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Title: Macro Economics
Description: It contains all that you may ndd in Economics
Description: It contains all that you may ndd in Economics
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INTRODUCTION TO MACROECONOMICS
E202
$
¥
Dr
...
Dilts
Department of Economics
Doermer School of Business and Management Sciences
Indiana-Purdue University-Fort Wayne
June 1, 1993
Revisions: May 1994,
December 1995,
July 1996,
November, 2000,
May 2003,
May 2006
PREFACE
This Course Guide was developed in part because of the high cost of college
textbooks, and in part, to help organize students’ studying by providing lecture notes
together with the reading assignments
...
Jayla Heller, the Department’s secretary has
been kind enough to go through all of the frustration and hard work to put the guide in
the appropriate format and put it online
...
The department, neither school, nor the professor make anything whatsoever
from this Guide
...
Like the sign in the Mom and Pop bait shop on Big Barbee
Lake says, “This is a non-profit organization, wasn’t planned to be – it just worked out
that way
...
The professor also wishes to acknowledge the fact that several students have
proposed changes, improvements, caught errors, and helped to make this document
more useful as a learning tool
...
i
Introduction & Use of Guide
This Course Guide is provided to assist students in mastering the subject matter
presented E202, Introduction to Macroeconomics
...
At
several institutions, prepared course materials are made available to students to assist
their learning
...
Because macroeconomics is such an important foundation for
business, engineering, and the social sciences this Guide has been prepared
...
First, the course syllabus is
included in the Guide
...
Third, the Guide provides students with problems and
study-guides to aid each individual in the retaining the materials presented by the text
and lecture
...
Organization
The Guide is divided into twelve units, following the organization of the Tentative
Course Outline found in the syllabus
...
Also in the Guide is the course
syllabus included before the twelve sections covering the substantive portions of the
course
...
The
final section of the Guide contains sample examinations, including answers
...
A teacher cannot cause a student to learn, all a teacher
can do is to organize and present the material, grades can provide a small extrinsic
reward for accomplishment, but it is the student's ability, effort, and desire that
determine how much and how well they will learn
...
ii
SYLLABUS
E202, Introduction to Macroeconomics
Dr
...
Dilts
Room 340D Neff Hall
Phone 481-6486
Department of Economics and Finance
School of Business and Management Sciences
Indiana - Purdue University - Fort Wayne
COURSE POLICIES
1
...
2
...
The Professor's office is Neff 340D
...
The following grade scale will be applied in this course for determination of final
grades:
A
B
C
D
F
100 - 90 percent
89 - 80 percent
79 - 70 percent
69 - 60 percent
below 60 percent
All final grade calculations shall be rounded up
...
01 and 69
...
4
...
0 on a 4
...
5
...
The MIDTERM examination is worth 40% of the final grade
...
The QUIZZES are worth
10% of the final grade, and only the best two quiz scores will be used in
this calculation
...
B
...
Examinations will be worth
100 points, and will consist of twenty multiple choice questions (worth four
points each), and twenty true-false questions worth one point each) for a
total of 100 points
...
The final examination will be given at the time and place scheduled by the
university
...
7
...
If you cannot attend class at exam time
you must make prior arrangements to take an equivalent examination before
your classmates
...
e
...
8
...
The over whelming
preponderance of students do not engage in dishonesty, and the professor owes
it to these students to strictly police this policy
...
The provisions of these policies and the course objectives are subject to testing
...
COURSE OBJECTIVES
This is an introductory principle of economics course that covers topics in
macroeconomics
...
The course will present factual material concerning the operation of the
aggregate economy as well as the development of rudimentary understanding of
economic policy
...
It is important that this level of understanding be achieved
...
Even though there are no grades assigned for class participation, students are
encouraged to participate in classroom discussions
...
iv
REQUIRED TEXT
David A
...
Fort Wayne: 2003, memo
...
McConnell and Stanley L
...
New
York: McGraw-Hill
...
Introduction to Macroeconomics, Economic Policy and the Course
DAD Chapter 1
M & B Chapter 1
2
...
Unemployment and Inflation
DAD Chapter 3
M & B Chapter 8
4
...
Classical and Keynesian Models
DAD Chapter 5
v
M & B Chapter 9
6
...
Fiscal Policy
DAD Chapter 7
M & B Chapter 12
MIDTERM EXAMINATION
8
...
Money & Banking
DAD Chapter 8
M & B Chapter 13
10
...
Federal Reserve and Monetary Policy
DAD Chapter 10
M & B Chapter 15
12
...
Introduction to Economics
Lecture Notes
1
...
a
...
b
...
c
...
d
...
e
...
f
...
2
...
3
...
a
...
b
...
Ceteris paribus - means all other things equal
...
Problems with abstractions, based on assumptions
...
When a model is so complex that it
cannot be easily communicated or its implications understood - it is
less useful
...
Goals and their Relations - Positive economics is concerned with what is;
normative economics is concerned with what should be
...
a
...
Economic efficiency,
2
...
Economic freedom,
4
...
Equitable distribution of income,
6
...
Price level stability, and
8
...
5
...
Interpretation - precise meanings and measurements will often become
the subject of different points of view, often caused by politics
...
Complementary - goals that are complementary are consistent and can
often be accomplished together
...
Conflicting - where one goal precludes or is inconsistent with another
...
Priorities - rank ordering from most important to least important; again
involving value judgments
...
The Formulation of Public and Private Policy - Policy is the creation of guidelines,
regulations or law designed to affect the accomplishment of specific economic
goals
...
Steps in formulating policy:
1
...
2
2
...
Evaluation - gather and analyze evidence to determine whether policy
was effective in accomplishing goal, if not re-examine options and
select option most likely to be effective
...
Objective Thinking:
a
...
Because of political beliefs and other value system components rational,
objective thinking concerning various issues requires the shedding of
these preconceptions and biases
...
Fallacy of composition - is simply the mistaken belief that what is true for
the individual, must be true for the group
...
Cause and effect - post hoc, ergo propter hoc - after this, because of this
fallacy
...
Correlation - statistical association of two or more variables
...
Causation - where one variable actually causes another
...
d
...
3
2
...
Gross Domestic Product - (GDP) the total value of all goods and services
produced within the borders of the United States (or country under analysis)
...
Gross National Product - (GNP) the total value of all goods and services
produced by Americans regardless of whether in the United States or overseas
...
National Income Accounts are the aggregate data used to measure the wellbeing of an economy
...
The mechanics of these various accounts are:
Gross Domestic Product
- Depreciation =
Net Domestic Product
+ Net American Income Earned Abroad
- Indirect Business Taxes =
National Income
- Social Security Contributions
- Corporate Income Taxes
- Undistributed Corporate Profits
+ Transfer Payments =
Personal Income
- Personal Taxes =
Disposable Income
4
4
...
Incomes Approach
a
...
Y = C + Ig + G + Xn is the expenditures approach (where Y = GDP)
5
...
More information is necessary before conclusions can be
drawn concerning social welfare
...
Nonmarket transactions such as household-provided services or barter
are not included in GDP
...
Leisure is an economic good but time away from work is not counted,
however, movie tickets, skis, and other commodities used in leisure time
are
...
Product quality - no pretense is made in GDP to account for product or
service quality
...
Composition & Distribution of Output - no attempt is made in GDP data to
account for the composition or distribution of income or output
...
e
...
f
...
g
...
S
...
Criminal activities, tax evasion, and other such activities are the
underground economy
...
Price Indices - are the way we attempt to measure inflation
...
5
a
...
b
...
GDP Deflator is based on a broader market basket and may be more
useful in measuring inflation
...
Standard of living - is eroded if there is inflation and no equal increase
in wages
...
COLA - are escalator clauses that tie earnings or other payments to
the rate of inflation, but only proportionally
...
Other indices - American Chamber of Commerce Research
Association in Indianapolis does a cross sectional survey, there are
wholesale price indices and several others designed for specific
purposes
...
Inflation/Deflation - throughout most of U
...
economic history we have
experienced deflation - which is a general decline in all prices
...
d
...
7
...
CPI = (current year market basket/ base year market basket) X 100 the
index number for the base year will be 100
...
Inflating is the adjustment of prices to a higher level, for years when the
index is less than 100
...
Deflating is the adjustment of prices to a lower level, for years when the
index is more than 100
...
to change nominal into real the following equation is used:
Nominal value/ (price index/100)
6
d
...
The process is a simple one
...
7
3
...
Business Cycle - is the recurrent ups and downs in economic activity observed in
market economies
...
Troughs are where employment and output bottom-out during a recession
(downturn)
b
...
Seasonal trends are variations in data that are associated with a particular
season in the year
...
Secular trends are long-run trend (generally 25 or more years in
macroeconomic data
...
Unemployment - there are various causes of unemployment, including:
a
...
8
b
...
c
...
3
...
a
...
1
...
4
...
a
...
b
...
S
...
c
...
d
...
5
...
Okun's Law states that for each 1% unemployment exceeds the natural
rate there will be a gap of 2
...
6
...
Occupation - mostly due to structural changes
...
Age young people tend to experience more frictional unemployment
...
Race and gender reflect discrimination in the labor market and sometimes
in educational opportunities
...
Inflation - general increase in all prices
...
CPI - is the measure used to monitor inflation
...
Rule of 70 -- the number of years for the price level to double =
70/%annual rate of increase
...
Demand - pull inflation
Price
Aggregate
Supply
Aggregate
Demand
Output
Using a naive aggregate demand - aggregate supply model (similar to the supply
and demand diagrams for a market, except the supply is total output in all
markets and demand is total demand in all markets, as the aggregate demand
shifts outwards prices increase, but so does output
...
Cost - push inflation - again using a naive aggregate supply - aggregate demand
approach cost-push inflation results from a decrease in aggregate supply:
10
Aggregate
Supply
Price
Aggregate
Demand
Output
a
...
Effects of inflation impact different people in different ways
...
a
...
b
...
11
c
...
12
4
...
Aggregate demand is a downward sloping function that shows the inverse
relation between the price level and domestic output
...
The reasons for the downward sloping
aggregate demand curve are:
a
...
b
...
g
...
c
...
13
2
...
a
...
Consumer indebtedness,
c
...
Interest rates,
e
...
Amount of current excess capacity in industry,
g
...
Net exports,
i
...
Exchange rates
...
Aggregate Supply shows amount of domestic output available at each price level
...
a
...
14
b
...
c
...
4
...
a
...
Changes in input productivity, and
c
...
5
...
Ratchet Effect - is where there is a decrease in aggregate demand, that
producers are unwilling to accept lower prices (rigid prices and wages) therefore
there is a ratcheting of the aggregate supply curve (decrease in the intermediate
and Keynesian ranges) which will keep the price level the same, but with reduced
output
...
15
An increase in aggregate demand from AD1 to AD2 moves the equilibrium from
point a to point b with real output and the price level increasing
...
Instead,
the new equilibrium will be at point c with the price level remaining at the higher
level and output falling to the lowest point
...
16
5
...
Classical theory of employment (macroeconomics) rests upon two founding
principles, these are:
a
...
b
...
2
...
In other words, every level of output creates enough income to purchase
exactly what was produced
...
Among others, there is one glaring omission in Say's Law -- what about
savings?
3
...
Output produces incomes, but savings is a leakage
b
...
4
...
The classicists believed that a laissez faire economy would result in
macroeconomic equilibria and that only the government could cause
disequilibria
...
Keynesian Model - beginning in the 1930s the classical models failed to explain
what was going on, hence a new model was developed -- the Keynesian Model
...
Full employment is not guaranteed, because interest motivates both
consumers & businesses differently - just because households save does
not guarantee businesses will invest
...
Price-wage rigidity, rather than flexibility was assumed by Keynes
17
6
...
Consumption schedule - the 45-degree line is every point where
disposable income is totally consumed
...
Saving schedule - shows the amount of savings associated with the
consumption function
...
To the left of the
intersection of the consumption function and the 45-degree line, the
consumption function lies above the 45-degree line
...
To the right of the intersection of the consumption function with the
45 degree line the consumption schedule is below the 45-degree line
...
c
...
The Marginal Propensity to Save (MPS) is
the proportion of any increase in disposable income saved
...
MPC + MPS = 1
18
d
...
Add the slope of the
consumption function (8/10) to the slope of the savings function (2/10) and
they equal one (10/10)
...
The Average Propensity to Consume (APC) is total consumption divided
by total income, Average Propensity to Save (APS) is total savings divided
by total income
...
APC + APS = 1
7
...
Wealth,
b
...
Expectations concerning future prices, incomes and availability of
commodities,
d
...
Taxes
...
Investment
a
...
Determinants of investment demand are:
1
...
Business taxes,
3
...
Stock of capital on hand, and
5
...
c
...
induced investment
(function of GDP):
1
...
S
...
20
2
...
Variations in the durability of capital,
b
...
Variability of profits, and
d
...
21
6
...
Equilibrium GDP - is that output that will create total spending just sufficient to
buy that output (where aggregate expenditure schedule intersects 45 degree
line)
...
Disequilibrium - where spending is insufficient (recessionary gap) or too
high for level of output (inflationary gap)
...
Expenditures - Output Approach
a
...
Investment in this model is autonomous and
the amount of investment is the vertical distance between the C and the C
+ I lines
...
3
...
a
...
22
b
...
actual investment, the reason that the leakages - injection
approach works is that planned investment must equal savings
...
The original equilibrium is where I1 is equal to S and that level of
GDP is shown with the solid indicator line
...
4
...
In other
words, if $10 is injected into the system, then it is income to someone
...
If MPC is
...
00
...
00 in income and will spend $8
...
90
...
Instead of summing all of the income,
expenditures, and/or savings there is a short-hand method of determining the
total effect -- this is called the Multiplier, which is:
a
...
Significance - any increase in expenditures will have a multiple effect on
the GDP
...
Paradox of thrift - the curious observation that if society tries to save more it may
actually save the same amount - unless investment moves up as a result of the
savings, all that happens is that GDP declines and if investment is autonomous
then savings remain the same
...
Full Employment level of GDP may not be where the aggregate expenditures line
intersects the 45 degree line
...
a
...
The dotted line shows
the current macroeconomic equilibrium
...
Inflationary gap
The distance between the C + I line and the 45 degree line along the
dashed indicator line is the inflationary gap
...
24
7
...
Shifts in aggregate demand can be shown with
holding the price level constant and showing increases or decreases in C + I in
the Keynesian Cross model
...
25
7
...
Discretionary Fiscal Policy - involves government expenditures and/or taxes to
stabilize the economy
...
Employment Act of 1946 - formalized the government's responsibility in
promoting economic stability
...
Simplifying assumptions for the analyses presented here:
1
...
G does initially impact private decisions,
3
...
Some exogenous taxes collected,
5
...
Fiscal policy impacts only demand side
...
Changes in Government Expenditures - can be made for several reasons:
a
...
To close a recessionary gap the government must spend an amount
that time the multiplier will equal the total gap
...
To close an inflationary gap the government must cut expenditures by
an amount that times the multiplier will equal the inflationary gap
...
Political goals, and
c
...
26
An increased government expenditure of $20 billion results in an increase
in GDP of $80 billion with an MPC of
...
3
...
a
...
The lump sum tax must be multiplied by the MPC to obtain the
reduction in consumption;
4
...
b
...
c
...
4
...
a
...
b
...
27
5
...
Progressive is where the effective tax rate increases with ability to pay,
b
...
Proportional is where a fixed proportion of ability to pay is taken in taxes
...
Automatic stabilizers help to smooth business cycles without further legislative
action:
a
...
Unemployment compensation,
c
...
Fiscal Lag - there are numerous lags involved with the implementation of fiscal
policy
...
a
...
b
...
c
...
8
...
a
...
b
...
9
...
It is alleged that private spending is
displaced when the government borrows to finance spending:
a
...
10
...
Because there is a foreign sector that impacts GDP
there are potential problems for fiscal policy arising from foreign sources
...
Increased interest - net export effect
1
...
b
...
1
...
S
...
Economic Growth
Lecture Notes
1
...
Each of these definitions has its uses
...
a
...
b
...
Beer
Pizza
2
...
Middle-income countries $760 to $9300 per capita GDP in 2000
b
...
30
1
...
The industrial, high income countries are the
U
...
, Canada, Australia, New Zealand, Japan, and Western Europe
...
Growth-paths are the historical tracing of how an economy moved
from being less developed to a developed economy
...
31
d
...
1
...
Output
Time
2
...
It is
nearly impossible to attract capital to a developing nation, if the
government is corrupt and there is little in the way of political stability or
the rule of law
...
S
...
e
...
3
...
a
...
U
...
natural resources
c
...
Innovation
4
...
32
a
...
5
...
a
...
Help here is important
b
...
Narcotic effect of foreign aid
d
...
Political instability
1
...
Capital Flight
g
...
Money and Banking
Lecture Notes
1
...
Medium of exchange - accepted as "legal tender" or something of general
and specified value
...
Use avoids reliance on barter
...
Barter requires a coincidence of wants and severely complicates a
market economy
...
Measure of value - permits value to be stated in terms of a standard and
universally understood standard
...
Store of value - can be saved with little risk, chance of spoilage and
virtually no cost and later exchanged for commodities without these
positive storage characteristics
...
Supply of money
a
...
1
...
M2 is M1 + noncheckable savings account, time deposits of less
$100,000, Money Market Deposit Accounts, and Money Market Mutual
Funds
...
M3 is M2 + large time deposit (larger than $100,000)
...
Near Money - are items that fulfill portions of the requirements of the functions of
money
...
Credit cards - fulfill exchange function, but are not a measure of value and
if there is a credit line, can be used to store value
...
Other forms of near money:
2
...
Stocks and Bonds - earnings instruments, but can be used as store of
value
...
Implications for near money - stability, spending habits & policy
4
...
No more gold standard
1
...
The Value of money depends upon:
1
...
because the government claims it is legal tender, and
3
...
5
...
Demand for Money - three components of money demand:
a
...
Asset demand
c
...
The money demand curve
slopes downward and to the right
...
7
...
With bonds that pay a specified interest payment per quarter then:
1
...
U
...
Financial System
a
...
b
...
The Board of
Governors and Chairman are nominated by the President of United
States
...
Board of Governors
2
...
Federal Advisory Council
4
...
Functions
36
1
...
Check clearing services,
3
...
S
...
Supervision of banks,
5
...
Moral hazard - insuring reduces insured's incentive to assure risk does not
happen
37
10
...
Balance sheet (T accounts -- assets = liabilities + net worth)
a
...
2
...
Goldsmiths used to issue paper money receipts, backed by stocks of gold
...
1
...
b
...
S
...
In the early part of this century several financial panics pointed to
the need for a central banking and financial regulation
...
States and private companies used to issue paper money
...
In the early days of U
...
history Spanish silver coins were widely
circulated in the U
...
3
...
S
...
c
...
1
...
RRR (Required Reserve Ratio) and multiple expansion of money supply through
T accounts
a
...
Loans from Fed - discount rate at which Fed loans reserves to
members
38
2
...
Deposits with Fed
4
...
RRR = Required reserve/demand deposit liabilities
c
...
Money created through deposit/loan redepositing
a
...
1
...
10, then a bank must retain 10% of each
deposit as a reserve and can loan 90% of the deposit; the multiple
expansion of money, assuming a required reserve ratio of
...
00
9
...
10
...
_______
$ 100
...
00
8
...
29
...
_______
$90
...
00 in new money
...
Money multiplier Mm = 1/RRR
a
...
b
...
05 the money multiplier is 20 & with a
required reserve ratio of
...
39
c
...
40
11
...
Monetary policy, defined and objectives
a
...
b
...
2
...
Open Market Operations is the selling and buying of U
...
treasury
obligations in the open market
...
Expansionary monetary policy involves the buying of bonds
...
The Fed buying bonds, it puts money into the hands of those who had
held bonds
...
Contractionary monetary policy involves the selling of bonds
...
The Fed sells bonds it removes money from the system and replaces it
with bonds
...
Required Reserve Ratio - the Fed can raise or lower the required reserve ratio
...
Increasing the required reserve ratio, reduces the money multiplier, hence
reduces the amount by which multiple expansions of the money supply
can occur
...
Decreasing the required reserve ratio increases the money multiplier,
and permits more multiple expansion of the money supply
...
The Discount Rate is the rate at which the Fed will loan reserves to member
banks for short periods of time
...
Velocity of Money - is how often the money supply turns-over
...
The quantity theory of money is: MV = PQ
1
...
6
...
Interest rates and the business cycle may present a dilemma
...
b
...
7
...
a
...
8
...
a
...
9
...
Discretionary monetary policy often misses targets in U
...
monetary
history
b
...
Economic Stability and Policy
Lecture Notes
1
...
The misery index is the inflation rate plus the unemployment rate
...
The Phillips Curve is a statistical relation between unemployment and inflation
named for A
...
Phillips who examined the relation in the United Kingdom and
published his results in 1958
...
a
...
b
...
43
This long-run view of the Phillips Curve is also called the Natural Rate
Hypothesis
...
If this is the case, then business and consumers
cannot be fooled into thinking that there is a reason for unemployment to cure
inflation or vice versa
...
Possible positive sloping has hypothesized by Milton Friedman
...
The positively sloped Phillips curve is show in the following
picture:
The positively sloped transitional Phillips Curve is consistent with the
observations of the early 1980s when both high rates of unemployment
existed together with high rates of inflation -- a condition called stagflation
...
Cruel choices only exist in the case of the short-run trade-off view of the
Phillips Curve
...
3
...
If the
accuracy of consumers' and business expectations permit them to behave as
though they know what will happen, then it is argued that only a vertical Phillips
Curve is possible, as long as political and economic institutions remain stable
...
Market policies are concerned with correcting specific observed economic woes
...
Equity policies are designed to assure "a social safety net" at the minimum
and at the liberal extreme to redistribute income
...
The Lorenz Curve and Gini Coefficients are used to measure income
distribution in economies
...
The 45 degree line shows what the distribution of income
would be if income was uniformly distributed across the population
...
The Gini coefficient is the percentage of the triangle mapped out by the 45
degree line, the indicator line from the top of the 45 degree line to the
percentage of income axis, and the percentage of income axis that is
accounted for by the area between the Lorenz curve and the 45 degree
45
line
...
b
...
The Investment Tax
Credit, WIN program, and various state and federal training programs are
focused increasing productivity
...
Trade barriers have been reduced through NAFTA and GATT in hopes of
fostering more U
...
exports
...
Wage-Price Policies
a
...
Carter
tried voluntary guidelines that failed, and Nixon tried controls that simply
were a disaster
...
Supply Side Economics of the Reagan Administration were based on the theory
that stimulating the economy would prevent deficits as government spending for
the military was increased
...
a
...
Laffer's idea was rather simple, he posited that there was
optimal tax rate, above which receipt went down and below which receipts
went down
...
" What the supply-siders
thought was that tax rates were too high and that a reduction in tax rates
would permit them to slide down and to the right on the Laffer Curve and
collect more revenue
...
We got a big tax rate reduction and found, unfortunately, that
we were below the optimal and tax revenues fell, while we dramatically
increased the budget
...
b
...
These
economists thought there was too much government regulation
...
7
...
a
...
b
...
8
...
Public choice literature
1
...
Epilogue
Lecture Notes
1
...
Knowledge is prerequisite for democracy
1
...
Business conditions
1
...
2
...
c
...
Individual economic planning – 401K, investments, etc
...
Understanding markets requires understanding the environment in
which they work – full circle to a and b above
2
...
a
...
b
...
Technological changes - products and processes available today which
didn’t exist 10 years ago
d
...
e
...
3
...
Economics majors, areas in which they work, one of fastest growing
majors in U
...
universities
48
b
...
c
...
The specific
purpose of this chapter is to define economics (and its major component fields of study),
describe the relation between economic theory and empirical economics, and examine
the role of objectivity in economic analysis, before examining economic goals and their
relations
...
Definitions
Economics has been studied since sixteenth century and is the oldest of the
social studies
...
The subject matter examined in economics is the behavior of
consumers, businesses, and other economic agents, including the government in the
production and allocation processes
...
Economics is one of those words that seems to be constantly in the newspapers
and on television news shows
...
Economics is the study of the allocation of SCARCE resources to
meet UNLIMITED human wants
...
Robert Heilbroner describes economics as a "Worldly Philosophy
...
This worldly philosophy has been used to explain most rational
human behavior
...
)
51
Underlying all of economics is the base assumption that people act in their own
best interest (at least most of the time and in the aggregate)
...
Consistent responses to stimuli are necessary for a model
of behavior to predict future behavior
...
As limiting as this assumption may seem, it
appears to be an accurate description of reality
...
Most academic disciplines have evolved over the years to become collections of
closely associated scholarly endeavors of a specialized nature
...
An examination of one of the scholarly journals published by the American
Economics Association, The Journal of Economic Literature reveals a classification
scheme for the professional literature in economics
...
In other words, the realm of economics
has expanded to such an extent over the centuries that it is nearly impossible for
anyone to be an expert in all aspects of the discipline, so each economist generally
specializes in some narrow portion of the discipline
...
Economics can be classified into two general categories; these are (1)
microeconomics and (2) macroeconomics
...
In
other words, microeconomics is concerned with the behavior of individuals or groups
organized into firms, industries, unions, and other identifiable agents
...
Macroeconomics is concerned with the aggregate performance of the
entire economic system
...
These matters are the topics to be examined this course (E202),
Introduction to Macroeconomics
...
A significant amount of the material covered in this course involves public
policy and has a significant historical foundation
...
In many respects, that makes this course of current interest, if not fun
...
These scientific endeavors can be classified into two
categories, (1) economic theory and (2) empirical economics
...
These theories are
typically rigorous mathematical models (abstract representations) of behavior
...
Empirical economics relies upon facts to present a description of
economic activity
...
The tests that are typically applied to
economic theories are statistically based, and is generally called econometric methods
...
Sociology, psychology and anthropology typically rely on inductive logic
to create theory
...
In other
words, the scientist will observe evidence and attempt to create a principle or a theory
based on any consistencies that may be observed in the evidence
...
Deductive logic involves formulating
and testing hypotheses
...
The development of rigorous models
expressed as equations typically lend themselves to rigorous statistical methods to
determine whether the models are consistent with evidence from the real world
...
Therefore,
empirical methods are focused on rejecting hypotheses and those that fail to be rejected
over large numbers of tests generally attain the status of principle
...
In each of the social sciences, it is common to find that the basic theory is
developed using inductive logic
...
The usefulness of economics depends on how accurate economic theory
predicts behavior
...
The internal consistency brought to
economic theory by mathematical models often fosters objectivity
...
If the assumptions are
either unrealistic or formulated to introduce a specific bias, objective analysis ca still be
thwarted (under the guise of scientific inquiry)
...
Models are abstractions from reality - the best model is the
one that best describes reality and is the simplest (the simplest requirement is called
Occam's Razor)
...
Often (as will be pointed-out in this course) the assumptions underlying
a model are not accurate descriptions of reality
...
One assumption frequently used in economics is ceteris paribus which means
all other things equal (notice that economists, like lawyers and doctors will use Latin to
express rather simple ideas)
...
Economic Goals, Policy, and Reality
Most people and organizations do, at least rudimentary planning, the purpose of
planning is the establishment of an organized effort to accomplish some economic
goals
...
Goals are, in a sense, an
idea of what should be (what we would like to accomplish)
...
This brings another classification scheme to bear on economic thought
...
Positive economics is concerned with what is; and normative economics is
concerned with what should be
...
Evidence concerning economic performance or achievement of goals falls
within the domain of positive economics
...
The types of goals a society adopts depends very much on the stage of economic
development, system of government, and societal norms
...
Each goal (listed above) has obvious merit
...
For example, it is easy for the very wealthy to
cite as their primary goal, economic freedom, but it is doubtful that anybody living in
poverty is going to get very excited about economic freedom; but equitable distributions
of income, full employment and economic security will probably find rather wide support
54
among the poor
...
Economics can hardly be separated from politics because the establishment of
national goals occurs through the political arena
...
A word of warning, eCONomics can be, and has often been used, to
further particular political agendas
...
For example, Ronald Reagan argued that government
deficits were inexcusable, and that the way to reduce the deficit was to lower peoples'
taxes -- thereby spurring economic growth, therefore more income that could be taxed
at a lower rate and yet produce more revenue
...
Reagan is often accused, by his
detractors, of having a specific political agenda that was well hidden in this analysis
...
(Who really knows?)
Most political commentators, both left and right, have mastered the use of assumptions
and high-sounding goals to advance a specific agenda
...
On the other hand, goals can be publicly spirited and accomplish a substantial
amount of good
...
The Morrell Act was passed 1861 and created Land Grant
institutions for educating the working masses (Purdue, Michigan State, Iowa State, and
Kansas State (the first land grant school) are all examples of these types of schools)
...
In other words, economic goals that are complementary are consistent
and can often be accomplished together
...
Because any society's resources are limited, there must be decisions about
which goals should be most actively pursued
...
Prioritizing is the rank ordering of goals, from the most
important to the least important
...
In the public policy arena, prioritizing of
economic goals is often the subject of politics
...
An individual can
easily prioritize goals
...
For the United States to establish national priorities is a far larger task
...
Smith suggests that there are three
legitimate functions of government in a free enterprise economy
...
There is little or no controversy
concerning the first two of these government functions
...
Often you hear that some non-profit organization or government agency should
be "run like a business
...
If the capitalist
model is correct, then the only reason for an entrepreneur to establish and operate a
business is to make profits (otherwise, the conduct of the business is irrational and
cannot be explained as self-interested conduct)
...
For example, a church may
be established for the purposes of maximizing spiritual well-being of the congregation
(the doing of good-works, giving testimony to one's religion, worship of God, and the
other higher pursuits)
...
A University is to increase the body of knowledge through
basic and applied research, professional services, and (of primary importance to the
students) to provide for the education of students
...
Inherent in this argument is the
assumption (a fallacy) that the profit motive would suffice to assure that society received
a quality product (spiritual or educational or both) and in the quantities necessary to
accomplish broad social objectives
...
It is through our free, democratic processes that we
establish national, state and local priorities
...
56
Policy
Policy can be generally classified into two categories, public and private policy
...
Public policy is how national economic goals are pursued
...
Therefore, to understand goals one needs to understand
something of the process of formulating policy
...
For students in other
programs the brief treatment here will suffice for present purposes
...
Stating goals - must be measurable with specific stated objective to be
accomplished
...
Options - identify the various actions that will accomplish the stated
goals & select one, and
3
...
_____________________________________________________________________
Both the public and private policy formulation process are dynamic processes
...
Step 1 involves the setting of goals
...
Step 2 involves selecting the appropriate model and the options associated with
that model to accomplish the specified goal
...
The monitoring of progress involves the gathering of evidence
and the appropriate analysis to determine whether the policy is doing what was
anticipated or whether the policy needs revision
...
The major difference between public policy and private policy is that private
policy is not subject to democratic processes
...
Often private policy is made behind closed-doors without public
accountability
...
Objective Thinking
Most people bring many misconceptions and biases to economics
...
Because of political beliefs and
other value system components rational, objective thinking concerning various
economic issues fail
...
In turn, such objectivity requires the shedding of the most basic
preconceptions and biases -- not an easy assignment
...
The appropriate decision based on
economic principles may be inconsistent with other values
...
e
...
If an
inconsistency between economics and ethics is discovered in a particular application, a
rational person will normally select the option that is the least costly (i
...
, the majority
view their integrity as priceless)
...
In other words,
economics does not provide all of the answers; it provides only those answers capable
of being analyzed within the framework of the rational behavior that forms the basis of
the discipline
...
After all,
few things excite more emotion than our material well-being
...
Among the most common
logical pitfalls that affect economic thought are: (1) the fallacy of composition, and (2)
post hoc, ergo prompter hoc
...
The fallacy of composition is the mistaken belief that what is true for the
individual must be true for the group
...
In other words, this fallacy
is simply assuming a small, unscientifically selected sample will predict the behavior,
values, or characteristics of an entire population
...
U
...
U
...
Statistical inference can be drawn from a sample of individual
observations, but only within confidence intervals that provide information concerning
the likelihood of making an incorrect conclusion (E270, Introduction to Statistics,
provides a more in depth discussion of confidence intervals and inference)
...
Simply because one event follows, another does not
necessarily imply there is a causal relation
...
All of us have, at one time or another experienced a simple
coincidence
...
For example, during the thirteenth century people noticed that the black plague
occurred in a location when the population of cats increased
...
In fact,
the plague was carried by fleas on rats
...
The people killed the
predatory cats, and therefore, rat populations increased, and so did the population of
fleas that carried the disease
...
The idea that cats were observed
increasing in population gave rise to the conclusion that the cats brought the plague is a
post hoc, ergo prompter hoc fallacy, but this example has an indirect relation between
cats in the real cause
...
Many superstitions are classic examples of this type of fallacy
...
There is no causal relation
between breaking glass and bad luck or walking under ladder (unless something falls off
the ladder on the pedestrian)
...
However,
more in depth analysis is often costly, and the cost has the potential of causing
decision-makers to skip the informed part and cut straight to the opinion
...
The following box presents a case where policy was implemented based
on the failure to recognize that there is a significant amount of interdependence in the
U
...
economy
...
Dilts, Indiana Policy Review, Vol
...
5, pp
...
)
Many a cliché seems to center on pork
...
It only seems fitting that one more story
concerning pork should be brought to your attention
...
The farmers brought political
pressure to bear on the Congress and our representatives to deregulate the price of
pork
...
Shut down our steel mills? How could this be?
Since it is not intuitively obvious how this happened, I'll explain
...
And, as luck would have it,
we didn't have good trade relations with the new management -- the Japanese
...
We had not yet developed synthetic fibre and therefore has
to rely on the fibre previously available
...
Now hemp grows in the same places, under the same climatic conditions as
does corn
...
And because corn was not being grown in the
Midwest, the farmers sought alternative feed for the increased number of hogs they
were raising
...
)
Oats, wheat and barley were available from the Great Plains region
...
In their search for transportation, the farmers found that railroads were
regulated and reserved for military and heavy industry; trucks needed gasoline and
rubber, both in short-supply; and airplanes were being built almost exclusively for
military purposes
...
But they eventually found a source of shipping that was neither
regulated nor controlled, because it was international in nature -- the iron-ore barges
on the Great Lakes
...
And there you have it: Without the
requisite iron ore the steel mills could not produce; they were actually shut down for a
period as a direct result of deregulating the price of pork
...
S
...
While our economic freedom is one of the prime ingredients in making our
economy the grandest in the world, such freedom requires that it be exercised in a
responsible fashion, lest the freedom we prize becomes a source of social harm
...
Government and the exercise of our democratic responsibilities
is suppose to provide the checks on the negative results of the type portrayed in the
above box
...
Most of the statistical methods used in econometrics (statistical examination
of economic data) rely on correlation
...
This statistical association means that the two variables move
predictably with or against each other
...
For example, a graduate student once
found that Pete Rose's batting average was highly correlated with movement in GNP
during several baseball seasons
...
On the other hand, we can test for causation (where one variable actually causes
another)
...
As with
most statistical methods Granger causality models permit testing for the purpose of
rejecting that a causal relation exists, it cannot be used to prove causality exists
...
As is true with economics, statistics are simply a tool for analyzing evidence
...
Caution is required in accepting
statistical evidence
...
Statistics do
not lie, but sometimes statisticians do!
Objectivity and Rationality
Objective thinking in economics also includes rational behavior
...
Acting in one's best interests is how rationality is
defined
...
This economic perspective involves weighing the costs against the
benefits of each additional action
...
61
KEY CONCEPTS
Economics
Microeconomics
Macroeconomics
Empirical economics v
...
Deductive logic
Model Building
Assumptions
Occam’s Razor
Normative economics v
...
Private
Objective Thinking
Fallacy of Composition
Cause and effect
Bias
Correlation v
...
Why
do you suppose this is?
Sample Questions:
Multiple Choice:
62
Which of the following is not an economic goal?
A
...
C
...
Full Employment
Price Stability
Economic Security
All of the above are economic goals
Which of the following methods can be applied to test for the existence of statistical
association between two variables?
A
...
C
...
Correlation
Granger causality
Theoretical modeling
None of the above
True - false:
Non-economists are no less or no more biased about economics than physics or
chemistry {FALSE}
...
63
Chapter 2
National Income Accounting
The aggregate performance of a large and complex economic system requires
some standards by which to measure that performance
...
As imperfect as the
national income accounting methods are, they are the best measures we have and they
do provide substantial useful information
...
Gross Domestic and Gross National Product
The most inclusive measures we have of aggregate economic activity are Gross
Domestic Product and Gross National Product
...
In the case of Gross Domestic Product, we are
concerned with what is produced within our domestic economy
...
On the other
hand, Gross National Product is concerned with American production (regardless of
whether it was produced domestically)
...
These measures (GDP and GNP) are the two most commonly discussed in the
popular press
...
Often these data are presented as being overall measures of our
population's economic well-being
...
To fully understand these limitations we must first understand how these
measures are constructed
...
For example, if we count a finished automobile in the
national income accounts, what about the paint, steel, rubber, plastic, and other
components that go into making that car? To systematically eliminate double counting,
only value-added is counted for each firm in each industry
...
By focusing only on value-added at each step of
the production process in each industry, national income accountants are thus able to
avoid the problems of double counting
...
S
...
1
192
...
4
646
...
1
3742
...
8
13
...
1
78
...
3
467
...
6
1772
...
2
32
...
8
212
...
1
1042
...
6
1
...
7
-1
...
2
-14
...
4
-399
...
1
286
...
4
1010
...
0
5513
...
0
The above box presents the GDP accounts in the major expenditures components
...
Put in equation form:
GDP (Y) = C + Ig + G + Xn
GDP can also be calculated using the incomes approach
...
The following illustration shows how GNP and GDP are calculated using the
incomes approach as follows:
65
_____________________________________________________________________
Depreciation
+
Indirect Business Taxes
+
Employee Compensation
+
Rents
+
Interest
+
Proprietors' Income
+
Corporate Income Taxes
+
Dividends
+
Undistributed Corporate Profits
= Gross National Product
- Net American Income Earned Abroad
= Gross Domestic Product
_____________________________________________________________________
In a practical sense, it makes little difference which approach to calculating GDP
is used, the same result will be obtained either way
...
The sub-accounts under each approach
provide useful information for purposes of understanding the aggregate performance of
the economy and potentially formulating economic policy
...
The following accounts illustrates how GDP is broken down into another useful
set of sub-accounts
...
The
following illustration demonstrates how the sub-accounts are calculated:
66
______________________________________________________________________
Gross Domestic Product
- Depreciation =
Net Domestic Product
+ Net American Income Earned Abroad
- Indirect Business Taxes =
National Income
- Social Security Contributions
- Corporate Income Taxes
- Undistributed Corporate Profits
+ Transfer Payments =
Personal Income
- Personal Taxes =
Disposable Income
_____________________________________________________________________
The expenditures approach provides information concerning from what sector
proportions of GDP come
...
Likewise, the incomes approach provides greater detail to our
understanding of the aggregate economic output
...
National Income takes out of Net National Product all ad valorem taxes that
must be paid during production and net American income originating from overseas
...
e
...
The amount of Personal Income that
households are free to spend after paying their taxes is called Disposable Income
...
However, we do know that this information fails to accurately measure our
aggregate economic well-being
...
67
National Income Accounts as a Measure of Social Welfare
Accounting, whether it is financial, cost, corporate, nonprofit, public sector, or
even national income, provides images of transactions
...
National income accounting, as do other accounting practices, also
has significant limitations in the availability of data and the cost of gathering data
...
GDP and GNP are nothing more than measures of total output (or income)
...
Further,
national income accountants make no pretense to measure only positive contributions
to total output that occur through markets
...
More information is necessary
before conclusions can be drawn concerning social welfare
...
In other words, the services of a cook if employed are counted, but
the services of a man or woman doing the cooking for their own household is not
...
In the earliest
decades of national income accounting, many of the more routine needs of the
household were served by the household members' own labor
...
In other words, the same level of service may have been provided, but
more of it is now a market activity, hence included in GNP
...
S
...
Certainly,
less market activity is in evidence in less developed countries that could be
characterized as household maintenance
...
Less developed countries' populations rely
predominately on subsistence farming or fishing, and therefore even food and clothing
may be rarely obtained in the marketplace
...
The only way leisure time could be included in GNP is to impute (estimate) a value for
the time and add it to GNP (the same method would be required for household services
of family members)
...
However, commodities
used in leisure activities are included in GNP
...
Product quality is not reflected in GNP
...
There is also
little information available upon which to base a sound conclusions concerning whether
the qualitative aspects of our total output has increased
...
S
...
No attempt is made in GDP data to account for the composition output
...
The
U
...
Department of Commerce publishes information concerning output and classifies
that output by industry groups
...
I
...
) and permits relatively easy tracking of total output by industry group, and
by components of industry groups
...
Whale oil lamps and horseshoes gave way to electric lights and
automobiles between the Nineteenth and Twentieth Centuries
...
In almost every aspect of life, the commodities that we use
have changed within our lifetimes
...
As we move further back in time, the commodities change even more
...
For centuries, after the fall of the Roman Empire, the composition
of total output was very similar
...
Therefore, the rapid change in available commodities
is a function of the advancement of knowledge, hence the advancement in technology
...
In the early centuries of this millennium, only a
privileged few had lifestyles that most of us would recognize as middle income or
above
...
With the tremendous
increases in knowledge over the past two-hundred years, technology has increased our
productivity so substantially that in the 28 industrialized nations of the world, the
majority of people in those countries do not know poverty
...
In short, with the increase in output has come an
increase in the well-being of most people
...
In the United
States, the largest economy in the world, there are still over 40 million people (about
14½ percent) that live in poverty, and only a very few these in life threatening poverty
...
The other 81 percent experience a middle-income lifestyle in the United
States
...
Poverty disproportionately falls to youngest and oldest segments of our population
...
Environmental problems are not addressed in the national income accounts
...
The image created by the accounts is that pollution,
deforestation, chemical poisoning, and poor quality air and water that give rise to
cancer, birth defects and other health problems are economic goods, not economic
bads
...
The only time these economic bads are
accounted for in GNP is when market transactions occur to clean-up the damage, and
these transactions are added to GNP
...
The largest understatement of GNP comes from something called the
underground economy
...
It includes all illegitimate
(mostly illegal) economic activities, whether market activities or not
...
Estimates abound
concerning the actual size of the underground economy in the United States
...
S
...
The F
...
I
...
It is clear that drugs, organized theft,
robberies, and other crimes against property are very substantial in the United States
...
After all, Al Capone never went to jail for all of the overt criminal acts involved in his
various criminal enterprises, he went to jail for another crime, that is, because he did
not pay income taxes on his ill-gotten gains
...
The maximum
estimates place this industry someplace in the order of a $500 billion per year business
in the U
...
Few legitimate industries are its equal
...
The image that the national income accounts portrays is that the $100 billion, plus that
is spent on law enforcement and corrections because of drug trafficking is somehow an
economic good, not a failure of our system
...
As almost any insurance company official can tell you, car theft is also another major
industry
...
Further, that if this car theft ring were a
legitimate business it would be the fourteenth largest in the United States (right above
Coca-Cola in the Fortune 100)
...
If
estimates are anyplace close to correct, and $500 billion per year are the gross sales of
drug dealers, and if the profits on this trade are only eighty percent (likely a low
estimate), and if the corporate income tax rate of forty-nine percent could be applied to
this sum, then instead of a $270 billion budget deficit, the Federal government would be
experiencing a surplus of something in the order of $130 billion, without any reduction in
expenditures for law enforcement and corrections (which could be re-allocated to
education, health care or other good purposes)
...
Price Indices
Changes in the price level poses some significant problems for national income
accountants
...
In fact, we had an increase in GNP, but
only in the current dollar value of that number
...
Comparisons between these two time periods means very little because the price
levels were not the same
...
Nominal GDP is the value of total output, at the prices that exist at that time
...
Real GDP is the value
of total output using constant prices (variations in price levels being removed)
...
There are a wide array of price
indices
...
M
...
A
...
These indices
are based on surveys of prices of a specific market basket of goods, at a particular point
in time
...
Further complicating matters, is the fact that the market basket of goods changes
periodically as researchers believe consumption patterns change
...
For the consumer price indices, there is a standard set of assumptions used to
guide the survey takers concerning what should be included in the market basket
...
There are also assumptions concerning home ownership, gift giving, diet, and
most aspects of the hypothetical family's standard of living
...
If
someone has a fixed income and there is a two percent inflation rate per year, then their
standard of living will decrease two percent per year (assuming the index used is an
accurate description of their consumption patterns)
...
e
...
Under the two percent annual inflation scenario, a household would need a
two percent increase in income each year simply to avoid a loss in purchasing power of
their income (standard of living)
...
Prior to World War II, however, the majority of American economic history is marked by
deflation
...
With a deflationary economy all one
must do to have a constant increase in their standard of living is to keep their income
constant while prices fall
...
Suppose you want to buy a
house
...
If you purchase a
house worth $50,000 and borrow eighty percent of the purchase price, $40,000 you
may have a problem
...
In the sixth year, you owe more on
72
your thirty-year mortgage than the market value of the house
...
On the other hand, if you owe a great deal of money, you have the opportunity to
pay back your loans with less valuable money the higher the rate of inflation
...
The inflationary experience of the post-World War II period has resulted in our
expecting prices to increase each year
...
One of the most notable changes in our economic behavior has
been the wide adoption of escalator provisions in collective bargaining agreements,
executory contracts, and in entitlement laws (social security, veterans' benefits, etc
...
O
...
A
...
For example, the escalator contained in the General Motors and United
Auto Workers contract provides for employees receiving 1¢ per hour for each
...
This protects approximately $5
...
01/
...
(There is no
escalator that provides a greater benefit to income receivers than the GM-UAW national
agreement)
...
(Price data
that measures changes over time are called time series, and those that measure
differences within a time period but across people or regions are called cross sections)
...
On this ACCRA index Fort Wayne generally ranges between about 96
...
0, where 100 is the national average and the error of estimate is between 2 and 4
percent
...
For example, the components of the CPI are also
broken down so that we have detailed price information for health care costs, housing
costs, and energy costs among others
...
The CPI is based on a market basket of goods and is expressed
as a percentage of the value of the market baskets' value in a base year (the year with
which all prices in the index are compared)
...
Note that the index number for the base year will
be 100
...
By using this index, we can convert nominal values into real values (real value
are expressed in base year dollars)
...
Inflating is the adjustment of prices to a higher level, for years when
the index is less than 100
...
The process whereby we inflate and deflate is relatively simple and
straightforward
...
By 1996, the CPI increased
to 110
...
If we want to know how much $1
...
We accomplish this by dividing 110 by 100 and obtaining 1
...
1 and find
...
If we
want to know how much a 1989 dollar would buy in 1996, we must inflate
...
909; we then divide 1 by
...
10, which is the value of a 1989 dollar in 1996
...
Changing base years is a
relatively simple operation
...
This results in a new index with 1987 as a base year
...
The price index method has problems
...
In the case of the consumer price index, families without children or
with more than two may find their cost of living differs from what the index suggests
...
For families with ten
year old, fixed rate mortgages and high current mortgages rates, the CPI may
understate their current cost of living
...
74
Cost of Living Adjustments
David A
...
Deitsch, Labor Relations, New York: Macmillan
Publishing Company, 1983, p
...
To the casual observer, COLA clauses may appear to be an excellent method
of protecting the real earnings of employees
...
COLA is
not designed to protect the real wage of the employee but is simply to keep the
employee's nominal wage, within certain limits, close to its original purchasing power
...
4 increase in the CPI (if no ceiling is present) the base
wage which is being protected from the erosive effect of inflation is $2
...
3 increase in the CPI protects $3
...
2 increase in
the CPI protects $5
...
This is quite easy to see; since the CPI is an index
number computed against some base year (CPI = 100 in 1967) and the adjustment
factor normally required in escalator clauses is 1 cent per some increase x, in the
CPI, the real wage which is protected by the escalator is the inverse of the CPI
requirement or 1/x
...
Gross National Product
Value added
Expenditures Approach
Income Approach
Criticisms
Net Domestic Product v
...
Deflation
75
Cost-Push Inflation v
...
Deflating
STUDY GUIDE
Food for Thought:
Critically evaluate the use of national income accounts as measures of social welfare
...
Using the following data calculate GDP, NDP, NI, PI, and DI
Undistributed Corporate profits $40
Personal consumption expenditures $1345
Compensation of employees $841
Interest $142
Gross exports $55
Indirect business taxes $90
Government expenditures $560
Rents $115
Personal taxes $500
Gross imports $75
Proprietors income $460
Depreciation $80
Corporate income taxes $100
Net Investment $120
Dividends $222
Net American income earned abroad $5
Social security contributions $70
77
Sample Questions:
Multiple Choice:
If U
...
corporations paid out all of their undistributed corporate profits as dividends to
their stockholders then which of the following national income accountants would show
an increase?
A
...
C
...
Gross Domestic Product
Net Domestic Product
Personal Income
National Income
The following are costs of market baskets of goods and services for the years indicated:
1900
1910
1920
1930
1940
1950
1960
$100
$102
$105
$90
$100
$110
$160
Using 1920 as a base year what is the price index for 1900 and for 1960?
A
...
C
...
1900 is 105, 1960 is 160
1900 is 95
...
4
1900 is 111
...
8
Cannot tell from the information given
If there is a very large underground economy in the United States, then which of the
following statements is true?
A
...
Its existence means we are understating the GDP unless somehow we can
measure it appropriately
C
...
All of the above are true
78
True - False:
The GDP is overstated because of the relatively large amount of economic activity that
occurs in the underground economy {TRUE}
...
79
Chapter 3
Unemployment and Inflation
The measurement of the efficacy of a macroeconomic system focuses on
employment and price level stability
...
These two problems are unemployment (associated with recessions) and inflation
(associated with the lose of purchasing power of our incomes)
...
Mixed Economic System and Standard of Living
American capitalism is a mixed economic system
...
However, our economic system is
predominately capitalist
...
Perhaps more important, our high standards of living
are widely shared throughout American society (with fewer than 17
...
The accomplishments of American society ought not be taken lightly, no other
epoch and no other nation, has seen a "golden" age as impressive as modern America
...
Free
market systems have a troubling propensity to experience recessions (at the extreme
depressions) periodically
...
At times we also
seem to lose faith in accelerating rates of growth or economic progress
...
All of these problems have resulted in down-turns in economic activity
...
Together these down-turns and expansions are referred to as the
business cycle
...
Troughs, in the business cycle, are where
employment and output bottom-out during a recession (downturn) or depression
(serious recession)
...
These ups and downs
(peaks and troughs) are generally short-run variations in economic activity
...
The Great Depression of the 1920s and 1930s was a rare exception
...
One of the most confusing aspects of the business cycle is the difference
between a recession and depression
...
This downturn in output is associated with increased
levels of unemployment
...
In 1934, the U
...
economy experienced 24
...
The recession of 1958-61 reached only
6
...
This level of reduced economic activity is clearly only a
recession
...
7%
...
This 1981-85 period was clearly the worst
performing economy since World War II, but it also was clearly nothing compared to the
problems in the decade before World War II
...
That is, a recession is when your neighbor is out of
work, a depression is when you are out of work!
In general, the peaks and troughs associated with the business cycle, are shortrun variations around a long-term secular trend
...
Prior to World War II the secular trend started as relatively flat and limited growth
period and then it took a sharp downward direction until the beginnings of the War in
Europe (a period of about twenty years)
...
81
The following diagram shows a long-term secular trend that is substantially positive (the
straight, upward sloping line)
...
If we map out economic activity
since World War II we would observe a positive long-term trend, with marked ups and
downs showing the effects of the business cycle
...
These variations,
called seasonal variations, last only weeks and are associated with the seasons
of the year
...
Throughout most of the Midwest agriculture and
construction tend to be seasonal
...
In the upper Midwest, north of Fort Wayne, outside work is very limited due to extreme
weather conditions, making construction exhibit a seasonal trend
...
Unemployment
Unemployment is defined to be an individual worker who is not gainfully
employed, is willing and able to work, and is actively seeking employment
...
During the Vietnam War unemployment dropped to 3
...
5% in 1969
...
Because of
82
the economic expansion of the Vietnam era more jobs were available, but during the
same period many people dropped out of the work force who may otherwise have been
unemployment or, alternatively, vacated jobs that became available to others to avoid
military service
...
Additionally, there was a substantial expansion in the manpower needs of
the military with nearly 500,000 troops in Vietnam in 1969
...
Unemployment can decrease because more jobs become available
...
Unemployment is more than idle
resources, unemployment also means that some households are also experiencing
reduced income
...
Economists classify unemployment into three category by cause
...
Frictional
unemployment consists of search and wait unemployment, which is caused by people
searching for employment or waiting to take a job in the near future
...
Cyclical
unemployment is due to recessions, (the downturns in the business cycle)
...
Full employment is not zero unemployment, the full employment rate of
unemployment is the same as the natural rate
...
However, there is not complete professional agreement concerning the
natural rate, some economists argue that the natural rate, today is, about 5%
...
The reason that frictional and structural unemployment will always be observed is
that our macroeconomy is dynamic
...
There is also a certain proportion of
structural unemployment that should be observed in a healthy economy
...
Therefore, the structural component
83
of the natural rate is only a fraction of the total structural rate in periods where there is
displacement of older industries that may result from other than normal economic
progress
...
e
...
The level of output associated with full utilization of our productive
resources, in an efficient manner is called potential output
...
It is the level of employment
and output associated with being someplace on the production possibilities curve (from
E201)
...
Full employment is not zero unemployment and potential GNP is not total
capacity utilization (full production), such levels of production are destructive to the labor
force and capital base because people fulfill other roles (i
...
, consumer, parent, etc
...
The Nazi's slave labor camps (during World War II)
were examples of the evils of full production, where people were actually worked to
death
...
The work force is about half of the total population
...
Another way to look
at it, is that the labor force consists of those persons who are employed or unemployed
who are willing, able and searching for work
...
In
aggregate the average number of hours worked by employees in the U
...
economy
generally is something just under forty-hours per week (generally between 38 and 39
hours per week)
...
Part time employees are included in the work force
...
Those who do not
have 40 hours of work (or the equivalent) available to them are classified as part time
employees
...
5 million U
...
workers were are involuntarily
part-time workers, and about 12 million were voluntarily part-time employees, this is up
about 3 million from total part time employment in 1982
...
Discouraged workers are those persons who dropped out of labor force because they
could not find an acceptable job (generally after a prolonged search)
...
There are also those individuals who have recently
lost jobs who are not interested in working, but do not wish to lose their unemployment
benefits
...
This is called false search and serves
to overstate the unemployment rate
...
However, what evidence exists suggests that in recent years the
discouraged worker problem is the larger of the two problem, suggesting that the
unemployment rate may be slightly understated
...
Based on empirical observation an economist determined that there was a fairly stable
relation between unemployment and lost output in the macroeconomy
...
As we move away from an economy in full employment, noninflationary equilibrium, we find that we lose jobs in a fairly constant ratio to the loss of
output
...
5%) between
actual GDP and potential GDP
...
It is also
true that unemployment tends to trail behind total output of the economy, so it is not a
perfect or current indicator
...
In other words, as the economy goes into recession that last variable
to reflect the loss of output is the unemployment rate
...
There are several factors that have been
historically associated with who bears what proportion of the aggregate levels of
unemployment
...
The individual occupational choice will effect the likelihood of becoming
unemployed
...
There are also
specific occupations (even highly skilled or highly educated) that may experience
unemployment due to structural changes in the economy
...
As educational resources declined in the 1970s and
again recently, many persons with a Ph
...
level education and certified teachers
experienced unemployment
...
Age also plays a role
...
As people enter the
work force for the first time their initial entry puts them into the unemployed category
...
However, there is some evidence that age discrimination may present a problem for
older workers (the Age Discrimination Act covers those persons over 40, and it appears
those over 50 experience the greatest burden of this discrimination)
...
Most frequently the race and gender effects
are the result of unlawful discrimination in the labor market
...
Edmund Phelps developed a theory called statistical theory of racism and
sexism that sought to explain how discrimination could be eliminated as a determinate
of the burden of unemployment
...
This formed the basis of affirmative action
programs
...
86
Inflation
The news media reports inflation, generally, as increases in the CPI
...
Inflation is defined as a general increase in all prices (the
price level)
...
The closest we have to a
measure of inflation is the GNP deflator that measures prices for the broadest range of
goods and services, but even this broader index is not a perfect measure, but its all we
have and some information (particularly when we know the short-comings) is better than
perfect ignorance
...
The rule of 70 gives a short-hand method of determining how long it
takes for the price level to double at current inflation rates
...
e
...
For
example, with ten percent inflation, the price level will double every seven years (70/10
= 7)
...
These three theories are demand-pull, cost-push, and pure inflation
...
Each of these
theories will be reviewed in the remaining sections of this chapter
...
The following chapter will develop a more sophisticated
aggregate supply/aggregate demand model, but for present purposes the naive model
will suffice
...
However, the
price variable here is not the price of a commodity, it is the price level (the CPI for want
of a better measure) and the quantity here is the total output of the economy, not some
number of widgets
...
This increase in all prices is
called inflation
...
Total output is associated with employment (remember Okun's
Law?)
...
Policy measures
designed to control demand-pull inflation, will shift the aggregate demand curve to the
left, (i
...
, reduce aggregate demand) and this reduction in aggregate demand is
associated with loss of output, hence increased unemployment
...
In this
case, a decrease in the aggregate supply curve
...
88
Aggregate
Supply
Price
Aggregate
Demand
Output
The OPEC Oil embargo may present the best case for cost-push inflation
...
Therefore, the dramatic increase in the price
of oil shifted the aggregate supply curve to the left (a decrease) , resulting in cost-push
inflation
...
This decrease in aggregate supply also
results in reduced output, hence unemployment
...
Pure Inflation
Pure inflation results from an increase in aggregate demand and a simultaneous
decrease in aggregate supply
...
The following aggregate supply/aggregate demand diagram illustrates the theory
of pure inflation:
89
Aggregate
Supply
Price
Aggregate
Demand
Output
Notice in this diagram, that aggregate supply shifted to the left, or decreased by exactly
the same amount that the aggregate demand curve shifted to the right or increased
...
Intuitively, this makes sense, with the loss of aggregate supply we would expect an
increase in prices, and with an increase in aggregate demand we would also expect an
increase in prices
...
In this case, with equal
changes in aggregate demand and supply output should remain exactly the same
...
These economists do not reject the idea that inflationary
pressures can occur because of an oil embargo or increases in consumer demand
...
They are quick to point out that a change in a single price in the price index
market basket can give the appearances of inflation, when all that happened was a
change in the relative price of one commodity with respect to all others
...
Inflation, in the monetarist view, can only occur if the
money supply is increased which permits all prices to increase
...
An increase
in all prices or in the price of a particular good, therefore, is a failure of the Fed to
appropriately manage the money supply
...
Creditors and
those living on a fixed income will generally suffer
...
If inflation is fully anticipated and people can adjust their nominal income or their
purchasing behavior to account for inflation then there will likely be no adverse effects,
however, if people cannot adjust their nominal income or consumption patterns people
will likely experience adverse effects
...
Normally, if you cannot adjust income, are a creditor with a fixed
rate of interest or are living on a fixed income you will pay higher prices
...
Debtors, whose loans specify a fixed rate of interest, typically benefit from
inflation because they can pay loans-off in the future with money that is worth less
...
It should
come as no surprise that the double digit inflation of fifteen years ago caused
subsequent loan contracts to often specify variable interest rates to protect creditors
from the erosive effects of unanticipated inflation
...
If savings
are placed in long-term savings certificates that have a fixed rate of interest, inflation
can erode the earnings on those savings substantially
...
Inflation will effect savings behavior in another way
...
Rather than to save now, consumers spend now
...
An increase in aggregate demand will
cause demand-pull inflation
...
At the other extreme, recessionary expectations may cause people to save,
that results in reduced aggregate demand, and another spiral effect can result (but
downwards)
...
It is more likely that people
will not take extreme views of economic problems
...
As
91
economic conditions change, consumers and producers change their expectations to
account for these changes; in another words, they adapt their expectations to current
and near term information about future economic events
...
It appears that the overwhelming majority of the players in the
macroeconomy are adaptive in their expectations
...
Dilts, Mike Rubison, Bob Paul, “Unemployment: which person's burden man or woman, black or white?" Ethnic and Racial Studies
...
12, No
...
100-114
...
The race and sex of the work force are significant determinants of the
relative burdens of unemployment
...
The dispersion of unemployment
for blacks varies directly with the business cycle, which suggests greater labor force
participation sensitivity by this group
...
...
These are rather
startling results
...
KEY CONCEPTS
Business Cycle
Peaks
Troughs
Seasonal trends
Secular trends
Unemployment
frictional
structural
cyclical
92
Full employment
Natural rate of unemployment
Potential output
Labor Force
part-time employment
discouraged workers
false search
Okun’s Law
Burden of Unemployment
Inflation v
...
Critically evaluate the three categories of unemployment, be sure to discuss the
problems with conceptualizing and measuring each
...
Which is worse? Why?
93
Sample Questions:
Multiple Choice:
Which of the following is most likely to benefit from a period of unanticipated inflation?
(assuming fixed assets and liabilities)
A
...
Those whose liabilities exceed their assets, and whose loans are variable rate
C
...
None of the above will benefit
People who are unemployed due to a change in technology that results in a decline in
their industry fit which category of unemployment?
A
...
C
...
frictional
structural
cyclical
natural
True - False:
Seasonal variations in data are impossible to observe in annual data {TRUE}
...
This model is one of two models (the other is the Keynesian
Cross) of the U
...
macroeconomic system that we will develop in this course
...
However, because the Keynesian Cross permits more direct analysis of the
multiplier effects and other economic phenomenon it will be the model that is relied
upon for the majority of the course
...
Rather than to be able to observe changes during
each second of a period of time (dynamic), we will compare the economy in one time
period with the model in a subsequent and distinct period
...
In this view of the
macroeconomy we simply aggregate everything on the supply side to obtain an
aggregate supply curve and aggregate everything on the demand side to obtain an
aggregate demand curve
...
However, because the two functions are
aggregations, the horizontal axis does not measure the quantity of a particular good, it
measures GNP
...
Aggregate Demand
The aggregate demand curve is a downward sloping function that shows the
inverse relationship between the price level and gross domestic output (GDP)
...
e
...
95
The reasons for the downward sloping aggregate demand curve are:
(1) the wealth or real balance effect,
(2) the interest rate effect, and
(3) the foreign purchases effect
...
On the other hand, as the price level
decreases the savings and wealth consumers have will purchase more
...
Assuming a fixed supply of money, an increase in the price level will increase
interest rates
...
g
...
This negative relation between the interest rate and purchases is
called the interest rate effect
...
Remember from Chapter 2 that if
exports remain constant and imports increase GNP declines (net exports)
...
The foreign
purchases effect is the propensity to increase purchases of imports, when the domestic
price level increases
...
Therefore, the aggregate
demand curve will slope downward and to the right, as shown in the diagram below:
96
The determinants of aggregate demand are the factors that shift the aggregate
demand curve
...
The expectations of producers and consumers concerning real income or
inflation (including profits from investments in business sector) will effect aggregate
demand
...
Should real income or inflation be
expected to fall, purchases may be postponed in favor of future consumption or
investment
...
Should any of these
three decrease there should be an increase in aggregate demand due to the increased
ability to purchase output
...
The amount of excess capacity in
industry will also impact the demand for capital goods
...
97
Government expenditures account for a significant proportion of GNP
...
The same is true of national income earned abroad, as American
economic activity moves abroad, the demand for domestic output will generally decline
...
S
...
If the Japanese Yen loses value with respect to the U
...
dollar, then
Japanese goods will become cheaper
...
S
...
As the dollar loses value relative to a foreign currency, such as the Yen, then
the Japanese goods become more expensive and American consumers will substitute
American goods for Japanese goods and aggregate demand increases
...
Several of these determinants may change at the same time, and
possibly in different directions
...
For example, if the dollar gains
one or two percent in value relative to the Yen this alone may cause a slight decrease in
aggregate demand
...
Aggregate Supply
The aggregate supply curve shows the amount of domestic output available at
each price level
...
These ranges of the aggregate supply curve are identified in the
following diagram
...
In other words,
wages and prices are assumed to be sticky (fixed) in this range of the aggregate supply
curve
...
Classical
economists believed that aggregate supply curve goes vertical at the full employment
level of output
...
The intermediate range is the transition between the horizontal and vertical
ranges of the aggregate supply curve
...
The determinants of aggregate supply cause the aggregate supply curve to shift
...
As input prices increase, aggregate supply decreases
...
In other words, for the
same level of production cost, we got less GNP
...
In other words, for the same level
of production cost we got more GNP
...
If labor
or capital becomes more productive then producers will receive more output for the
same cost of production
...
Changes in the legal or institutional environment will also increase aggregate
supply
...
To the extent that there are no diseconomies, this increases aggregate supply
...
e
...
E
...
changes concerned, among
99
others, the New York Stock Exchange), better schools, better health care, and less
crime all have the potential for increasing aggregate supply through the institutional
environment of business
...
The idea of equilibrium in
the macroeconomy is similar to that in microeconomic market
...
The following diagram portrays a
macroeconomy in equilibrium
...
Should aggregate demand increase up
to where the intermediate range starts, only output will change
...
In the classical range if aggregate demand increases, output will remain the
same, but the price level will increase
...
The solid
aggregate demand curve is the initial equilibrium
...
The changes in aggregate supply are analytically only marginally more
complicated than aggregate demand
...
As aggregate supply shifts downward along
100
the aggregate demand curve in the Keynesian and intermediate ranges, the price level
falls, and output will increase
...
The following diagram portrays
an increase in aggregate supply, the line labeled (AS1) and a decrease in aggregate
supply, the line labeled (AS2), and the original aggregate supply curve is the solid line
...
The Rachet Effect is
where there is a decrease in aggregate demand, but producers are unwilling to accept
lower prices (rigid prices and wages)
...
Therefore, there is a ratcheting of the aggregate supply curve (decrease in the
intermediate and Keynesian ranges) which will keep the price level the same, but with
reduced output
...
The same is argued to exist for wages in the labor market, in
other words, unions will resist decreases in wages associated with a decrease in
aggregate demand, hence they too, will place downward pressure on aggregate supply
...
However, if prices are
inflexible downward, then a decline in aggregate demand from AD2 to AD1 will not
restore the economy to its original equilibrium at point a
...
The ratchet effect means that the aggregate supply curve has shifted
upward (a decrease) in both the Keynesian and intermediate ranges
...
Critically evaluate both the Keynesian and Classical ranges of the aggregate supply
curve
...
Why does the aggregate demand curve slope downward? Why do we find ranges in
the aggregate supply curve? Explain
...
B
...
D
...
What would we expect to observe, if there is no ratchet effect?
A
...
C
...
In the classical range only a reduction in prices
In the Keynesian range only a reduction in output
Both A and B are correct
Neither A or B are correct
True - False:
All economists are convinced that ratchet effect exists in today's economy
...
{TRUE}
104
Chapter 5
Classical and Keynesian Models
The purpose of this chapter is to extend the analysis presented in Chapter 4
...
Introduction
The Classical theory of employment (macroeconomics) traces its origins to the
nineteenth century and to such economists as John Stuart Mill and David Ricardo
...
However, the work of
the classical school laid the foundations for current economic theory and a great
intellectual debt is owed to these economists
...
After all, the miracle of free market
capitalism was suppose to always result in a return to prosperity after short periods of
correction (recession)
...
It became very obvious by 1935 that the market
mechanisms were not going to self-adjust and bring the economy out of a very deep
depression
...
His book, The General Theory, (1936) was to change how
economists would examine macroeconomic activity for the next six decades (until
present)
...
He also provided the paradigm that explained how recessions can spiral
downwards into depression without active government intervention to correct the
observed deficiencies in aggregate demand
...
Many economists, on both sides of the Atlantic, were working on the problem of
why the classical theory had failed so miserably in explaining the prolonged, deep
downturn and in offering policy prescriptions to cure the Great Depression
...
As soon as John Maynard Keynes
105
had worked out the “general” theory, he literally rushed to print before someone beat
him to the punch, so to speak
...
The Classical Theory
The classical theory of employment (macroeconomics) rests upon two
fundamental principles, these are: (1) underspending is unlikely to occur, and (2) if
underspending should occur, the wage-price flexibility of free markets will prevent
recession by adjusting output upwards as wages and prices declined
...
The classicists believed that spending in
amounts less than sufficient to purchase the full employment level of output is not likely
...
The classicists based their faith in the market system on a simple proposition
called Say's Law
...
" In other words, every level of output creates enough income to purchase
exactly what was produced
...
There are leakages from the system
...
Savings give rise to gross private
domestic investment and the interest rates are what links savings and investment
...
In fact, people save for far different reasons that investors' purchase
capital
...
In
other words, as the economy entered a recession both wages and prices would decline
to bring output back up to pre-recession levels
...
The classicists believed
that a laissez faire economy would result in macroeconomic equilibria through the
unfettered operation of the market system and that only the government could cause
disequilibria in the macroeconomy
...
Automobile producers have not lowered
prices in decades
...
There has
106
been some concession bargaining by the unions in this industry, but even where wages
were held down, it is rare that a union accepts a nominal wage cut
...
Even though
the neo-classicists have come to realize that the market system has its imperfections,
they believe that government should be the economic stabilizer of last resort
...
The one exception they seem to allow, is the possibility of a major external
shock to the system, otherwise they claim there is sufficient flexibility to prevent major
depressions, with only very limited government responses (primarily through monetary,
rather than fiscal policy)
...
Keynesian Model
Keynes recognized that full employment is not guaranteed, because interest
motivates both households and businesses differently - just because households save
does not guarantee businesses will invest
...
Further, Keynes was
unwilling to assume that self-interest in a market system guaranteed that there would be
wage-price flexibility
...
Under the Keynesian assumptions there is no magic in the market system
...
Therefore, Keynes believed that
government had to be pro-active in assuring that underspending did not spiral the
economy into depression once a recession began
...
However, it must be
remembered that the Great Depression was an economic downturn unlike anything
experienced during our lifetimes
...
However, such economic devastation is something that is nearly impossible to imagine
unless one has lived through it
...
The U
...
economy had almost no social safety net, no
unemployment compensation, little in the way of welfare programs, no social security,
no collective bargaining, and very small government
...
Even though these programs may have a
personal significance, they were intended to prevent future demand-deficiency
depressions
...
Once recessionary pressures begin to build in the
economy, the loss of employment does not eliminate a household's consumption as
soon as savings are depleted
...
Further, the government has been
proactive in stabilization of economic downturns since the beginning of World War II
...
The government's ability to tax and to engage in deficit spending provides the
flexibility in the market system to deal with underspending that was only presumed to
exist by deflating the economy
...
Aggregate supply and aggregate demand can now be expanded to include the
savings and investment in the analysis to make for a more complete model
...
The Consumption Schedule
In beginning the development of the Keynesian Cross model, we return to
aggregate supply and aggregate demand
...
Along the horizontal
axis we are going to measure income (disposable income)
...
What this forty-five degree line illustrates is every point where expenditures and
income are equal
...
At this point, (400) all disposable income is consumed and
nothing is saved
...
The distance
between the 45 degree line and the consumption schedule is dissavings, shown in the
savings schedule graph by the savings function falling below zero
...
To the right
of the intersection of the consumption function with the 45 degree line, the consumption
schedule is below the 45 degree line
...
This analysis shows how savings is a leakage from the system
...
What is not consumed is saved, and vice versa
...
The Marginal Propensity to Consume (MPC) is the proportion of any increase in
disposable income that is spent on consumption (if an entire increase in income is spent
MPC is 1, if none is spent then MPC is zero)
...
The relation
between MPC and MPS is that MPS + MPC =1, in other words, any change in income
will be either consumed or saved
...
The slope of the consumption function is
...
2 or (2/10)
...
If ten dollars of additional income is obtained then $2 ($10
times
...
8) will be spent on consumption
...
However, average propensities to consume or save deal with what happens to
total income
...
Again, (just like the marginal propensities) if income can be either saved or
consumed (and nothing else) then the following relation holds, the average propensity
to consume plus the average propensity to save must equal one (APC + APS = 1)
...
95 and the
average propensity to save is
...
95 times $1000) and $50 in savings ($1000 times
...
The non-income determinants of consumption and saving cause the
consumption and savings functions to shift
...
In general, it has been empirically observed that the greater the amount of wealth
possessed by a household the more of their current income will be spent on
consumption, ceteris paribus
...
Conversely, the less wealth
110
possessed by a household the greater the incentive to save
...
The young (twenties) tend to save for homes and children, in the late
twenties through the forties, savings were less evident as children were raised, and with
the empty nest, came savings for retirement
...
An increase in the price level has the effect of causing the consumption function
to shift downward
...
As the value of wealth decreases, so too does
the command over goods and services, so consumption must fall (and savings
increase)
...
The expectations of households concerning future prices, incomes and
availability of commodities will also impact consumption and savings
...
If, on the other hand,
households expect incomes to increase, prices to fall, or commodities to become more
generally available, current consumption will decline (and savings will increase)
...
If consumers
are heavily indebted, save a third of their income goes on debt maintenance then
current consumption will decline to pay off debts (dis-savings)
...
Taxation operates on both the savings and consumption schedules in the same
way
...
On
the other hand, if taxes are decreased, then both the savings and consumption
functions will increase (shift upwards)
...
The following diagram
shows an investment demand curve
...
The
reason for this is relatively simple
...
A firm must be able to borrow the money to purchase capital at an interest rate
that is less than the expected net rate of return for the investment project to be
undertaken Therefore, there is an inverse relation between expected return and the
111
interest rate; and the interaction of the interest rate with the expected rate of return
determine the amount of investment
...
The determinants of investment demand are: (1)
acquisition, maintenance & operating costs of capital, (2) business taxes, (3)
technology, (4) stock of capital on hand, and (5) expectations concerning profits in
future
...
Therefore, anything that increases the expected net return
will shift the investment demand curve to the right, anything that cause the expected
return to fall will shift the investment demand curve to the left (decrease)
...
If the
acquisition, maintenance and operating costs decline, we would expected a higher rate
of return on this investment and therefore the demand curve shifts to the right
(increase)
...
If business taxes increase, the expected
net (after tax) return will decline, this shifts the investment demand curve to the left
...
Changes in technology will also shift the investment demand curve
...
By decreasing production costs or improving product
quality through technological improvements competitive advantages may be reaped and
this is one of the most important determinants of investment since World War II
...
To the
extent that producers have a large stock of capital goods on hand, investment demand
will be dampened
...
Business investment decisions are heavily influenced by expectations
...
For example, expectations that technological break-throughs may make
current computer equipment less competitive may dampen current investment demand
...
Autonomous v
...
Investment that is based on population growth,
expected technological progress, changes in the tax structure or legal environment, or
on fads is generally not a function of the level of total output of the economy and is
called autonomous investment
...
Induced investment is functionally related to the level of Gross Domestic Product
...
Induced investment is that investment that is "induced" because of
increased business activity
...
113
Throughout American economic history the level investment has been very
volatile
...
There are several reasons for this
instability, including: (1) variations in the durability of capital, (2) irregularity of
innovation, (3) variability of profits, and (4) the expectations of investors
...
Because of the durability and expense of capital
goods, their purchase can be easily postponed
...
Perhaps the most important contributors to the instability of investment in the
post- World War II period is the irregularity of innovations
...
During World War II there was heavy public investment in basic research in medicine
and the pure sciences
...
Again, in the late 1950s and early 1960s an
explosion of basic research occur that led to commercial advantages
...
For the private sector to invest there must be some expectation of profits flowing
from that investment
...
In the late 1940s, automobile producers knew
that profits would be nearly guaranteed because no new private passenger cars were
built in the war years
...
The expectations of business concerning profits, prices, technology, legal
environment and most everything effecting their business are simply forecasts
...
Because these expectations vary substantially
across businesses and over time, there should be significant variability in investment
decisions
...
Expenditures
Consumption Function
Marginal Propensity to Consume v
...
S
...
autonomous investment
STUDY GUIDE
Food for Thought:
Compare and contrast the classical model of the economy with the Keynesian model
...
Develop the consumption and savings schedules
...
What is the relation between savings and investment? Explain
...
Sample Questions:
Multiple Choice:
If you receive $40 in additional income and you save $4, what is your marginal
propensity to consume?
A
...
C
...
0
...
9
1
...
B
...
D
...
{TRUE}
116
Chapter 6
Equilibrium in the Keynesian Model
The purpose of this chapter is to extend the analysis of Chapter 5
...
In Chapter 7, that follows we will complete the analysis
of the Keynesian view of the macroeconomy
...
Further,
once achieved, an equilibrium in a macroeconomy has no propensity to change, unless
there is a shock to the system, or some variable changes to cause a disequilibrium
...
The neo-classicists view the primary macroeconomic as one of maintaining
equilibriums
...
Keynesians, on the other hand, begin their analysis with
disequilibrium because this is the natural state for a macroeconomy
...
In fact, this is
the major analytical difference between the neo-classical and Keynesian economists
...
This
provides for us the formula by which we can complete the model we began in the
previous chapter
...
The above figure shows a simple economy with no public or foreign sectors
...
The equilibrium level of GDP is indicated above where C + I is equal to the 45 degree
line
...
Keynes' Leakages - Injections Approach
The same result obtained in the expenditures - output approach above can be
obtained using another method
...
The leakages injections approach relies on the equality of investment and savings at equilibrium in a
macroeconomic system (I = S)
...
The amount of savings is what is available for gross
private domestic investment
...
However, this must be planned investment
...
Inventories can increase
beyond that planned, and inventories are investment (stock of unsold output)
...
Consider the following diagram, where savings is equal to I1, investment
...
Inv
...
The original equilibrium is where I1 is equal to S
...
If we experience a decrease in planned investment we move down to I2, with a
reduction in GDP (Recession), just like an increase in unplanned investment, and if an
increase in investment is observed it will be observed at I3, which is expansionary, and
this is similar to unplanned depletion of inventories (which could also be inflationary)
...
This re-spending
effect is called the multiplier, and we will provide a more detailed analysis of the
multiplier effects in the following chapter, however, the re-spending effect represented
by the multiplier will be introduced here to provide a full understanding of the model
...
In other
words, if $10 is injected into the system, then it is income to someone
...
If MPC is
...
00
...
00 in income
and will spend $8
...
90
...
Instead of summing all of the income, expenditures, and/or savings
there is a short-hand method of determining the total effect -- this is called the
Multiplier, which is 1/1-MPC or 1/MPS
...
119
The re-spending effect and the leakage - injection approach to GDP provides for
curious paradox
...
To accumulate capital, it
is often the policy of less developed countries to encourage savings, to reduce the
country's dependence on international capital markets
...
The reason that savings may remain the same is that unless
investment moves up as a result of the increased savings, all that happens is that GDP
declines
...
If investment
is autonomous then there is no reason to believe that investment will increase simply
because the savings rate increased
...
Full Employment
Simply because C + I + G intersects the 45 degree line does not assure utopia
...
The full employment level of GDP may be to the right or to the left of the
aggregate expenditures line
...
In either case, there is macroeconomic
disequilibrium, that will generally require appropriate corrective action (as will be
described in detail in the following chapter on fiscal policy)
Both forms of disequilibrium can be illustrated using the expenditures - output
approach
...
Is the level
of GDP that is associated with potential GDP or full employment
...
The dotted line shows the current macroeconomic equilibrium
...
5% of
lost potential GDP is associated with 1% unemployment above the full employment
level
...
5%
...
The distance between the C + I line and the
45 degree line along the dashed indicator line is the inflationary gap
...
In this case, there is too
much spending in the economy or some other (similar) problem that has resulted in an
inflated price level
...
These same problems can be shown, somewhat less elegantly, using the
aggregate supply - aggregate demand model, but with the loss of as precise
representation of the multiplier
...
Shifts in aggregate demand can be shown with holding the price level constant
and showing increases or decreases in C + I in the Keynesian Cross model
...
However,
from this point on will concentrate on our efforts on mastering the Keynesian Cross
...
Macroeconomic Disequilibrium
Expenditures - Output Approach
Leakages - Injections Approach
Planned v
...
What specifically is meant by a recessionary gap? Explain, and how does this differ
from an inflationary gap? Explain
...
122
Sample Questions:
Multiple Choice:
With a marginal propensity to consume of
...
B
...
D
...
25
2
...
00
None of the above
An inflationary gap is:
A
...
employment level of output
B
...
The amount by which the full employment level of output exceed the current level
of output
D
...
{TRUE}
The equilibrium level of output is that output whose production will create total spending
just sufficient to purchase that output
...
The revolutionary Keynesian
view that government must take a proactive role in stabilization of the business cycle
focused in large measure on the powers of the federal government to tax and to make
expenditures
...
The purpose of this chapter is to examine the fiscal policy tools and
their effectiveness
...
The economic history of the first half of the twentieth
century was a relatively stormy series of financial panics prior to World War I, a
relatively stagnant decade after World War I, and the Depression of the 1930s
...
It should therefore come as no
surprise that the Congress wished to assure that there was a pro-active role for the
government to smooth-out these swings in the business cycle
...
Its fiscal powers are
necessary to providing essential public goods
...
There is also the ebb and flow of politics
...
Johnson represents the public opinion of the 1960s, today's political agenda seems to
be substantially different
...
The government's taxing and spending authority to stabilize the economy
is called discretionary fiscal policy
...
In
times of underspending, the short-fall is made up by government spending or reductions
in taxes
...
However, in recent year the discretionary fiscal policies of the
federal government have become extremely controversial
...
Milton Friedman and others, have argued that there is no role for discretionary
fiscal policy
...
In
other words, Friedman believes that the classical economists, while over simplifying the
argument, were basically correct about keeping government out of the economy
...
The utility of these abstractions is to eliminate many of the
complications that have the potential to confuse the analyses and to simplify the
presentation of the concepts in which we are interested
...
In other words, a good model is one that is a close approximation of the
real world
...
We will assume that all investment and net exports are
determined by factors outside of GDP (exogenously determined), it is also assumed
that government expenditures do initially impact private decisions and all taxes are
lump-sum personal taxes (with some exogenous taxes collected, i
...
, customs duties)
...
The Goals of Government Expenditures
The primary and general goal of discretionary fiscal policy is to stabilize the
economy
...
However, for present purposes we
are concerned only with government expenditures used to stabilize the economy (taxes
will be examined elsewhere in this chapter)
...
The government can
also mitigate inflation by reducing government expenditures
...
Therefore, the government must have substantial information about the
economy to make fiscal policy work effectively
...
Further, the policy makers will need to know the current level of output
and what potential GDP is, (potential GDP is that output associated with full
125
employment)
...
For present purposes, we will assume the government has all the necessary information
at hand to conduct fiscal policy
...
In fact, this is also true of
investment and consumption expenditures, not just government expenditures
...
They will save a portion of the
expenditures and spend the rest, which then become income to someone else
...
This is the re-spending
effect discussed in Chapter 6
...
The
multiplier is the short-cut method of determining the total impact of an increase or
decrease in total spending in the economy
...
5, then the multiplier is 2 and the total
increase in spending resulting from the increase of $10 in government expenditures is
$20
...
In reality there are more leakages
...
These are
also leakages and would be added to the denominator in the multiplier equation
...
The complex multiplier has remained relatively
stable over the past couple of decades is estimated to be about 2
...
The following diagram presents a case of recession, that will be eliminated by
increasing government expenditures by just enough to eliminate the recession, but not
to create inflation
...
We also know that MPC is
...
25
...
75 we know the multiplier is 4 (1/
...
We also know that we
must obtain another $80 billion in GDP to bring the economy to full employment
...
Therefore to close this gap we must
spend $20 billion and the multiplier effect turns this $20 billion increase in government
expenditures into $80 billion more in GDP
...
The leakages approach yields the same results
...
127
Taxation in Fiscal Policy
The government can close a recessionary gap by cutting taxes, just as effectively
as it can by increasing government expenditures
...
The lump sum tax must be multiplied by the MPC to obtain the
reduction in consumption, however, such taxes are also paid proportionately from
savings
...
The tax is multiplied by the MPC and then by the simple multiplier to obtain the total
impact on GDP
...
8, then if we are going to increase GDP by $100 billion we must cut taxes
by $25 billion
...
8 is 1/
...
The decrease in taxation
necessary to increase GDP by $100 billion is the $100 billion divided by 4 or $25 billion
...
In other words, to get the same effect on
GDP you must decrease taxes by more than you would have had to increase
expenditures
...
This balanced budget approach can be used to expand the economy
...
In other
words, if you increases taxes by the same amount as expenditures, GNP will increase
by the amount of the initial increase in government expenditures
...
Therefore, the balanced budget multiplier is always one
...
75, then the simple multiplier is 4, (1/
...
25)-1], therefore the government must spend $50 billion and increase
taxes by $50 to increase GDP by $50
...
Perhaps the most controversial of all
tax issues concerns the structure of taxation
...
Progressive taxation is where the effective tax rate increases with ability to pay
...
A proportional tax structure is where a fixed proportion of ability to pay is taken in taxes
...
Therefore, if
the distribution of the tax across income groups will have a variable impact on the
consumption and savings
...
, are regressive
...
States like Kansas, California and New Jersey have mildly progressive
income taxes
...
Therefore, the current tax structures are not neutral
with respect to their re-distributional effects across income groups
...
Probably the most regressive of these taxes is the
gasoline tax
...
The
purpose of these programs was to provide the economy with a system of automatic
stabilizers to help smooth business cycles without further legislative action
...
Since the end of the Carter administration these automatic stabilizers have
become controversial
...
Since
2002 much of this “welfare reform” has also come under fire for not having produced the
results that were advertised
...
The idea behind a progressive income tax was basic fairness
...
As recessions occur, it is that segment of the population with the
greatest wealth that will have resources upon which to draw to pay taxes, the poor will
generally be impacted the most by high level of unemployment and recessions
generally leave them with very little ability to pay
...
The payroll tax is generally less than one percent of the first $10,800 of payrolls
...
The preponderance of this tax is paid during periods of expansion and is placed in a
trust fund
...
The effect is that money is taken out of the system during
expansion and injected during recession, which dampens the top of the cycle (peaks)
and eases the bottom of the cycle (trough)
...
The significant increases in the proportion of
poor people during recessions, however, do not add as much to the downward spiral of
underspending, that would have otherwise been observed in the absence of these
entitlement programs
...
Among these problems are (1) fiscal lags, (2) politics, (3) the
crowding-out effect, and (4) the foreign sector
...
Fiscal Lag
There are numerous lags involved with the implementation of fiscal policy
...
These fiscal lags fall into three
basic categories
...
The recognition lag is the amount of time for policy
makers to realize there is an economic problem and begin to react
...
Operational lags
are how long it takes for the fiscal actions to effect economic activities
...
For example, it is not
uncommon for the Congress to cut taxes because of a perceived recession that
subsequently ends within months of the enactment of the legislation
...
Politics, Crowding-out, the Foreign Sector and Fiscal Policy
Often politics overwhelms sound economic reasoning in formulating fiscal
policies
...
Perhaps
worse, is the fact that most bills involve log-rolling and negotiations
...
The end result is that politics confounds the formulation of policy designed to
deal with technical ills in the economy
...
131
there is little empirical evidence that demonstrates the exact magnitude of this
crowding-out effect, but there is almost certainly some small element of this
...
This problem is called Ricardian
Equivalence
...
To the extent that capital markets are
not open (foreign investors) the argument is plausible, however, in open economies
there is little empirical evidence to support this view
...
The most
technical of these problems is the net export effect
...
As the value of the dollar increases it makes
U
...
goods more expensive overseas and foreign goods less expensive domestically
...
There have also been shocks to the U
...
economy that have their origins outside
of the United States and are difficult if not impossible to address with fiscal policy
...
The United States and Holland supported the
Israeli in their war with the Arabs in the early 1970s
...
Because of our support, the Arabs
embargo oil shipments to the United States and Holland, which had the result of
increasing domestic oil prices and decreased aggregate supply, hence, driving up the
price level
...
KEY CONCEPTS
Social Welfare Programs
1946 Employment Act
Politics and change
Expenditures
Expansionary v
...
Contractionary Fiscal Policy
Multipliers
Simple
132
Taxation
Balanced Budget
Tax Structure
Proportional
Regressive
Progressive
Automatic Stabilizers
Progressive Income Taxes
Unemployment Compensation
Entitlement Programs
Fiscal Lags
Recognition
Administrative
Operational
Politics and Fiscal Policy
Log-rolling
Public Choice Economics
Government Deficits
Crowding-out
Ricardian Equivalence
Open Economy
STUDY GUIDE
Food for Thought:
Develop the expenditures - output model and show an increase (decrease) in taxes to
close an inflationary (recessionary) gap
...
Do the exercise one more time using the
balanced budget approach
...
Critically evaluate fiscal policy as an economic stabilization policy
...
Which is most reliable as a fiscal policy tool, taxes or expenditures? Defend your
answer
...
95, what would you do to close
the gap?
A
...
C
...
Increase taxes $5 million
Decrease expenditures $5 million
Increase taxes $100 and decrease expenditures $100
None of the above
2
...
1 which of the following policy
would close the gap?
134
A
...
C
...
Increase taxes and expenditures by $70 million
Increase expenditures by $7 million
Decrease taxes by $7
...
{TRUE}
Automatic stabilizers, such as unemployment compensation, provide counter cyclical
relief from economic instability without additional government action
...
Some definitions of growth will
offered, before proceeding to discussion of the causes of economic growth in the United
States and other nations
...
Definitions
Economic growth is defined in one of two ways, as a total (hence GDP) or as a
per capita (hence GDP per capita)
...
The second
definition is of the greatest importance in defining the standard of living in a country
...
Beer
Pizza
Remember the assumptions underpinning the production possibilities model is
that there are only two commodities produced, there is a fixed technology and number
of resources, and these resources are used in an economically efficient manner
...
The way that this growth can be obtained is
that the assumptions are relaxed
...
While this model shows growth, it shows it
only as a total concept, and nothing is represented with respect to how these additional
commodities are distributed
...
Developing economies are classified into two categories, middleincome countries $760 to $9300 per capita GDP in 2000, and low-income countries
those below $760 per capita GDP in 2000
...
The industrial, high income countries are the U
...
,
Canada, Australia, New Zealand, Japan, and Western Europe
...
Growth-paths are the historical tracing of how an economy moved from being
less developed to a developed economy
...
These commonalities have given
rise to the theory that there are prerequisites to economic growth, which include:
(1) Establishing and implementing domestic rules of law,
(2) Opening the economy to international trade,
(3) Controlling population growth,
(4) Encouraging foreign direct investment,
(5) Building human capital,
(6) Reasonable monetary institutions and markets,
(7) Minimizing the role of the military both domestically and internationally,
and
(8) Encouraging the growth of the private sector relative to the public sector
...
Once the infrastructure
is in place, the a substantial private economy can be expected to grow, if these
prerequisites and the infrastructure continue in place
...
It is nearly impossible to attract
capital to a developing nation, if the government is corrupt and there is little in the way
of political stability or the rule of law
...
S
...
Economic growth is a long-term secular trend
...
The above diagram shows several aggregate demand and aggregate supply
curves
...
The mapping out of the equilibriums, filling in all the intermediate
periods, is basically a mapping of a long term secular trend of economic activity
...
138
Output
Time
U
...
Growth
The accumulation of capital in the United States was both domestic capital, and
the attraction of foreign capital
...
At the beginning of the 19th century the U
...
had substantial European ties,
and was insulated from the political instability in Europe by the great barrier of the
Atlantic Ocean
...
With this the British traditions in common law and a strong constitutional form of
government gave this country both the rule of law and substantial political stability,
which permitted both foreign and domestic sources of capital accumulation to thrive
...
Cyrus
McCormick, George Washington Carver, Alexander Graham Bell, and Thomas Edison
all were responsible for significant innovations that created whole industries and
contributed substantially to the economic growth of the United States
...
The decade of the 1990s saw growth rates in the United States that were
unprecedented
...
S
...
Much of this growth ended in
139
2000
...
com companies
...
”
The Asian Tiger economies, China, Taiwan, Indonesia, South Korea, Malaysia,
the Philippines, and Thailand all experienced very substantial growth
...
The semi-conductor industry has suffered substantial
decline since 2000 and the growth rates of these Asian Tiger economies have gone
down drastically
...
Global Economic Development
The majority of the world’s population lives in low-income countries, and many of
these low-income countries have very substantial foreign debts
...
It is clear that population growth, the lack of health care, education, and
infrastructure added to the heavy debt burdens of these developing countries are
substantial impediments to economic growth
...
Many of the low income countries, particularly in Africa, are heavily in debt to
governments and private banks in the industrialized portions of the world
...
In many cases, this debt was acquired to buy military hardware, or was stolen by
corrupt former government leaders (Saddam Hussein is alleged to have left Iraq with
tens of billions of dollars in 2003)
...
Debt relief is something that is just beyond the
horizon, if economic disaster is to be avoided in many of these indebted countries
...
The United States and Japan both
provide very significant amounts of foreign aid to the developing portions of the world
...
2 percent of its GDP in various
foreign aid programs to developing countries
...
More than a
dozen other high income also provide substantial amounts in foreign aid
...
Corrupt foreign governments can
easily divert aid from productive endeavors to things never intended by the donor
country
...
Foreign aid can provide substantial improvements in infrastructure, incomes, and even
political stability
...
The end result, the developing
country becomes addicted, with no way out – or so the criticism goes
...
An open economy is also one way in which a growth path can be established
...
International trade, free and open trade, is one way in which a
developing economy might very well increase their per capita incomes, and hence
develop a consumer economy to assist in their own economic development
...
Developing economies fear becoming
economic colonies of industrialized nations, and are suspicious of such “free trade
...
There are historical
reasons for these fears, but free and open trade, based on comparative advantage, and
living wages is likely beneficial to all of the trading partners
...
” The highly skilled and educated persons in developing countries seem to have a
propensity to immigrate to North America and Western Europe
...
At the same time, the less skilled and educated are remaining in the
developing world, when such workers are in short supply in certain parts of the
industrialized world, hence, immigration policies towards those workers might serve
both groups of countries better if they were liberalized
...
If political stability is to be achieved and maintained in the developing world, then
the industrialized countries need to create some sensible policies towards the
exportation of arms to developing countries
...
141
KEY CONCEPTS
Economic Growth
Total
Per capita
Developed or high income countries
Developing countries
Middle income countries
Low Income countries
Growth Paths
Prerequisites to Growth
Secular Trend
Asian Tigers
Impediments to Growth
Debt
Brain Drain
Role of Developed Economies in Developing Economies
Foreign Aid
International Trade
Human Capital - Brain Drain
STUDY GUIDE
Food for Thought:
Why is growth deemed to be a long term secular trend? Explain
...
142
Sample Questions:
Multiple Choice:
Which of the following are NOT prerequisites to economic growth:
A
...
C
...
Brain Drain
Controlling population growth
Opening the economy to international trade
Encouraging foreign direct investment
How is growth illustrated in a production possibilities curve?
A
...
C
...
A point inside the curve
A point outside the curve
A shift of the curve to the left
A shift of the curve to the right
True - False:
Foreign aid to a developing economy is unambiguously good for the country receiving
that aid
...
{TRUE}
143
Chapter 9
Money and Banking
In primitive, tribal societies the development and use of money occurs only after
that society reaches a size and complexity where barter is no longer a viable method of
transacting business
...
When one individual has something another wants, and vice
verse, trade can be arranged be there is a coincidence of wants
...
When individuals live in a higher interdependent society, most necessities of life are
obtained through market transactions
...
This
volume of business makes barter nearly impossible
...
The purpose of this chapter is to introduce the reader to money and to the
banking system
...
The following chapters will
extend the analyses to demonstrate how money is created and how the monetary
system is used to stabilize the fluctuations in the business cycle
...
Each of these functions will be examined, in turn, in the following paragraphs
...
It is generally accepted as "legal
tender" or something of general and specified value, such that, people have faith that
they can accept it for payment, because they can use it in exchange without loss of
value
...
A barter economy makes exchange difficult, it may take several trades in
the market before you could obtain the bread you want for the apples you have
...
If you have apples and want bread, you simply
sell the apples for money and exchange the money for bread
...
In other words, money is
the grease that lubricates modern, sophisticated economic systems
...
Without money as a standard by which to
gauge worth, value would be set by actual trades
...
However, the nomads that wandered the northern plains of that country could
tell you in terms of goats, carpets, skins, and weapons what the range of values were
for horses
...
Money
permits the value of each commodity to be stated in simple terms of a single and
universally understood unit of value
...
Money can be saved with little risk, with virtually
no chance of spoilage, and little or no cost
...
To store money
(save) and later exchange it for commodities is far more convenient than having to store
commodities for future use, or to have to continually go through barter exchanges
...
Our prices are stated in terms of money, our transactions are facilitated by
money, and we can store the things we which to consume in the future by simply saving
money
...
The Supply of Money
The supply of money has a very interesting history in both U
...
economic history
and world economic history
...
The reason for this was that money, in those days, was primarily
coinage minted of gold, silver, and copper
...
In addition,
"barbarians" were constantly raiding Roman territory and it was the gold and silver that
they carried back with them (for trade)
...
This rapid deflation, added to a extremely maldistributed income, and loss of productive resources resulting in a rapidly declining
145
economy after the second century A
...
The Roman economy collapsed, with the
collapse of the economy the military and government were also doomed
...
In 1792, the U
...
Congress enacted the first coinage act
...
The Congress set the ratio of the value
of gold to silver in the coinage at 15 units of silver equaled one unit of gold
...
This arbitrary setting of the coinage value of these metals resulted in the gold coins
disappearing from circulation (being melted down as bullion) and only silver coins
circulating
...
In fact, the
standard unit adopted for U
...
coinage was the dollar, however, the Spanish minted
coins that were also called dollars (from a Dutch word, tolar)
...
S
...
S
...
Herein is the problem with using
gold or silver as minted coins or as backing for currency
...
Their relative values fluctuate and
result in money disappearing if the value of the metal is more than the unit of currency
in which the metal is contained
...
As the value of the gold or silver made the currency worth more as
bullion, that currency disappeared and was quickly replaced by monetary devices of
lesser value
...
A modern example of this is available from U
...
coinage
...
Therefore, the last general circulation coins that were minted in the United
States that contained any silver was 1964
...
67 ounces), but that silver is worth $5
...
Therefore, you do not see actual silver dollars in circulation, and will
not until the value of silver drops below $1
...
This observation is Gresham's
law in operation
...
The government issued paper money, particularly after
the Greenback Act of 1861 (there were numerous examples of U
...
paper money
before that year, including bank notes, state notes, and colonial notes)
...
146
Today, there are numerous definitions of money
...
The largest component of the M1 money supply is checkable deposits
(checking accounts, credit union share drafts, etc
...
Near Money
Near money are the items that fulfill portions of the requirements of the functions
of money
...
Credit cards are often accepted in transactions, and
the line of credit they represent can serve as a medium of exchange
...
Much of the wealth smuggled out of Europe at the end of World War
II by escaping Nazis was smuggled out in the form of gem stones, gold, and silver
bullion
...
However, in modern times, there is a potential for problems
...
The State of Indiana issued currency in the 1850s, in
part to help finance the canals that were being built across the State
...
State currency or even private bank currency is not controlled by a central bank
and is worth only what faith people have in it or the intrinsic value of the monetary unit
...
What Gives Money Value?
The value of the U
...
dollar (or any other currency) can be expressed as the
simple reciprocal of the price level:
D = 1/P
Where D is the value of the dollar and P is the price level
...
This is true of
147
any currency (money in general)
...
The value of money is determined by three factors, these factors are: (1) its general
acceptability for payment, (2) because the government claims it is legal tender (hence
must be accepted for payment), and (3) its relative scarcity (as a commodity)
...
It is not that the coin or paper has intrinsic value that makes
money of value in exchange, it is simply because people know that they can accept it in
payment and immediately exchange it for like value in other commodities, because
virtually everyone trusts its value in exchange
...
The international currency markets provide a very good example of why trust provides
money with value
...
A hard currency is one that can be exchanged for
commodities in any nation in the world
...
The U
...
dollar, French
franc, German deutsche mark, Canadian dollar, Japanese Yen, British pound, and
Italian lire are recognized as hard currencies (generally the Swiss franc is also included
in the hard currencies)
...
The reason that these countries are the creditor nations is that they
are the largest free market economies, have democratic and stable governments, and
long histories of rather stable financial markets
...
In
other words, the economic systems and governments that generate these currencies
are the markets from which everyone else imports a wide array of necessary
commodities
...
Because of their limited value in exchange, and rather volatile value these currencies
are called "soft" currencies
...
Hard currencies are
generally trusted, hence accepted, soft currencies are not
...
For example, the
United States is a large, economically powerful country
...
People have faith and trust in the
U
...
government making good on its financial obligations, therefore people have taken
notice when the United States government says that Federal Reserve Notes are legal
tender
...
Because money is a
scarce and useful commodity it also has value the same as any other commodity
...
S
...
S
...
S
...
S
...
S
...
By spring 1971, the exchange rate problems had become acute
...
Under these conditions, the
U
...
dollar was rapidly losing value against the German deutsche mark
...
To protect the value of the dollar and its exchange
rate with the German mark, however, the German central bank was losing control
over its domestic monetary policy
...
The scenario was the same for all countries that had
trade surpluses with the United States
...
Given that the United
States was rapidly losing its gold reserves, on August 155, 1971, by Richard Nixon's
order, it was announced that the United States officially abandoned the Bretton
Woods system and refused to exchange gold for U
...
dollars held by foreigners
...
S
...
The move to a flexible exchange rate system where the
exchange rates are determined by the basic market forces was the official demise of
the Bretton Woods system
...
Dilts, Doing
Business in Less Developed Countries: Financial Opportunities and Risks
...
74
...
Transactions demand for
money is the demand that consumers and business have for cash (or checks) to
conduct business
...
There is also an asset
demand for money
...
Together, the
asset and transaction demand for money comprise the total demand for money
...
The price of money is interest, primarily because money is also a claim on capital
in the financial markets
...
The Money Market
The money market is a particularly interest market
...
In examining only M1, the
currencies of various countries are exchanged for one another for the purpose of doing
business across national boundaries
...
For example, 105 Yen is the value of
a dollar, in the case of a Deutsche Mark, 1
...
There is also the credit market
...
A consumer purchasing a house will typically need a
mortgage and will borrow to buy a house
...
Both
types of borrowing influence the credit markets, because money is a relatively scarce
commodity
...
S
...
S
...
Typically the government borrows by selling Treasury Bonds
...
The Federal Reserve System regulates the money
supply through monetary policy and can increase or decrease the money supply by the
various actions it has available to it in regulating the banking system and in selling or
buying Treasury Bonds
...
The intersection of the money demand and money supply curves represents equilibrium
in the money market and determines the interest rate (price of money)
...
Both private companies and governments issue
bonds and receive cash
...
This is the primary market, where
bonds are sold directly by the government or company
...
This method of paying interest creates a "secondary" market for bonds
...
As the market value of the bond
increases, it drives down the rate of return on the bond, conversely, if the market value
of the bond decreases the rate of return increases
...
If the bond
remains at the $1000 face value the interest rate is 6%
...
If the market price of this $1000 bond increases
to $1200 then the rate of return falls to only 5% (60/1200 =
...
On the other hand, if
the bond is viewed as more risky, or there is an excess supply of bonds the market
price may fall, say to $800, then the rate of return increases to 7
...
075)
...
Bonds are good investments
when the interest rate is falling
...
In other words, falling interest rates mean larger market values
for the bonds, and greater profits for investors in bonds
...
S
...
S
...
The complete analysis of
these markets is not a single course, its an entire curriculum called Finance
...
D
...
C
...
These member
banks are generally large, nationally chartered banks that do significant amounts of
commercial banking
...
However, under the
Federal Reserve Act, the Board of Governors and Chairman are nominated by the
President of United States and confirmed by the Senate
...
Fort Wayne is in the Chicago region, however, Evansville is in the St
...
The functions of FED are basically associated with bank regulation and the
conduct on monetary policy
...
Set reserves requirements,
2
...
Fiscal agents for U
...
government,
4
...
Control money supply through Open Market Operations (buying and
selling of bonds)
...
Because the
FED is the agency through which Treasury obligations are bought and sold the FED is
the fiscal agent for the federal government
...
The Federal Deposit Insurance Corporation is a quasi-governmental corporation
whose purpose is to insure the deposits of member banks
...
However, after the savings & loans crisis, these other agencies were
consolidated under the control of F
...
I
...
The reason for these programs was the
experience of the banking industry during the Great Depression when many depositors
lost their life savings when the banks failed
...
" Runs are where depositors demand their funds, simply because they have lost
faith in the financial ability of the banks to meet their obligations (sometimes the loss of
faith was warranted, often it was nothing more than panic)
...
D
...
C
...
There is a problem with such insurance arrangements
...
Moral hazard is the effect that having insurance reduces the insured's
incentive to avoid the hazard against which they are insured
...
The managers of the failed saving
and loans often would extend loans or make investments that were high risk, but were
less concerned because if it resulted in failure, the government would pay-back the
depositors
...
D
...
C
...
KEY CONCEPTS
Functions of Money
Medium of Exchange
Avoidance of Barter
Measure of Value
Store of Value
Supply of Money
M1, M2, and M3
Near Money
Value of Money
Demand for Money
Transactions Demand
Asset Demand
Total Demand
Money Market
Interest rates
Federal Reserve System
Board of Governors
FMOC
Federal Advisory Council
12 regions
Functions of the Fed
Sets Reserve Requirements
153
Check clearing
Fiscal agent for the U
...
government
Supervision of Banks
Control of Money Supply
Moral Hazard
STUDY GUIDE
Develop and explain each:
Functions of money,
Demand for money,
Money supply, and
Value of money
...
What is near money? Explain and critically evaluate the use of near money
...
S
...
B
...
D
...
If a U
...
government 30-year bond sold originally for $1000 with a specified interest
rate of five percent, each year the bond holder receives $50 from the government
...
B
...
D
...
56%
5
...
50%
None of the above
True - False:
If the Fed wishes to decrease the money supply they can buy bonds {FALSE}
...
155
Chapter 10
Multiple Expansion of Money
The purpose of this chapter is to analyze how banks create money and how the
Federal Reserve System plays an essential role in regulating the banking system
...
Paper money is produced at the United States Bureau of Printing and Engraving
in Washington, D
...
Each day, the Bureau of Printing and Engraving produces about
$22 million in new currency
...
The stock of currency is created and maintained by a simple
printing and distribution process
...
The majority of the M1 money supply is checkable
deposits
...
S
...
The U
...
Bureau of
Printing and Engraving has developed a new fifty dollar bill that will make counterfeiting
more difficult
...
S
...
A few years ago, a strip was added to U
...
currency that when held to the light shows the denomination of the bill, so that
counterfeiters cannot use paper from one dollar bills to create higher denomination bills
...
S
...
Assets and Liabilities of the Banking System
Assets are items of worth held by the banking system, liabilities are claims of
non-owners of the bank against the banks' assets
...
Over the centuries a system of double
entry accounting has evolved that presents images of businesses
...
Accounts have developed a balance sheet approach to present the double entry
results of the accounting process
...
On the right hand side of the ledger are entered all of the claims against those
assets (claims by owners are net worth and claims by non-owners are liabilities)
...
This rather
simple method, is an elegant way to assure that claims and assets balance
...
Rational for Fractional Reserve Requirements
The fractional reserve approach to monetary stability dates from the middle-ages
in Europe
...
In return the goldsmiths would issue receipts for the gold they received
...
The stocks of gold acted as a reserve to assure
payment if the paper claims were presented for payment
...
The reserves of gold held by the goldsmiths created faith in the receipts as
mediums of exchange, even though there was no governmental involvement in the
issuing of this money
...
Genghis Khan first issued paper money in the thirteenth century
...
Therefore in the case of the Great Khan, it was the ability to
punish the untrusting individuals that gave money its value
...
The U
...
did not have a central banking system, as we know it, from the 1840s
through 1914
...
S
...
S
...
Both failed and were eliminated
...
During the first half of this country's history both states and private companies
issued paper money
...
It is little wonder that most of this currency became
worthless, except as collectors' items
...
S
...
The first widespread issuance of U
...
paper money was during the Civil War
(The Greenback Act), which included fractional currency (paper dimes & nickels!)
...
S
...
Today, the Federal Reserve requires banks to keep a portion of its deposits as
reserves, to help assure the solvency of the bank in case of a financial panic, like those
experienced in the first decade of this century and again in the 1930s
...
In turn, this public faith should
prevent future runs on the banking system that have historically caused so much
economic grief due to bank failures
...
The minimum legally allowable RRR is three percent, where
the current RRR has been set by the Board of Governors
...
The RRR is the amount of
reserves that a bank must keep, as a percentage of their total liabilities (deposits)
...
A
bank can keep reserves as vault cash or deposits with the regional Federal Reserve
bank
...
The FED regulates the borrowing of reserves, and sets an interest rate
for these short term loans if they are borrowed from the FED
...
The rate of interest
charged on reserves borrowed from other member banks is called the Federal Funds
Rate (currently about 5
...
The banking system has three forms of reserves, these are actual, required, and
excess reserves
...
The required reserves are the amounts the Board of
Governors requires the banks to keep (as vault cash, deposits with the FED, or
borrowed)
...
It is the excess reserves of the banking system that may be used by the
member banks to expand the checkable deposits component of the U
...
money supply
...
Rather
than printing Federal Reserve Notes, the majority of the money supply is created
through a system of deposits, loans, and redeposits
...
For example, if the RRR is
...
The
multiple expansion of money, assuming a required reserve ratio of
...
00
|
9
...
00
|
8
...
10
|
7
...
|
...
|
...
00
|
$90
...
00 (required reserves)
|
$100
...
00 in new money
...
Notice,
however, that the T-account balances, and that there is $100
...
There is a far easier way to determine how much the money supply can be
expanded through the multiple deposit - loan, re-deposit - loan mechanism
...
The money multiplier is the reciprocal
of the required reserve ratio:
Mm= 1/RRR
159
The money multiplier is the short-hand method of calculating the total entries in
the banking systems' T-accounts and shows how much an initial injection of money into
the system can generate in total money supply through checkable deposits
...
This element of monetary policy will be discussed in
greater detail in the following chapter
...
The potential creation of money is therefore inversely related to the required
reserve ratio
...
05 the money multiplier is
20
...
00 increase in deposits can potentially create $20 in new
checkable deposits as it is loan and re-deposited through the system
...
20 the money multiplier is 5 and only $5 of new
money can be created from an initial deposit of $1
...
With the current required reserve ratio of
...
33
...
00 can potentially create $33
...
The reason that the word potential is used to describe
this process, is that there is no guarantee that the banking system will be able to loan all
of its available excess reserves
...
The monetary history of several nations illustrates how well the multiple
expansion of money has been understood
...
As the FED struggled with
understanding how the system worked in this country, the Swiss understood since the
turn of the century
...
The result is that the Swiss have
experienced unusually stable price levels ever since 1945
...
Most of American history experienced significant deflation
...
The reason this problem persisted for so many decades in this country was that there
was no stable central banking system to manage the money supply and that the value
of the U
...
dollar was tied to an increasingly rare commodity - gold
...
In Chapter 3 we examined
the various theories of inflation
...
Because V and Q grow very slowly, they are generally
regarded as nearly constant
...
During expansions in the business cycle, investment demand is generally high
and banks can often loan all of their excess reserves
...
01 then banks could expand the money supply $100 for each $1
...
If the required reserve ratio was only
...
Without any
required reserve ratio, the money supply could be theoretically be expanded infinitely for
each dollar of new deposits
...
During this period of a political swing to the right of public opinion, the idea of deregulation has gained some new support
...
Without monetary controls imposed by a
central bank, there will most certainly be serious economic problems associated with
the loss of some modicum of sensible control of the money supply
...
No professional economist today advocates such a policy
...
This need for regulation has been long recognized by economists
...
Most prominent
among the classical economists writing at the beginning of the twentieth century
concerning monetary economics was Irving Fisher, who developed the modern quantity
theory of money presented in Chapter 3
...
The German experience immediately following World War I was
one such event
...
161
Consider the following short excerpt from Irving Fisher’s classical work on the
Quantity Theory of Money:
We come back to the conclusion that the velocity of circulation either of money or
deposits is independent of the quantity of money or of deposits
...
There still remains one seeming way of escape from the conclusion that the sole
effect of an increase in the quantity of money in circulation will be to increase prices
...
We now proceed to show that (except during transition
periods) the volume of trade, like the velocity of the circulation of money, is
independent of the quantity of money
...
The
stream of business depends on natural resources and technical conditions, not on
the quantity of money
...
We conclude, therefore, that a change in the quantity of
money will not appreciably affect the quantities of goods sold for money
...
Irving Fisher, The Purchasing Power of Money
...
15457
...
S
...
25 RRR
...
Explain the sources of reserves for member banks
...
Sample Questions:
Multiple Choice:
With a required reserve ratio of
...
B
...
D
...
B
...
D
...
{FALSE}
Money multiplier with a RRR of
...
{TRUE}
164
Chapter 11
Federal Reserve and Monetary Policy
The neo-classicists continue to reject the idea that the government has a proactive role to play in economic stabilization
...
There is some merit to this point of view
...
Monetary policy, on the other hand, has very short lags between
the recognition of a problem and the impact on the macroeconomy
...
The purpose of this chapter is the examine the role of the FED in the formulation
and implementation of monetary policy for the purpose economic stabilization
...
Monetary Policy
The monetary policies of a government focus on the control of the money supply
...
The focal point of control over real economic activity through the management
of monetary aggregates is the interest rate
...
Monetary policy in the United States is conducted by the Federal Reserve, either
through the Board of Governors or the Open Market Committee
...
e
...
The fundamental objective of monetary policy is to assist
the economy in attaining a full employment, non-inflationary macroeconomic
equilibrium
...
The FED can buy and sell U
...
Treasury bonds, called open market operations,
it can control the required reserve ratio, within statutory limits, and it can manipulate the
discount rate (the interest rate charged by the FED for member banks to borrow
165
reserves)
...
Each of these tools will be examined in the
following paragraphs
...
S
...
OMO directly influences the money supply through
exchanging money for bonds held by the public (generally commercial banks and
mutual funds)
...
When the
FED buys bonds, it replaces bonds held by the public with money
...
Contractionary monetary policy involves the FED selling bonds to the general public
...
S
...
The FED sells and buys both long-term (thirty year) Treasury bonds, and shortterm (primarily two, five and ten year) Treasury bonds
...
However, what
most security analysts argue is that the FED's bond buying and selling behavior is not a
leadership position
...
In times, of high inflation or steep
recession, however, the evidence suggests that the FED's OMO leads the market,
rather than follows
...
The Required Reserve Ratio
As discussed in the previous chapter, it is the required reserve ratio that
determines the size of the money multiplier
...
Therefore, the FED can directly control how much the banking system can expand the
money supply through the manipulation of the required reserve ratio
...
Increasing the required reserve ratio, reduces the money multiplier, hence reduces the
amount by which multiple expansions of the money supply can occur
...
166
Most of the new deposits that result in the multiple expansion of money occur
because the FED bought bonds from the public
...
The Discount Rate
The Discount Rate is the rate at which the FED will loan reserves to member
banks for short periods of time
...
The raising of the discount rate will discourage the borrowing of required
reserves by member banks, hence encourages using their reserves as required
reserves, rather than excess reserves (which they loan and start the multiple expansion
of money)
...
FED Targets
The FED must have benchmarks to determine the need for and effectiveness of
monetary policies
...
As noted by Irving Fisher, the velocity of
money is how often the money supply turns-over, and is unrelated to economic activity
...
Therefore, in any policies aimed at controlling inflation or deflation the FED's
monetary targets should simply be the money supply
...
Many consumer purchases and most investment is interest rate sensitive
...
If investment is too low to maintain fullemployment level of GDP, the FED can reduce the required reserve ratio or buy bonds
thereby increasing the supply of money and lowering the interest rate
...
There are dilemmas for the FED in selecting targets for their monetary policies
...
Expansionary
monetary policy may result in higher interest rates, by increasing the rate of inflation,
which will be reflected in the interest rates
...
At the same time, there is no necessary coordination of
fiscal and monetary policies
...
Therefore, the FED must keep an eye on the Congress and account for any fiscal
policies that may be contradictory to the appropriate monetary polices
...
Not only must the FED correct problems in the
economy, it may well have to correct Congressional fiscal mistakes, or at least, account
for this errors when implementing monetary policies
...
Easy money policies involves the lowering of
interest rates, and expanding the money supply
...
Tight money policies
involve the increasing interest rates, and contracting the money supply
...
Consider the following diagram showing both tight and easy money policies
...
As the FED engages in tight money policies
the supply curve is shifted to the left (dashed line labeled tight), this increases the
168
interest rate and lowers the amount of money available in the economy
...
With easy money policies, the quantity of money increases and the
interest rate falls
...
In the case of an easy money policy, as the
interest falls, investment will increase which results in an increase in the C+I+G line as
illustrated below:
The decrease in the interest rate is associated with an increase in investment
(the vertical distance between C+I+G1 and C+I+G2) which results in an increased GDP
and levels of spending
...
Even
though most neo-classicists argue that monetary policy is necessary to the proper
functioning of a market economy
...
The most extreme
of the neo-classicists argue there is simply no role for either discretionary fiscal or
monetary policies, except in dealing with extreme variations in economic activity
...
Friedman won his
Nobel Prize for, among other contributions, his work on the monetary history of the
United States
...
Based on the presumption
169
that discretionary fiscal policy can be abolished, Friedman would have all monetary
policies based on a simple rule that follows directly from the quantity theory of money
...
Such monetary policy leaves nothing to the discretion of policy makers
...
If the FED
underestimates growth, there could be small deflations, that could be eliminated but
subsequent adjustments to the money supply, and overestimations of the growth rate
causing inflation could be dealt with in the same type of subsequent adjustments
...
Real Business Cycle Theory is another paradigm that
has arisen out of the ashes of the classical school, and these economists would not find
much to argue with Friedman about, as far as the analysis goes
...
When these types of events occur, the Real Business
Cycle Theorists would have the government play a pro-active role, but focused
specifically on the shock or structural problem
...
KEY CONCEPTS
Monetary Policy
Expansionary
Contractionary
Tools of Monetary Policy
Bonds
Required Reserves Ratio
Discount Rate
Velocity of Money
Quantity Theory of Money
Target Dilemma in Monetary Policy
170
STUDY GUIDE
Food for Thought:
Critically evaluate the tools and the independence of the Fed to use them in monetary
policy
...
If we are experiencing 10 percent inflation with $4 billion real economy (in
other words nominal GDP is $4
...
8 how do we
control inflation? Would we want to? Explain
...
Sample Questions:
Multiple Choice:
If the Fed wanted to create a tight money policy which of the following is inconsistent
with this goal?
A
...
C
...
Increasing the Required Reserve Ratio
Increasing the Discount Rate
Buying bonds
All of the above are consistent with a tight money policy
171
If the Fed wishes to stimulate the economy during a recession what might we expect to
observe?
A
...
C
...
Lowering the Required Reserve Ratio
Lowering the Discount Rate
Fed Buying Bonds
None of the above
True/False:
The main goal of the Federal Reserve System is to assist the economy in achieving and
maintaining a full-employment, non-inflationary, stability
...
{FALSE}
172
Chapter 12
Economic Stability and Policy
Perhaps the most important macroeconomic problems of the last forty years are
unemployment and price level instability
...
There are several other matters that have
also been the focus of economic policy, including poverty (income distribution), and the
federal debt and budget deficit
...
The Misery Index
During the Reagan administration both unemployment and inflation topped ten
percent
...
The
misery index is the summation of the civilian unemployment rate and the consumer
price index
...
The consumer price index is based on a market basket of goods that household
typically purchase
...
The unemployment rate also focuses on the welfare of
families, when the household wage earning is out of work it has serious implications for
that household's income
...
Since 1973 American households have not fared well
...
S
...
Between 1973 and 1993 the median real income of American
households has not changed
...
However, between 1973 and 1993 there has been a dramatic
increase in the number of two wage earner households, and households where a fulltime worker also has a part-time job
...
S
...
Crime, drug abuse, social and economic alienation, and stress related
illnesses have become epidemic
...
As Lester Thurow has noted:
173
If the real GNP is up and real wages are down for two thirds of the work force, as an
algebraic necessity wages must be up substantially for the remaining one third
...
In the 1980s educational
attainment and increases or decreases in earnings were highly correlated
...
The less education, the bigger the income reduction;
the more education, the bigger the income gains
...
In the decade of
the 1980s, the real income of the most affluent five percent rose from $120,253 to
$148,438, while the income of the bottom 20 percent dropped from $9,990 to $9,431
...
At the end of the decade, the top 20
percent of the American population had the largest share of total income, and the
bottom 60 percent, the lowest share of total income ever recorded
...
New York: William Morrow and Company, 1992, p
...
It is beyond dispute that since 1981 there has been a fundamental change in
American society
...
The Bush Administration’s 2003 Tax Cut has also been heavily criticized as
having provided significant tax relief for the wealthy in the form of reduced rates on
dividends
...
This is an empirical question and will be answered by
cold, objective evidence within the year
...
It was
not until the recession of 1981-85 that we experienced very large amounts of
unemployment together with high rates of inflation
...
This policy dilemma, results from acceptance of a
statistical relation observed between unemployment and inflation named for A
...
Phillips who examined the relation in the United Kingdom and published his results in
1958
...
The Short-Run, Trade-off Phillips Curve
The following diagram presents the short-run trade-off view of the Phillips curve
...
W
...
Over two years after A
...
Phillips'
paper was published in Economica, Richard Lipsey replicated Phillips' study specifying
a non-linear form of the equation and using the price level, rather than nominal wages in
his model
...
The short-run, trade-off view of the Phillips curve is often used to support an
activist role for government
...
It is this
negative relation between unemployment and inflation, portrayed in the above diagram,
that gives rise to the idea of cruel policy choices between unemployment and inflation
...
175
Natural Rate Hypothesis
Classicists argue that there can only be a short-run, trade-off type Phillips Curve
if inflation is not anticipated in the economy
...
In the long run the Phillips Curve is alleged to be vertical at the natural rate of
unemployment, as shown in the following diagram:
In this view of the Phillips Curve any rate of inflation is consistent with the natural
rate of unemployment, hence the Natural Rate Hypothesis
...
If this is the case, then businesses
and consumers cannot be fooled into thinking that there is a reason for unemployment
to cure inflation or vice versa, as is necessary for the short-run, trade-off of the Phillips
Curve to exist
...
The possibility of a positive sloping Phillips
Curve was first hypothesized by Milton Friedman
...
In fact, the experience of 1981-85 may well be a transitional period, just like that
envisioned by Friedman
...
The Reagan appointments to the N
...
R
...
, Justice Department
(particularly the Anti-Trust Division), the Supreme Court (and Circuit Courts of Appeals,
and District Courts) and significant changes in the tax code changed much of the legal
environment significantly
...
The positively sloped Phillips Curve is show in the following
picture:
The positively sloped transitional Phillips Curve is consistent with the
observations of the early 1980s when both high rates of unemployment existed together
with high rates of inflation (the positive slope) -- a condition called stagflation (economic
stagnation accompanied by inflation)
...
However, there maybe a "Lady and Tiger Dilemma" for policy makers
relying on the Phillips Curve to make policy decisions
...
Therefore, to act, through taxes or expenditures, may result in having a
counter-productive effect by the time the policy impacts the economy (the tiger)
...
However, if the rational expectations theories are correct, then the long-shot is
exactly what would be predicted
...
If the accuracy of consumers' and businesses' expectations permit them to
behave as though they know what will happen, then it is argued that only a vertical
Phillips Curve is possible, as long as political and economic institutions remain stable
...
These market policies have been focused on mitigating poverty,
mitigating unemployment, and cooling-off inflation
...
One class of market policies have been focused on reducing poverty in the
United States
...
In part, the distribution of
income is measured by the Lorenz Curve, and more completely by the Gini coefficient
...
The 45
degree line shows what the distribution of income would be if income was uniformly
distributed across the population
...
The further the
Lorenz Curve is bowed toward the percentage of income axis the lower the income in
the poorer percentiles of the population
...
If the Gini coefficient is near zero,
income is close to uniformly distributed (and the 45 degree line); if is near 1 then income
is distributed in favor of the richest percentiles of the population (and the Lorenz curve is
close to the horizontal axis)
...
However, if the high income skewness of the
178
distribution is not related to productivity, then the skewed distribution is inefficient and
unfair, hence mal-distributed
...
5, and
while incomes in the lower three-quarters of the upper quintile are highly correlated with
education (and presumably productivity) the overwhelming amount of the highest part of
the distribution does not have any prima facie evidence to prove the justice or efficiency
of such high incomes
...
In
particular, Viacom and Disney were experiencing stock holder queries concerning
executive salaries
...
Productivity has also the subject of specific policies
...
For the most part, there has been very little evidence
concerning most of these programs that give reason for optimism
...
Many of the recent treaties concerning international trade have aspects that can
be classified as market policies
...
In fact, little if any, positive effects have been
observed from these initiatives
...
These controls worked well during World War II, mainly because of
appeals to patriotism during a war in which the United States was attacked by a foreign
power
...
However, absent the popular support for these policies
created by World War II for rationing and wage and price controls, these policies have
been uniformly failures
...
179
Debt and Deficit
The supply side economics of the Reagan Administration were based on the
theory that stimulating the economy would prevent deficits as government spending for
the military was substantially increased
...
The Laffer Curve (named for Arthur Laffer) is a relation between tax rates and tax
receipts
...
If the government was
below the optimal tax rate, an increase in the rate would increase receipts and in the
rate was above the optimal rate, receipts could be increased by lowering tax rates
...
" What the supply-siders thought was that tax rates
were too high and that a reduction in tax rates would permit them to slide down and to
the right on the Laffer Curve and collect more tax revenue
...
Therefore Reagan proposed and obtained from
Congress a big tax rate reduction and found, unfortunately, that we were below the
optimal and tax revenues fell
...
The
reduction in revenues, combined with substantial increases in government spending
made for record-breaking federal budget deficits and substantial additions to our
national debt
...
These economists
thought there was too much government regulation
...
However, after Jimmy Carter de180
regulated the trucking and airlines industries, there was considerable rhetoric and little
action concerning the de-regulation other aspects of American economic life
...
Whatever anyone may think of Reagan's Presidency there is
simply no doubt that he was probably the most astute observer of the political arena of
any of his competitors
...
This is probably the single most popular political theme any candidate can adopt
...
The surest way to
lose a bid for public office is to promise to raise taxes
...
Being right, does not have anything to do with being
popular
...
In fact, during those eight years this country acquired nearly $1
...
No other President in U
...
history has generated this amount
of debt in nominal dollars
...
Again, in Mr
...
Debt itself is not necessarily an economic evil
...
If the debt is used to
fund education (Kennedy-Johnson administration), or to build highways (as in the
Eisenhower administration) the future stream of economic benefits may generate
growth which pays off the debt
...
So, in large measure, whether
the debt is an economic constraint or not depends critically on what that the government
expenditures that resulted in the debt provided for the future growth of the U
...
economic system
...
S
...
______________________________________________________________________
______________________________________________________________________
Table I: National Debt 1980 - 1988
____________________________________________________________________
YEAR
NATIONAL DEBT
(billions of U
...
dollars)
1980
908
...
3
1982
1136
...
2
1984
1564
...
0
1986
2120
...
6
1988
2600
...
0
1990
3206
...
5
1992
4002
...
4
1994
4643
...
0
1996
5181
...
7
1998
5478
...
1
2000
5629
...
1
_____________________________________________________________________
_____________________________________________________________________
Nearly $1692
...
The first nine months of this period was under Carter's
budget, but the first nine months of 1989 was under Reagan's and this data makes
Reagan's record look better than it really was
...
5 billion to the federal budget in interest payments
...
It cannot be
denied that Reagan was one of the most popular Presidents of this century
...
Is the Debt Really a Problem?
In addition to the issues discussed above there is a substantial historical
experience with the Federal debt
...
Naturally, a debt as large as ours will have an upward influence on interest
rates, but the evidence does not suggest that it is substantial
...
President Jefferson borrowed about the same amount as our GDP from England and
Holland to buy Louisiana from the French (we owe an amount almost the same as
GDP)
...
By the end of World War II, we
again had a national debt of $271 billion and a GDP of $211
...
The predictions
that my generation would be paying 60 and 70 percent effective tax rates to pay off the
debt never materialized
...
Surely the
size of debt and current deficits are not a source of any grief
...
The serious question is why did we acquire the debt and what must we give up if
we are to pay it off
...
The
increases in government expenditures for the military, caused our chief rivals to spend
larger proportions of their GNP on the military and eventually caused the economic and
political collapse of the Soviet bloc
...
Probably the only realistic answer to
whether the debt is a problem is what we do about it and what priorities we set
...
Let us all hope that
we choose correctly
...
Dilts, and Clarence R
...
Vol
...
4 (Winter 1994) pp
...
During the period examined, January 1974 to April 1990, the evidence reported
(here) suggests that there is a unidirectional causal relation from the inflation rate to
the rate of unemployment
...
e
...
The empirical findings reported
here, however, suggest a non-vertical Phillips Curve
...
Friedman argued that the proper
specification of the regression equations used to estimate the Phillips Curve relation
is of significance (both theoretically and empirically)
...
The statistical evidence presented here supports Friedman's claim that inflation is
properly specified as the independent variable in "Phillips Curve" analyses
...
W
...
This
finding is of significance to those researchers using ordinary least squares to
examine relations between inflation and unemployment
...
Maybe this box does not represent the final word in the Phillips curve
controversy, but this research suggests that there is a short-run view of the Phillips
curve and that the idea of rational expectations may not be as good as it looks at first
blush
...
184
KEY CONCEPTS
Misery Index
Inflation
Unemployment
Phillips Curve
Short-run Trade-off
Long-term, natural rate hypothesis
Positively sloped
Rational Expectations
Market Policies
Lorenz Curve
Gini Coefficient
Investment Tax Credits
NAFTA & GATT
Wage-Price Policies
Laffer Curve
Supply Side Economics
Budget Deficit
National Debt
STUDY GUIDE
Food for Thought:
Compare and contrast the various views of the Phillips Curve
...
Develop the Laffer Curve
...
185
What are market policies? Explain the major market policies observed in the U
...
economy today
...
Sample Questions:
Multiple Choice:
In the short-run view of the Phillips curve policy-makers are left with a cruel choice
...
B
...
D
...
Stagflation is:
A
...
C
...
general decreases in the price level
excess employment which causes inflation
both high rates of unemployment and inflation
both very low rates of unemployment and inflation
True - False:
The Laffer curve suggests that the higher the tax rate the lower will be tax revenues
...
{FALSE}
186
CHAPTER 13
Epilogue
Why should we study economics at all? Well, there are three pretty sound
reasons for becoming as knowledgeable as possible about macroeconomic issues
...
Democracy is a very tough form of government
...
The founding fathers did
not provide us with a fool-proof way of life or system of government
...
In other words, knowledge is prerequisite for democracy
...
If
certain factions in our society became anti-social, it was up to the government to rein
those factions in, and if the government because unruly, it was up to the electorate to
rein it in
...
In today’s economy things are
complicated
...
However, unless one understands how the economy
works and what the implications of the actions of the major players are one cannot hope
to maintain a free and balanced society
...
In a practical sense, the environment in which business is conducted will in large
measure determine the success or failure of that enterprise
...
In an environment where the Federal Reserve is
raising the interest rates, it would be unadvisable to start a construction business or
invest heavily in banking stocks
...
The importance of this
understanding cannot be minimized
...
One of
the major reasons that the prices of copper, gold, silver and oil are rising at nearly
187
unprecedented rates, is the dollar is losing value with respect to most other currencies
...
Oil from the Middle East, gold from South Africa,
Copper from Chile, silver from Peru and Beer from Holland have all gone up in price, in
some significant measure because the dollar is losing its value
...
To understand these shifting
fortunes you must understand the macroeconomy, and keep abreast of the relevant
economic data
...
I presume for most people, self-preservation is as powerful an
incentive as I have always found it to be
...
These habits require resources, and resources are best
obtained when we can bring a comparative advantage to bear
...
If you need no other reason to keep up with
what’s happening in economics, keep in mind, you need a retirement income, and
would like to accumulate at least enough wealth to be comfortable
...
Over the next fifty years there are going to be
significant changes in the way we do business, and what businesses will thrive
...
As we use up our
initial endowment of oil, coal, iron, copper, and a whole array of other resources we will
need to procure substitutes for these items, either close substitutes or entirely different
approaches to meeting many of our basic human needs
...
How we as individuals, and as societies
respond to these opportunities and crises will, in large, measure determine what our
economic future will be
...
Our standard of living, and our ability to cope has
seemingly increased faster than at any time in history
...
Thomas Malthus wrote nearly 300 years ago that people were going to face a
crises
...
The end result, according to Malthus is we’re all going to starve
...
His dismal prediction, (hence economics is called the
Dismal Science) failed to account for the favorable changes in agricultural technologies
that have resulted in obesity being a greater killer in this country than starvation
...
Global warming, terrorism, our deteriorating relations with other countries,
changes in technology, increasing life expectancies, and an increasingly global
economy will have significant effects on our futures
...
Economics Majors
Whether one becomes an economics major or not, it is clear that there should be
a commitment to continued study of the subject, even informally
...
Rather than report this second hand, here is an article which can
be found on the Economics Department website, and which is very informative, from the
Wall Street Journal:
The Hot Major For Undergrads Is Economics
By Jessica E
...
U
...
colleges and universities awarded 16,141 degrees to economics majors in
the 2003-2004 academic year, up nearly 40% from five years earlier, according
to John J
...
Since the mid-1990s, the number of students majoring in economics has been
rising, while the number majoring in political science and government has
declined and the number majoring in history and sociology has barely grown,
according to the government's National Center for Education Statistics
...
The number of students majoring in economics has been rising even faster at top
colleges
...
At nearly 800, it is now the most popular
major
...
, where 964 students majored in the subject in 2005
...
The
University of Chicago said that last year, 24% of its entire graduating class, 240
students, departed with economics degrees
...
Behind the turnaround is a clear-eyed reading
of supply and demand: In a global economy filled with uncertainty, many students
see economics as the best vehicle for a job promising good pay and security
...
In addition to probing the mechanics of inflation and exchange rates, academics
now use statistics and an economist's view of how people respond to incentives
to study issues such as AIDS, obesity and even terrorism
...
Pooja Jotwani, a recent graduate of Georgetown University in Washington D
...
,
says she is certain her economics degree helped her land a job in Lehman
Brothers Holdings Inc
...
She says the major strengthened her business skills and
provided her with something very simple: "financial security
...
Summers, president of Harvard and former
secretary of the Treasury
...
But those computer and engineering jobs look increasingly
threatened by competition from inexpensive, highly skilled workers in places like
India and China
...
He cites the recent example of computer science majors, whose ranks swelled in
the 1990s and quickly subsided in the early 2000s, soon after the dot-com bubble
190
burst and many companies started outsourcing computer-programming jobs
abroad
...
It wasn't just banks and insurance companies that
expressed interest in economics majors -- companies in industries such as
utilities and retailing did so, too
...
I
...
But he has gravitated to the topic anyway: He
chose a major combining economics, sociology, and anthropology because he
thinks economics is crucial to understanding the world
...
Roberto Angulo, chief executive
of AfterCollege Inc
...
"Students are
more employable if they study economics," he says
...
It isn't just the job calculus that is drawing students to the major: It also is the
rapid spread of economic globalization
...
Foreign students studying in the U
...
are flocking to the major
...
"When I grew up in Argentina,
my country plunged into a recession," she says
...
"
Indeed, the rising popularity of the economics major appears to be a global
phenomenon
...
John Sutton, chairman of the economics department at London School of
Economics, says the school's popularity is at an all-time high, in part due to
interest from Eastern Europe
...
Sutton says that as these countries undergo
capitalist changes, "bright young students are beginning to see economic issues
highlighted
...
The way air pollution affects the measurement of GDP is:
A
...
C
...
pollution is entirely ignored
any cleaning up of pollution is subtracted from GDP
any bad affects of pollution are subtracted from GDP
any cleaning up of pollution is added into GDP as production
2
...
What is the
college student experiencing?
A
...
C
...
Frictional unemployment
Structural unemployment
Natural rate unemployment
False search
3
...
B
...
D
...
If the consumers expect that there will be a recession that will possibly cause
them to lose their jobs, or suffer a reduction in real earnings (assuming
downward inflexible wages and prices) what should we expect to observe?
A
...
Output will remain the same, but prices will decline in the Keynesian range
of AS
C
...
D
...
193
5
...
B
...
D
...
If you consume $150 out of $200 in addition income then your marginal
propensity to save is:
A
...
C
...
1
...
75
...
25
7
...
In 1991 this same market basket cost $550; in 1992 it was $600
...
B
...
D
...
833
$600
1
...
Which of the following concepts is associated with the natural rate of
unemployment?
A
...
C
...
Natural disasters
Full employment
Recession
None of the above
9
...
B
...
D
...
The aggregate demand is most likely to shift to the left (decrease) when there is
a decrease in the:
A
...
C
...
money income
overall price level
total unemployment rate
level of personal income taxes
11
...
"
A
...
B
...
C
...
D
...
12
...
B
...
D
...
Which of the following is an automatic stabilizer?
A
...
C
...
Unemployment Security Programs
Progressive Income Tax Structure
Welfare Programs such as Food Stamps
All of the above are
14
...
B
...
D
...
If the unemployment rate is 8% and the current GDP is $100 billion, how much is
the recessionary gap?
A
...
C
...
There is no recessionary gap
$4
...
11 billion
16
...
05, which of the following fiscal policies may be
used to close this recessionary gap?
A
...
C
...
Increase government expenditures by $75 billion
Decrease taxes by $75 billion
Increase taxes and expenditures by $2500 billion
None of the above will work
17
...
2)?
A
...
C
...
Increase both taxes and expenditures by $80 billion
Increase both taxes and expenditures by $100 billion
Decrease both taxes and expenditures by $80 billion
Decrease both taxes and expenditures by $100 billion
18
...
B
...
D
...
What is the tax multiplier?
A
...
C
...
Always one
1/MPC minus one
1/MPS minus one
1/1-MPC
20
...
B
...
D
...
Macroeconomics is the study of economic systems in aggregate
...
Okun's law states that for every 2% that the unemployment rate exceeds the
natural rate there will be a 5% recessionary gap in GDP
...
Demand-pull inflation is the result of an increase in the costs of production
...
The Keynesian range of the aggregate supply curve is vertical, but the classical
range is horizontal
...
The difference between GDP and GNP is that GNP excludes incomes earned by
foreigners in the United States and includes incomes earned by Americans
abroad
...
Economic policy is concerned with describing people's behavior, but economic
theory is concerned with influencing people's behavior
...
A discouraged worker is one that will quit her or his job and become unemployed
in the near future
...
A regressive tax structure means that those with the highest ability to pay more
will pay more taxes
...
In the short-run there can be an increase in aggregate demand in the classical
range of aggregate supply that results only in higher prices and no change in
output
...
It is difficult to compare overall social welfare over great periods of time
(decades) because of the quality and mix of goods and services will differ
...
The real interest rate is the nominal interest rate minus the rate of inflation
...
Political considerations in passing budgets and tax bills help to enhance the
effectiveness of fiscal policy for economic stabilization
...
The fallacy of composition is the mistaken belief that what is true for the
individual must be true for the group
...
The existence of a substantial underground economy in the United States
probably means that GDP is overstated
...
Positive economics is concerned with what is, and normative economics is
concerned with what should be
...
MPC + MPS = 1
17
...
18
...
19
...
20
...
198
Sample Midterm Examination
ANSWERS:
Multiple Choice
1
...
3
...
5
...
7
...
9
...
11
...
13
...
15
...
17
...
19
...
D
A
A
A
C
B
D
B
D
A
C
C
D
B
D
A
B
B
C
C
True/False
1
...
3
...
5
...
7
...
9
...
11
...
13
...
15
...
17
...
19
...
T
T
F
F
T
F
F
F
T
T
T
F
T
F
T
T
F
F
T
F
199
Sample Final Examination
ANSWERS ARE FOUND AT THE END OF THE SECTION
Multiple Choice [4 points each]
1
...
S
...
B
...
D
...
A bond sold for $2000 with an original interest rate of 10% yields $200 per year
...
B
...
D
...
If $100 is deposited in a local bank and goes through the entire banking system,
by how much could the money supply be expanded with
...
B
...
D
...
Which of the following is the interest rate that member banks charge one another
for borrowing excess reserves?
A
...
C
...
Federal funds rate
Money Market rate
Discount rate
Prime rate
200
5
...
What is this cruel choice?
A
...
B
...
Inflation will exist regardless of the level of unemployment
D
...
What does the Laffer curve predict?
A
...
C
...
Above some tax rate, revenues fall
Below some tax rate, revenues can be increased by raising the rate
That there is some optimal tax rate that generates the most revenue
All of the above
7
...
B
...
D
...
Which of the following is a function of money?
A
...
C
...
Asset demand
Store of value
Total money demand
Transactions demand
9
...
B
...
D
...
Who controls the Required Reserve Ratio for Fed?
A
...
C
...
Member banks vote on it
The Board of Governors
Open Market Committee
U
...
President
201
11
...
A
...
Stabilization of the money supply is no problem, but interest rates have
been hard to control
C
...
The Fed has had no difficulty in stabilizing all of the monetary aggregates
at the same time
12
...
B
...
D
...
Stagflation is:
A
...
C
...
general decreases in the price level
excess employment which causes inflation
both high rates of unemployment and inflation
both very low rates of unemployment and inflation
14
...
B
...
D
...
S
...
S
...
Which of the following is the interest rate that the Fed charges member banks for
borrowing reserves?
A
...
C
...
Discount rate
Federal funds rate
Money Market rate
Prime rate
202
16
...
B
...
D
...
Which of the following is true of developing countries?
A
...
C
...
The population growth is generally too high
The is typically capital flight from the country
They suffer from a “brain drain”
All of the above are true
18
...
Foreign Aid
B
...
Assist with debt reduction for these countries
19
...
B
...
D
...
What is the tax multiplier?
A
...
C
...
Always one
1/MPC minus one
1/MPS minus one
1/1-MPC
True/False [1 point each]
1
...
S
...
2
...
3
...
203
4
...
5
...
S
...
6
...
7
...
S
...
8
...
9
...
10
...
2, the money multiplier is 5
...
The dilemma in monetary policy is that monetary policy effects each of the
money aggregates in different ways and at different times may effect the
economy differently
...
The velocity of money is how fast its value changes with respect to other
currencies
...
Supply side economists were concerned that there was too little regulation in the
U
...
economy and that lack of regulation hurt productivity
...
Inflation in a general increase in all prices, not just in some prices
...
One problem with fiscal and monetary policy is there is no mechanism to assure
the coordination of the two policies
...
The paradox of thrift has several dimensions, however in general it refers to the
observation that households may save more when the economy needs greater
consumption to reach a long stable equilibrium
...
Developing countries have little, if any, debt because they are not credit-worthy
...
A regressive tax structure means that those with the highest ability to pay more
will pay more taxes
...
Say’s Law states that for every 1% the unemployment rate exceeds the natural
rate we have lost 2
...
204
20
...
S
...
205
Sample Final Examination
ANSWERS:
Multiple Choice:
1
...
B
3
...
A
5
...
D
7
...
B
9
...
B
11
...
A
13
...
B
15
...
B
17
...
D
19
...
C
True/False:
1
...
3
...
5
...
7
...
9
...
11
...
13
...
15
...
17
...
19
...
F
T
T
F
T
T
F
F
F
T
T
F
F
T
T
T
F
F
F
T
206
Title: Macro Economics
Description: It contains all that you may ndd in Economics
Description: It contains all that you may ndd in Economics