Topics and percentages• 8-12% Basic Economic Concepts• 12-16% Measurement of Economic Performance• 10-15% National Income and Price Determination• 15-20% Financial Sector• 20-30% Inflation, Unemployment, and Stabilization
Policies• 5-10% Economic Growth and Productivity• 10-15% Open Economy: International Trade and Finance
8-12% Basic Economic Concepts
A. Scarcity, choice, and opportunity costsB. Production possibilities curveC. Comparative advantage, absolute advantage, specialization, and exchangeD. Demand, supply, and market equilibriumE. Macroeconomic issues: business cycle, unemployment, inflation, growth
Production Possibilities• Assumptions:
• Full Employment• Fixed Resources and Technology
• Movements• Along curve shows opportunity cost• Outward shift illustrates economic growth• Inward shift indicates destruction of resources
• Producing Capital Goods will lead to greater economic growth than producing consumer goods. (Butter will lead to more growth than guns)
Production Possibilities Graph
Capital Goods
Consumer Goods
A
B
CD
E
Points A,B,C, are efficient pts.Point D is underutilizationPoint E is economic growth
May Lead to mostFuture growth
May Lead to mostFuture economic growth
F.E. F.E.1
Supply and Demand Factors
• Demand Changes when:• Income changes• Related Products, complements and substitutes,
(price or quality change)• Expectations (future price change)• Consumers (more or less added)• Tastes, Fads, Preferences change
Demand Increase: As Demand Increases, Price and Quantity Increase as well.
P1
P2
Q1 Q2
S1
D1
D2
Price
Quantity
Demand Decrease: As Demand Decreases, Price and Quantity decrease as well
D1
D2
S1
P1
P2
Q1Q2
Price
Quantity
Supply Factors
• Supply Changes When:• Input prices change (resources and wages)• Government (tariffs, quotas, and subsidies)• Number of sellers change• Expectations (about price and product
profitability change)• Disasters (weather, strikes, etc..)
Supply Increase: As Supply Increases, Quantity Increases, but Price Falls.
Price
QuantityQ1 Q2
P1
P2
S1S2
D1
Supply Decrease: As Supply Decreases, Quantity Decreases, but Price Increases.
Price
Quantity
S1
S2
D1
P1
P2
Q1Q2
Comparative Advantage• A nation should specialize in producing goods in which it has a
comparative advantage: ability to produce the good at a lower opportunity cost.
Example:Cheese Wine
Spain: 2 pounds 2 Cases
France 2 pounds 6 Cases
Spain should produce cheese (1C = 1W)
France should produce wine (1W = 1/3C)
:
Currency Terms• AppreciationAppreciation: Currency is increasing in
demand (stronger dollar)• U.S. Currency will appreciate when more
foreigners: travel to the U.S., buy more U.S. goods or services, or buy the U.S. dollar to invest in bonds
Currency Terms• DepreciationDepreciation: Currency is decreasing in
demand (weaker dollar) Being SUPPLIED in exchange for other currency.• U.S. Currency will depreciate when fewer
foreigners: travel to the U.S., buy fewer U.S. goods or services, or sell the U.S. dollar to invest in their own bonds
15
Business Cycles• The increases and decreases in Real GDP
consisting of four phases:• Peak: highest point of Real GDP• Recession: Real GDP declining for 6 months• Trough: lowest point of Real GDP• Recovery: Real GDP increasing (trough to peak)
16
Business Cycle
Peak -- Greatest spending and lowest unemployment. Inflation becomes a problem.
Contraction/Recession -- Reduction of spending levels and increasing unemployment. Some cyclical unemployment begins.
Trough -- Least spending and highest unemployment Expansion -- Spending increases and unemployment
decreasesWe want to avoid extreme inflation and extreme
unemployment. We want stability!
Full Employment
17
The two big problems…The two big problems that plague the economy are:
INFLATIONINFLATIONUNEMPLOYMENTUNEMPLOYMENT
• People generally prefer steady, stable growth to large “ups” and “downs.” Therefore, government policies, both fiscal and monetary (see later sections), are aimed at flattening the business cycle.
• The government wants not only to stimulate the economy when it’s slow, but also to slow it down when it’s growing too quickly.
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12-16% Measurement of Economic Performance
A. National income accounts1. Circular flow2. Gross domestic product3. Components of gross domestic product4. Real versus nominal gross domestic product
B. Inflation measurement and adjustment1. Price indices2. Nominal and real values3. Costs of inflation
C. Unemployment1. Definition and measurement2. Types of unemployment3. Natural rate of unemployment
Circular Flow of Economic Activity
• Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses.
• Businesses demand household resources and supply goods and services to the product (factor) market.
20
GDP (Gross Domestic Product): The total dollar (market) value of all final goods and services produced in a given year.
Expenditure Formula:
• Consumption (C) + • Business Investment (I) +• Government Spending (G) + • Net Exports (Xn)
Gross Domestic Product
GDP: What Counts:• Goods Produced but not Sold (I)• Goods produced by a foreign country
(Japan) in the U.S. (Honda, Toyota)• Government spending on the military• Increase in business inventories
GDP: What DOES NOT count:
• Intermediate Goods (Tires sold by Firestone to Ford)
• Used Goods• Non-Market Activities (Illegal, Underground)• Transfer Payments (Social Security)• Stock Transactions
Shortcomings of GDP: Leading to GDP being understated.
• Nonmarket activities: (services of homemakers) does not count.
• Leisure: Does not include the value of leisure.
• Does not include improvements in product quality.
• Underground economy
GDP: Overstated• Includes damage to the environment
• Includes more spending on healthcare-Americans being unhealthy.
• Includes money spent to fight crime-more police officers, more jails, etc…
Real GDP• Real GDP= Nominal GDP adjusted for
inflation.• Calculation:
• Real GDP = Nominal GDPPrice Index in Hundredths( deflator)
Example: U.S. 2005 Real GDP= $12,4558 (billions)
1.1274 (based on 2000)
$11.048 Trillion
Real GDP Per Capita
• Most commonly used to compare and measure each country’s standard of living and overall economic growth.
• Real GDP/Nation’s Population
28
InflationInflation• Rise in the general level of prices• Reduces the purchasing power of money• Measured with the Consumer Price Index (CPI)
• Reports the price of a market basket , more than 300 goods that are typically purchased by an urban household
Calculating Inflation
• CPI in Recent Year – CPI in Past YearDivided by CPI in Past Year
(Number then Multiplied by 100)
Example: 2002 CPI = 179.9 2001 CPI = 177.1
Rate of Inflation: 179.9-177.1 = 1.58%177.1
Types of InflationTypes of Inflation
• Demand Pull InflationDemand Pull Inflation: ‘too much money chasing too few goods.”
• AD Curve will shift to the right, resulting in a higher Price Level and greater Output (until reaching Y*
• Cost-Push InflationCost-Push Inflation: Major cause is a supply shock-OPEC cutting back on oil production
• AS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.
Real and NominalNominal Terms• Real Income = Nominal Income
Price Index (Hundredths)
• Real Interest Rate = Nominal Interest Rate – Inflation Rate
• Nominal Interest Rate = Real Interest Rate + Inflation Premium
(anticipated inflation)
InflationInflation: WinnersWinners & LosersLosers
• WinnersWinners:• Debtors who borrow money that will be repaid with
“cheap” dollars.• Those who have anticipated inflation
• LosersLosers:• Savers (especially savings accounts)• Creditors (Banks will be repaid with those “cheap”
dollars• Fixed-Income Recipients (retirees receiving the same
monthly pension)
33
UnemploymentUnemployment• Calculation: Number of Unemployed
Labor Force
(Multiplied by 100 to put as a %)
The Labor Force is the total of employed and unemployed workers.
U.S. unemployment should be about 5%
EmployedEmployed• You are considered to be employed if:
• You work for 1 hour as a paid employee (so part-time workers count)
• You are temporarily absent from work (illness, strike, vacation)
• You work 15 hours or more as an unpaid worker (family farms are common)
UnemployedUnemployed
• Must be looking for work (at least 1 attempt in the past 4 weeks)
• Are reporting to a job within 30 days• Are temporarily laid off from their job
Not In Labor ForceNot In Labor Force
• A person who is not looking for work:• Full-time students• Stay at home parents• Discouraged workersDiscouraged workers: those who have given up
hope of finding a job.• Retirees
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UnemploymentUnemployment• 100% of the people will never be employed, so the
government considers 4-6% unemployment to be “full employment.”
• Types of Unemployment• Frictional - temporary and unavoidable• Structural - results from changes in technology
or a business restructure (ex. Merger)• Seasonal- occurs when industries slow or shut
down for a season • Cyclical - results from a decline in the business
cycle.We can never be at Full Employment if there is
any percentage cyclically unemployed.
38
10-15% National Income and Price Determination
A. Aggregate demand1. Determinants of aggregate demand2. Multiplier and crowding-out effects
B. Aggregate supply1. Short-run and long-run analyses2. Sticky versus flexible wages and prices3. Determinants of aggregate supply
C. Macroeconomic equilibrium1. Real output and price level2. Short and long run3. Actual versus full-employment output4. Economic fluctuations
Consumption and Saving
• As income increases, both consumption and savings will increase.
• The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption.• Wealth (financial assets)• Expectations about future prices and income• Real Interest Rates• Household Debt• Taxes
Marginal Propensities
• Marginal Propensity to Consume (MPC) and the Marginal Propensity to save (MPS) must equal 1.
• The MPS is used to derive the spending multiplier, which equals: 1_
MPS
If the MPS is .2, the spending multiplier is 5.
Any increase in spending must be multiplied by 5 to determine the overall increase in Real GDP.
Aggregate DemandAggregate Demand
AD (C + I + G + X)
PriceLevel
Real GDP
Downward sloping:1. Real-Balances Effect: change in purchasing power
2. Interest-Rate Effect: Higherinterest rates curtail spending
3. Foreign Purchase Effect: Substitute foreign products for U.S. products
Aggregate DemandAggregate Demand
• Determinants of AD:• C + I + G + Xn (Yes, its GDP)• An increase in any of these, due to lower interest rates
or optimism will increase AD and shift the curve to the right.
• A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left
Aggregate Demand DeterminantsAggregate Demand Determinants
• Consumption• Wealth• Expectations• Debt• Taxes
• Investment• Interest Rates• Expected Returns
• Technology• Inventories• Taxes
• Government• Change in Gov. spending
• Net Exports• National Income Abroad• Exchange Rates
Aggregate Supply Factors:Aggregate Supply Factors:
• R: resource prices (The CELL/ wages and materials, as well as OIL)
• E: environment [legal-institutional] (Taxes, Subsidies, more regulation)
• P: productivity (better technology)
Aggregate SupplyAggregate Supply
• Short Run:• Assumes that nominal wages
are “sticky” and do not respond to price level changes.
• Is Upward sloping as businesses will increase output to maximize profits
• Generally considered to be a year or less.
• Long Run:• Curve is vertical because the
economy is at its full-employment output.
• As prices go up, wages have adjusted so there is no incentive to increase production.
• Generally considered to be longer than a year.
Aggregate Supply Graph
Price Level AS
Recession Growth
InflationShort Run Long Run
Y*
Extended vertical lineIllustrates the LRAS andY* (Full-Employment)
Real GDP
Another look as AS
PL
RGDP
PL
Y*
LRASSRAS
AD
Changes that lead to a new equilibrium on the left of LRAS = Recession
Changes that lead to a new equilibrium on the right of LRAS = Inflation (AKA “an overheated economy”)
NOTE!!• For the AP exam, assume that there are only two
determinants that simultaneously affect BOTH short term aggregate supply and aggregate demand• business tax changes and • foreign currency changes.
• A change in business taxes shifts AD and AS in the same direction
• A change in FX sends both curves in the opposite directions.
Demand-Pull InflationDemand-Pull Inflation
AD1 (C + I + G + X)
AD2
AS
Price Level
Real GDPY*
P1
P2
Cost-Push InflationCost-Push Inflation
Y*Y
P1
P2
Price Level
Real GDP
AD1 ( C + I + G + X)
AS1
AS2
51
Demand-Pull InflationDemand-Pull Inflation
vs.
Cost-Push InflationCost-Push Inflation
52
DEMAND-PULL INFLATIONDEMAND-PULL INFLATION
o
P1
AS1
ASLR
AD1
a
Q1
Pri
ce L
evel
Real domestic output
bP2
P3
AD2
AS2
c
53
Q2
COST-PUSH INFLATIONCOST-PUSH INFLATION
o
P1
AS1
ASLR
AD1
a
Q1
Pri
ce L
evel
Real domestic output
bP2
AS2
Occurs when short-run AS shifts left
54
Q2
COST-PUSH INFLATIONCOST-PUSH INFLATION
o
P1
AS1
ASLR
AD1
a
Q1
Pri
ce L
evel
Real domestic output
bP2
P3
AD2
AS2
Government response with increased AD
c
Evenhigherpricelevels
55
COST-PUSH INFLATIONCOST-PUSH INFLATION
o
P1
AS1
ASLR
AD1
a
Q1
Pri
ce L
evel
Real domestic output
bP2
AS2
If government allows a recession to occur
Q2
56
Q2
COST-PUSH INFLATIONCOST-PUSH INFLATION
o
P1
AS1
ASLR
AD1
a
Q1
Pri
ce L
evel
Real domestic output
bP2
AS2
If government allows a recession to occur
Nominal wages fall &AS returns
to its originallocation
57
15-20% Financial Sector(Money and Banking)
A. Money, banking, and financial markets1. Definition of financial assets: money, stocks, bonds2. Time value of money (present and future value)3. Measures of money supply4. Banks and creation of money5. Money demand6. Money market7. Loanable funds market
B. Central bank and control of the money supply1. Tools of central bank policy2. Quantity theory of money3. Real versus nominal interest rates
58
Money Supply Terms
• M1= Checkable Deposits and Currency• M2= M1 + Savings deposits, money market
accounts, small time deposits (less than $100,000)
• Velocity of Money Equation:• MV = PQ ( GDP) (M= Money Supply and V =
Velocity (number of times per year the average dollar is spent on goods and services.
59
Banks and Balance SheetsAssets Liabilities
Reserves $15,000 Checkable Deposits $100,000Securities $15,000Loans $70,000
If the current reserve requirement is 10%:
1. What is the amount of new loans this bank can generate?Answer: $100,000 Checkable deposits X a 10% reserve requirement =
$10,000 required reserves. If the bank has $15,000 in reserves, $5,000 of those are excess reserves and can be loaned out .
2. How much in new loans can be generated by the entire banking system?
Answer: Money Multiplier = 1/Required Reserve Ratio=1/.1010 X $5,000 = $50,000
60
FED and the Money MarketMS1 MS2
MD
Nominal InterestRate
Quantity of Money
nir1
nir2
Q1 Q2
Vertical curve-Supply controlledBy the FED. An increase in MSleads to a rightward shift andlower nominal interest rates.
61
Interest Rate-Investment
• Expected Rate of Return: Amount of Profit (expressed as a percentage) a business expects to gain on a project/investment.• This rate must be greater than the interest in
order to be profitable.• The Real Rate of Return is most important. An
expected profit of 10%, that costs 5% in interest = The real rate of return: 5%.
62
Investment Demand Curve:
Quantity of Investment
Real Rate ofReturn
ID
r1
r2
Q1 Q2
At lower real interest rates businesses will Increase investment , leading to an increaseIn AD (aggregate demand). At higher rates ofInterest, less money will be invested
63
Shifts of the Investment Demand Curve
Expected Rate of Return
( Real Interest Rate.)
Quantity of Investment
ID1
ID2
ID3
A shift from ID1 to ID2 Represents an increase inInvestment demand. A shiftFrom ID1 to ID3 represents adecrease in investment Demand.
Loanable Funds Market and Expansionary Fiscal Policy
• Used for FISCAL POLICY (Government spending-Deficit Spending)
Quantity of Funds
Real Interest Rate
DLF1
DLF2
An increase in Gov. spending increases the demand for loanable funds and raises real interest rates
R1
R2
Q1 Q2
SLF
Loanable Funds Market and Contractionary Fiscal Policy
• Used for FISCAL POLICY (Government spending-Deficit Spending)
Quantity of Funds
Real Interest Rate
DLF2
DLF1
A decrease in Gov. spending decreases the demand for loanable funds and lowers real interest rates
R2
R1
Q2 Q1
SLF
66
Nominal:with Inflation
Real:without Inflation
67
GDP• Nominal GDP: GDP
measured in terms of current Price Level at the time of measurement. (Unadjusted for inflation)
• Real GDP: GDP adjusted for inflation; GDP in a year divided by a GDP deflator (Price Index) for that year
68
INCOMEINCOME• NOMINAL INCOME:
number of dollars received by an individual or group for its resources during some period of time
• REAL INCOME: amount of goods and services which can be purchased with nominal income during some period of time; nominal income adjusted for inflation
69
INTEREST RATE (I%)
• NOMINAL I%: interest rate expressed in terms of annual amounts currently charged for interest; not adjusted for inflation
• REAL I%: interest rate expressed in dollars of constant value (adjusted for Inflation) and equal to the NOMINAL I% minus the EXPECTED RATE OF INFLATION
70
NominalInterest
Rate
RealInterest
Rate
InflationPremium
=11%
5%
6%+
ANTICIPATED INFLATIONANTICIPATED INFLATION
71
WAGES• NOMINAL WAGES:
amount of money received by a worker per unit of time (hour, day, etc.);
• Money Wage
• REAL WAGES: amount of goods and sevices a worker can purchase with their NOMINAL WAGE; purchasing power of the nominal wage.
• (Real = Nominal – Inflation rate)
72
NOMINALNOMINAL/REAL TIPs
• If nominal rates INCREASE and Price Level INCREASE, the CHANGE in Real is “indeterminable.”
• If nominal Wage rates do NOT change and Price Level fall. REAL WAGES increase.
• NOMINAL RATES “PIGGY-BACK” REAL RATES & NOT VICE VERSA.
73
20-30% Inflation, Unemployment, and Stabilization Policies
A. Fiscal and monetary policies1. Demand-side effects2. Supply-side effects3. Policy mix4. Government deficits and debt
B. Inflation and unemployment1. Types of inflation
a. Demand-pull inflationb. Cost-push inflation
2. The Phillips curve: short run versus long run3. Role of expectations
Fiscal PolicyFiscal Policy• Using Taxes and Government spending to stabilize the
economy.
• Controlled by the President and Congress
• Discretionary Fiscal Policy: Congress must take action (change the tax rates) in order for the action to be implemented.
• Automatic Stabilizers: Unemployment benefits, Progressive Tax System, these changes are implemented automatically to help the economy.
FISCAL POLICY CHANGES AD …. EXCEPT when the question specifically states
there is a change in business taxes.
Types of Fiscal PolicyTypes of Fiscal Policy
• ExpansionaryExpansionary• Used to Fight a
Recession• LOWER TAXES• INCREASE
GOVERNMENT SPENDING
• ContractionaryContractionary• Used to fight Inflation• RAISE TAXES• DECREASE
GOVERNMENT SPENDING
Expansionary Fiscal PolicyExpansionary Fiscal Policy
Price Level
Real GDPAD1 ( C + I + G + X )
AD2
AS1
P1
Y*Y1
P2
Contractionary Fiscal PolicyContractionary Fiscal Policy
• Raising taxes or reducing government spending to fight inflation and stabilize the economy.
Price Level
Real GDP
AD1
P1
P2
AD2
Y*
AS
Tax Multiplier [-MPC/MPS]Tax Multiplier [-MPC/MPS]• Remember, if the government decreases
taxes, the result is not as great as a spending increase, since households will save a portion (MPS) of the tax cut.
• The Tax Multiplier = -MPC /MPS-MPC /MPS• Example: If the MPC is .8 and the MPS is .2• Spending Multiplier = 1/.2 or 5• Tax Multiplier = -.8 /.2 or -4-.8 /.2 or -4
Crowding-Out EffectCrowding-Out Effect• An Expansionary Fiscal Policy as previously
diagrammed will lead to higher interest rates.• At higher interest rates, businesses will take out
fewer loans and there will be a decrease in INVESTMENT (I)
• At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well.
• This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.
Net Export Effect & Expansionary Fiscal Policy
• Government spending has led to an increase in interest rates.• At higher interest rates, foreigners demand more U.S. dollars
to invest in bonds.• This leads to an appreciation of the U.S. dollar.• This leads to a decrease in Net Exports, as foreigners now
have to exchange more of their currency for the U.S. dollar to buy exports.
• This decrease in Net Exports will reduce AD and counter to some extent the expansionary fiscal policy.
Net Export Effect & Contractionary Fiscal Policy
• A decrease in government spending has led to a decrease in real interest rates.
• At lower interest rates, foreigners demand less U.S. dollars to invest in bonds.
• This leads to a depreciation of the U.S. dollar.• This leads to an increase in Net Exports, as foreigners now
have to exchange less of their currency for the U.S. dollar to buy exports.
• This increase in Net Exports will increase AD and further strengthen the contractionary fiscal policy.
Criticisms of Fiscal PolicyCriticisms of Fiscal Policy• Timing Problems
• Recognition Lag: identifying recession or inflation• Administrative Lag: getting Congress/President to agree
to take action• Operational Lag: Time needed to see the results of the
fiscal policy• Political Business Cycles: Politicians may take
inappropriate action to get reelected (lower taxes during an inflationary period). Plus it is difficult to raise taxes
The Federal Reserve System (FED)The Federal Reserve System (FED)
• Control Monetary Policy• Headquartered in Washington D.C.• 12 Federal Reserve Districts• Board of Governors (7 members) is the
central authority• Members are appointed by the President
and confirmed by the Senate
Federal Open Market Committee Federal Open Market Committee (FOMC)(FOMC)
• Made up of 12 people: Board of Governors + New York FED President + 4 other regional presidents (who rotate)
• Meets regularly to direct OPEN MARKET OPERATIONS (buying or selling of bonds) to maintain or change interest rates
FED and the Money MarketFED and the Money MarketMS1 MS2
MD
Nominal InterestRate
Quantity of Money
nir1
nir2
Q1 Q2
Vertical curve-Supply controlledBy the FED. An increase in MSleads to a rightward shift and
lower interest rates.
Easy Money Policy on AD/ASEasy Money Policy on AD/AS• Buying Government Bonds, lowering the discount rate, or lowering
reserve requirements, to fight a recession, by decreasing interest rates, increasing investment spending and/or consumption and increasing AD.
Price Level
Real GDPQ1
P1
P2
QF
AS
AD2
AD1 (C + I + G + X)
Effects of an Easy Money PolicyEffects of an Easy Money Policy
• LOWER INTEREST rates which will lead to an INCREASE in INVESTMENT and CONSUMPTION.
• The U.S. dollar will DEPRECIATE, leading to an increase in NET EXPORTS as well.
• These effects STRENGTHEN the overall monetary policy (opposite of fiscal policy’s crowding-out and net export effect
FED and a TIGHT Money PolicyFED and a TIGHT Money Policy
MS2 MS1
MD
Nominal InterestRate
Quantity of Money
nir2
nir1
Q2 12
Vertical curve-Supply controlledBy the FED. A decrease in the Money supply, shifts the MS curve to the left and raises interest rates.
Tight Money Policy and AD/ASTight Money Policy and AD/AS• Selling bonds, raising the discount rate, or raising reserve requirements
to fight inflation which will raise interest rates, decrease investment and/or consumption and decrease Aggregate Demand (AD).
Price Level
Real GDP
AD1
P1
P2
AD2
QF
AS
Effects of a Tight Money PolicyEffects of a Tight Money Policy
• At the higher interest rates, INVESTMENT SPENDING, and CONSUMPTION will decrease.
• At higher interest rates, the U.S. dollar will APPRECIATE (foreigners demand more U.S. securities). This will lead to a DECREASE in NET EXPORTS.
• Again, the Monetary Policy is STRENGTHENED as a result, unlike the effects of a contractionary fiscal policy.
Extended AD-AS Model• This is the other way to graph the AD-AS Model
AD
Price Level
Real GDPY*
P1
SRAS
LRAS
The intersection of the 3 curvesIs the Full-Employment Equilibrium
Extended AD-AS Model and Demand-Pull Extended AD-AS Model and Demand-Pull InflationInflation• In Demand-Pull Inflation, the AD curve has shifted to the right of the
LRAS and SRAS intersection.
AD2
Price Level
Real GDPY*
P2
SRAS
LRAS
Y2
The Price Level and Real GDP has increased.
AD1
PF
Extended AD-AS and Demand-Pull InflationExtended AD-AS and Demand-Pull Inflation
• Mainstream economists will fight inflation as previously discussed: with either a tight monetary policy or a contractionary fiscal policy. The goal would be to move the aggregate demand curve to the left.
• Classical economists would argue to DO NOTHING. As nominal wages rise, the SHORT-RUN AS curve will shift to the left (resources and wages are becoming more expensive), restoring the economy to its full-employment output level, but with a higher Price Level.
Extended AD-AS Model and Cost-Push Extended AD-AS Model and Cost-Push InflationInflation
AD1
Price Level
Real GDPY*
SRAS2 LRAS
Cost-Push inflation occurs when the SRAS has shifted to the left Of the LRAS and AD intersection.
P1
Y1
Here the Price level has Increased and REAL GDP
has decreased.
SRAS1
PF
Extended AD-AS and Cost-Push InflationExtended AD-AS and Cost-Push Inflation
• Mainstream economists must decide whether to target the Price Level or Unemployment, before taking any action.
• Classical economists would argue to DO NOTHING. Eventually, wages and resource prices must decrease and when they do the SRAS curve will shift back to the right, restoring the economy to its full-employment output level and the original Price Level.
Extended AD-AS Model and RecessionExtended AD-AS Model and Recession• In a recession due to a decrease in AD, the AD curve is to the left of the
LRAS and SRAS intersection; showing a decrease in both the Price Level and Real GDP.
AD
Price Level
Real GDPY*
SRAS
LRAS
P1
Y1
PF
Extended AD-AS and RecessionExtended AD-AS and Recession
• Mainstream economists will fight a recession as previously discussed: with either an easy money policy or an expansionary fiscal policy. The goal would be to move the aggregate demand curve to the right.
• Classical economists would argue to DO NOTHING. The decrease in wages and resource prices will shift the SRAS curve to the right, restoring the economy to its full-employment output level, but with a LOWER price. (SELF-CORRECTION)
Short-Run Phillips CurveShort-Run Phillips Curve• Suggests an inverse relationship between the inflation rate
and the unemployment rate.InflationRate(percent)
Unemployment Rate (percent)
2
8
2 8
When the unemployment rate isLow (2%), the inflation rate willMost likely be high (8%).
When theUnemployment rateIs high, inflation willlikely be low.
SRPC1
Short-Run Phillips CurveShort-Run Phillips Curve• When the Government fights unemployment, typically higher inflation
will result. When the Government fights inflation, typically, more unemployment will result. Thereby, we move along the Short-Run Phillips Curve. (Changes in AD = movements on the SRPC.
InflationRate(percent)
Unemployment Rate (percent)
A
B7
2
3 6
SRPC1
Shifting the Short-Run Phillips CurveShifting the Short-Run Phillips Curve
• The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time. (A change in AS)
SRPC1
SRPC2
4
5
6 7
Stagflation, unemployment andInflation occurring together (OPEC decreasing Oil supply,causes this type of shift)
Inflation Rate%
Unemployment Rate %
Shifting the Short-Run Phillips CurveShifting the Short-Run Phillips Curve• The Short-Run Phillips curve can also shift, this would mean that both
the unemployment rate and inflation rate are changing at the same time.
SRP2
SRPC1
5
7
When Supply increases (productivity surge in 90s)more than demand, prices willfall, while GDP and employmentIncrease; shifting the curve to the left.
Inflation Rate %
Unemployment Rate %
3
5
The SRPC is a mirror image of AS – If AS moves right, SRPC moves left.
Long-Run Phillips CurveLong-Run Phillips Curve• The Long-Run Phillips Curve is vertical, like the Long Run Aggregate
Supply Curve. So, in the long run there is no tradeoff between inflation and unemployment. Only the Price Level will change.
Inflation Rate%
Unemployment Rate %5
3
SRPC
LRPC
Laffer CurveLaffer Curve• What is the optimal tax rate? A tax of 0% will provide no tax revenue.
A tax rate of 100% will also lead to no tax revenue (no incentive to work). Answer must be somewhere in between.
Tax Rate
Tax Revenue0
100
Economic Philosophies• Classical: Believes that the government SHOULD
NOT interfere in the economy. And believes in self-correction of economic problems.
• Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending). Most “mainstream” economists are Keynesians
• Rational Expectations: Believes that monetary and fiscal policy have certain effects on the economy and take action to make these policies ineffective.
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5-10% Economic Growth and Productivity
A. Investment in Human CapitalB. Investment in Physical CapitalC. Research and development, and technological progressD. Growth Policy
Economic GrowthEconomic Growth• Five Factors connected to long run economic
growth.
• Supply Factors:• Increase in natural resources (quantity and quality)• Increase in human resources (quantity and quality)• Increase in capital goods• Improvements in technology
• Demand Factors:• Increase in consumption by households, businesses, and
government
Illustrating Economic GrowthIllustrating Economic Growth
• Production Possibilities Curve
Capital Goods
Consumer Goods
AB
PPC1
PPC2
Illustrating Long Run GrowthIllustrating Long Run Growth• Can also be illustrated with the extended AD-AS Model.
Real GDP
Price Level
AD1AD2
SRAS1 SRAS2LRAS1LRAS2
Y1 Y2
P1
P2
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10-15% Open Economy: International Trade and Finance
A. Balance of payments accounts1. Balance of trade2. Current account3. Capital account
B. Foreign exchange market1. Demand for and supply of foreign exchange2. Exchange rate determination3. Currency appreciation and depreciation
C. Net exports and capital flowsD. Links to financial and goods markets
International TradeInternational Trade
• Comparative Advantage and Specialization allows for economic growth and efficiency. (More of each good can be obtained by trading-Trading line illustrates this)
• Trade barriers create more economic loss than benefits.• Today there is a trend towards free trade and a reduction in
trade barriers.• Strongest arguments for protection are the infant industry
and military self-sufficiency arguments.• WTO oversees trade agreements and disputes, but has
become a target of protesters lately.
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The value of a foreign nation’s currency in relation to your own currency is called the exchange rateexchange rate.
Exchange Rates and International Exchange Rates and International MarketsMarkets
• An increase in the value of a currency is called appreciationappreciation.
• A decrease in the value of a currency is called depreciationdepreciation.
• Multinational firms convert currencies on the foreign exchange market, a network of about 2,000 banks and other financial institutions.
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Types of Exchange Rate SystemsTypes of Exchange Rate SystemsFixed Exchange-Rate Fixed Exchange-Rate
SystemsSystems• A currency system in
which governments try to keep the values of their currencies constant against one another is called a fixed exchange-rate system.
Flexible Exchange-Rate Flexible Exchange-Rate SystemsSystems
• Flexible exchange-rate systems allow the exchange rate to be determined by supply and demand.
Foreign Exchange MarketForeign Exchange Market• Let’s say a U.S. citizen travels to Japan. This transaction will provide a
supply of the U.S. dollar and result in a demand for yen. It will become cheaper for the Japanese to buy the dollar and more expensive for Americans to buy the Yen. The Yen is Appreciating and the dollar is Depreciating.
Quantity of U.S. Dollars Quantity of Yen
Yen Price of dollar(Y/$)
Dollar Price
of Yen($/Y)
P1
Q1
D$1
S$1
S$2
P2
Q2
P1
Q1
DY1
SY1
DY2
Q2
P2
Balance of PaymentsBalance of Payments: The sum of all transactions between U.S. residents and residents of all foreign nations
• Current Account: Shows U.S. exports and U.S. imports of goods and services.
• Capital Account: Shows the U.S. investment (financial as well as capital-plants and factories) abroad and Foreign investment in the U.S.
• Credits: A credit are those transactions for which the U.S. receives income (exports, foreign purchase of assets)
• Debits: Those transactions that the U.S. must pay for: imports and purchasing of assets abroad.
Balance of Payments [continued]• The Current Account and Capital Account must be equal.
• Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts.
• If the U.S. has more credits than debits it finances this difference by dipping into its reserve account.
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So,………… That’s it!
Easy, huh?
