary gap.

iii. The Government should institute an expansionary fiscal policy that involves increasing spending, decreasing taxes, and increasing transfer payments

4. The table below shows the United States components of M1 and M2 in billions of dollars for the month of December in the years 1998 to 2007 as published in the 2008 Economic report of the President.

Year Currency in

circulation

Traveler's checks

Checkable deposits

Money market

funds

Time deposits smaller

than $100K

Savings deposits

M1 M2 Currency in

circulation as a

percentage of M1

Currency in

circulation as a

percentage of M2

1998 $460.5 $8.50 626.50 $728.9 $952.40 $1,605.0 $1,095.5 $4,381.8 42.04% 10.5%1999 517.8 8.60 596.20 819.70 956.80 1,740.30 1,122.60 4,639.40 46.13 11.162000 531.2 8.30 548.00 908.00 1,047.60 1,878.80 1,087.50 4,921.90 48.85 10.792001 581.2 8.00 592.60 962.30 976.50 2,312.80 1,181.80 5,433.40 49.18 10.702002 626.3 7.80 585.60 885.30 896.00 2,778.20 1,219.70 5,779.20 51.35 10.842003 662.5 7.70 635.90 777.4 818.70 3,169.10 1,306.10 6,071.30 50.72 10.842004 697.6 7.50 671.20 697.1 829.90 3,518.30 1,376.30 6,421.60 50.69 10.912005 723.9 7.20 643.40 699.90 995.80 3,621.40 1,374.50 6,691.60 52.67 10.822006 748.9 6.70 611.40 799.40 1,170.40 3,698.60 1,367.00 7,035.40 54.78 10.542007 759.0 6.30 599.20 976.10 1,216.80 3,889.80 1,364.50 7,447.20 55.62 10.29

For a., b., c., & d., you may insert a completed Excel spreadsheet with your answers, if you wish.a. Complete the table by calculating M1 (5 points), b. Calculating M2 (5 points), c. Calculating currency in circulation as a percentage of M1 (5 points), and d. Calculating currency in circulation as a percentage of M2 (5 points). e. Examining the following three charts and your completed table, what trends or patterns in:

- M1, - M2, - Currency in circulation as a percentage of M1 - Currency of circulation as a percentage of M2 (5 points)?

f. What might account for these trends (10 points)? i. M1 consists of currency in circulation, traveler’s checks, and

checkable deposits. M2 consists of M1 plus money market


funds, time deposits, and savings deposits. From 1998 to 2007, there is no obvious trend in M1. Over the entire period, M1 grew by $269 billion (or 25%) but was essentially stable from 2004 to 2007; all of this growth occurred between 1998 and 2004. There is, however, a clear upward trend throughout the period for M2, which grew by $3,065 billion (or 70%) from 1998 to 2007. Currency as a percentage of M1 grew from 42.0% to over 55% from 1998 to 2007, but currency as a percentage of M2 remained relatively constant, varying from a low of 10.2% in 2007 to a high of 11.2% in 1999. The increase in currency as a percentage of M1 could reflect increased use of credit cards, with a corresponding reduction in the importance of traveler’s checks and checkable deposits. Yet, since currency as a percentage of M2 did not change, it could also reflect a shift from checkable deposits to money market funds, time deposits, and savings deposits.

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007$0.0

$100.0

$200.0

$300.0

$400.0

$500.0

$600.0

$700.0

$800.0

M1 components

$ in CircTrav checkscheck acts

Billi

ons o

f $

Currency in circulation as a percent of M1 has been increasing over the ten year period, but has been relatively stable as a percent of M2.


1998 1999 2000 2001 2002 2003 2004 2005 2006 2007$0.0

$500.0$1,000.0$1,500.0$2,000.0$2,500.0$3,000.0$3,500.0$4,000.0$4,500.0

M2 components compared to $ in Circulation

$ in circM1Sav actsTime Dep CD's$ Mkt funds

Billi

ons o

f $

Looking at M1, the amounts in travelers’ checks has remained stable at a relatively small amount over the ten years of data. However, comparing the actual amount of currency in circulation to the amounts in checking accounts, we see that, in the first two years more money was in checking accounts than in cash. Then, for five years, both were very close to each other. Finally, in the last three years currency in circulation has been increasing while the amounts in checking accounts have been decreasing. The trend is that people are holding more money as cash and less as deposits in checking accounts.

1998 1999 2000 2001 2002 2003 2004 2005 2006 20070.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

Currency in Circulation as a % of M1 & M2over 10 years

$ in Circ as % of M1$ in Circ as % of M2

perc

ent

Looking at M2 and comparing its components to the currency in circulation, we see that the total of M1, the time deposits (cd’s) and money market funds have shown only modest growth over the ten year period, but money in savings accounts has grown by over 240 percent. This means that people are saving substantially more money in regular savings accounts, especially from the year 2000 through 2007.


5. Considering the flow of money throughout a country’s economy and the importance of the proper level of money supply, answer the following questions.

a. Discuss how money is created within the banking system (15 points) 1. In the United States, we operate under a fractional reserve system. This means that a

bank is only required to keep a fraction (approximately 10%) of its deposits as reserves (cash on hand or deposits with the Federal Reserve). The rest it can use to make loans. The 10% is called the reserve ratio.

2. So let's say a bank gets a new deposit of $10,000. It keeps $1,000 on hand and loans out the other $9,000. Now the person getting the loan deposits the $9,000 in his bank. This bank now has $9,000 of new deposits to make loans, so it can loan out .9 x $9,000 or $8,100. Mathematically if all banks loan out their excess reserves and all loanees deposit their loans the banking system is capable of creating $10,000/.10= $100,000 or 10 times the initial deposit. This is called the money multiplier.

3. Money is deposited into checking accounts (checkable deposits), savings accounts, and certificates of deposit accounts (time deposits). Banks must keep, as reserves, at least ten percent of the checkable deposits on hand in their vault each night, on account with the Federal Reserve, or some other bank, in case some depositors wish to withdraw some of their money in cash. Banks can loan out the remainder of the checkable deposits, savings account amounts and time deposit amounts to borrowers. Many of those borrowers will in turn use that borrowed money to make purchases from others who will ultimately deposit that “borrowed” money back into banks. Now those banks, after keeping ten percent of their checkable deposits are now able to re-lend that same money again. And so the cycle continues, with each cycle of borrowing amounting to the banks “creating” new money as loans from earlier borrowed money. All the while, the amount of money deposited in banks at each cycle is counted in the money supply. Thus banks “create” money out of nothing.

b. Discuss how in the United States, the Federal Reserve uses monetary policy to control the money supply. (15 points)

1. Setting the reserve requirements. If the Fed wants to expand the money supply it can lower the reserve ratio and thus change the money multiplier. Lowering it expands the money supply; raising it contracts it.

2. The Fed can also raise or lower the discount rate, which is the rate it charges banks to borrow reserves. If it sets the rate high, it discourages banks from borrowing reserves to make loans and tends to contract the money supply. if it lowers the rate, the reverse happens.

3. The Fed also conducts what is called open market operations which is buying or selling government securities on the open market. When it buys securities, it increases the money supply, as the person selling to the Fed deposits the check in his bank and now the banking system has reserves to make additional loans. When it sells them it decreases the money supply, as it deposits the buyers check and now his bank has fewer reserves with which to make loans.Finally, although it does not control it directly, the Fed sets targets for and tries to influence the Federal Funds rate, which is the rate that banks charge each other to


borrow excess reserves. A high rate decreases the money supply; a low rate increases it.

4. The Federal Reserve (FED) is a quasi governmental organization, not under the control of either congress, or the President, but is responsible for regulating member banks and controlling the amount of money in the economy so as to encourage stable growth of the economy and full employment.

5. The federal funds rate is the TARGET rate set by the FED that it wishes banks to not exceed when making overnight loans to other banks, for the purpose of meeting overnight minimum reserve requirements.

6. The Discount rate is set slightly higher than the target federal funds rate and is the rate at which banks can borrow directly from the FED to meet the bank’s reserve requirement for overnight. If a bank tries charging another bank an interest rate higher than the target federal funds rate, the borrowing bank can say “No thanks, I’ll just borrow directly from the FED.”

7. Monetary policy is the FED’s tool to control the size of the total money supply in the economy. If the money supply is too large, then the economy will likely go into an inflationary period. If the money supply is too small the economy is likely to slip into a recession, or not grow. The FED is tasked with controlling the money supply so that the economy has steady growth and full employment.

8. These two interest rates become the floor interest rate around which banks “build” their retail loan interest rates for various categories of borrowers and various types of loans. When the FED changes the TARGET federal funds rate and the Discount rate, banks then make appropriate changes to the rates they charge customers for new loans. The higher the FED sets these two rates, the higher will be the bank new loan interest rates for all categories of loans and customers. Likewise, when the FED lowers these two interest rates, banks will follow suit by lowering their new loan interest rates.

9. The FED changes interest rates, by changing the target federal funds rate and the discount rate, to change the size of the money supply. Higher interest rates mean a smaller money supply because fewer people and businesses will want to borrow money at the higher interest rates. Fewer loans will mean less money “created” by banks and a smaller money supply. On the other hand, lower interest rates means a larger money supply, because at lower interest rates more people and businesses will be borrowing more money. More loans will mean more money “created” by banks and a larger money supply.


6. Your spouse, or someone else very close to you, has brought you a magazine article on the economy that has the following five graphical depictions of the state of our economy. Knowing that you have just completed an economics course at Kaplan, they ask you what each one means. For each of the following graphs, write a paragraph briefly, but thoroughly, explaining what you would tell that person about what that graph means and why it is important. (Each paragraph is worth a maximum of 6 points, for a total of 30 points.)

1. Gross Domestic Product

Explanation:So this is the chart showing the quarterly points of the United States’ Gross

Domestic Product up till summer of last year, 2010. It shows the increasing amount until late

2007 just before the crash and impending recession, until spring of 2009. By definition it was not

a depression, but truly a recession. Recently the GDP has become an increasing curve again and

looks to continue to go that way.


2. Components of Gross Domestic Product

Explanation:

This chart shows the amounts in each of the Components of Gross Domestic

Product. The formula being GDP= C + I + G + X – IM. This chart shows all the money the

United States government has spent up to the 2nd quarter of 2010 from 2005. The X –IM is the

difference between the money made from exports sold outside the US and the money spent

buying imports. The C, personal consumption expenditures is money that all US citizens had

spent. The I, gross private domestic investments is the amount of money that citizens had put

into investment type deal.

The yellow blocks above each component indicates the recession time to express

the spending in each component during that recession time frame December 2007 to June 2008.

Spending did go down but came back up after fear had gone away and safety had been ensured

of the US economy, mostly by Obama being elected President of the US.

3. Taxes, Surpluses/Deficits & National Debt


Explanation:

This chart shows the comparison between the US GDP and the US taxes,

surpluses, deficits, and national debt. Each year from 1996 till 2007 the GDP has increased

without fail. Even through the recession the GDP increased. This chart is showing the years,

1998-2001 that the taxes collected were more than what was spent overall. This can be attributed

by the taxes cuts that were made in 1997 but since the US had been so used to high taxes, they

didn’t spend much for quite awhile. Considering September 11, 2001 having a great impact on

the US’s response to increasing the US’s economy to show Al Quieda that they had not fully

beaten down the US.

4. Consumer Price Index


Explanation:This chart expresses the US consumer price index showing how the recession affected

prices of goods and services in the US. The rate of increase in the CPI slowed again in 2010 as

the December to December increase fell from 2009 to 2010. A deceleration in the gasoline index

accounted for much of the slowdown, as it increased in 2010 after rising very much in 2009. The

index for household energy, which declined in 2009, rose in 2010 as increases in the indexes for

fuel oil and electricity more than offset a decline in the natural gas index. The energy index as a

whole, rose in 2009, increased more again in 2010.


5. Unemployment Rate

Explanation:

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BU204 10 Finley Joey Unit 9

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