Definition of Economics

• The social science concerned with the efficient use of limited or scarce resources to achieve maximum satisfaction of human materials wants.
• Human wants are unlimited, but the means to satisfy the wants are limited.

The Economic Perspective

• Scarcity and choice
  • Resources can only be used for one purpose at a time.
  • Scarcity requires that choices be made.
  • The cost of any good, service, or activity is the value of what must be given up to obtain it.(opportunity cost).
• Rational Behavior
  • Rational self-interest entails making decisions to achieve maximum fulfillment of goals.
  • Different preferences and circumstances lead to different choices.
  • Rational self-interest is not the same as selfishness.
• Marginalism:benefits and costs
  • Most decisions concern a change in current conditions; therefore the economic perspective is largely focused on marginal analysis.
  • Each option considered weighs the marginal benefit against the marginal cost.
  • Whether the decision is personal or one made by business or government, the principle is the same.
  • The marginal cost of an action should not exceed its marginal benefits.
  • There is "no free lunch" and there can be "too much of a good thing."

Why Study Economics?

• Economics for citizenship.
  • Most political problems have an economic aspect, whether it is balancing the budget, fighting over the tax structure, welfare reform, international trade, or concern for the environment.
  • Both the voters and the elected officials can fulfill their role more effectively if they have an understanding of economic principles.
• Professional and personal applications
  • The study of economics helps to develop an individual's analytical skills and allows students to better predict the logical consequences of their actions.
  • Economic principles enable business managers to make more intelligent decisions.
  • Economics can help individuals make better buying decisions, better employment choices, and better financial investments.
  • Economics is however, mainly an academic, not a vocational subject.Its primary objective is to examine problems and decisions from a social rather than personal point of view.It is not a series of "how to make money" examples.

Economic Methodology

• Economists use the scientific method to establish theories, laws, and principles.
  • The scientific method consists of:
    • The observation of facts (real data).
    • The formulations of explanations of cause and effect relationships (hypotheses) based upon the facts.
    • The testing of the hypotheses.
    • The acceptance, reject, or modification of the hypotheses.
    • The determination of a theory, law, principle, or model.
  • Theoretical economics: The systematic arranging of facts, interpretation of the facts, making generalizations.
  • Principles are used to explain and/or predict the behavior of individuals and institutions.
  • Terminology-Principles, laws, theories, and models are all terms that refer to generalizations about economic behavior. They are used synonymously in the text, with custom or convenience governing the choice in each particular case.
  • Generalization-Economic principles are expressed as the tendencies of the typical or average consumer, worker, or business firm.
  • "Other things equal" or ceteris paribus assumption-In order to judge the effect one variable has upon another it is necessary to hold other contributing factors constant. Natural scientists can test with much greater precision than can economists. They have the advantage of controlled laboratory experiment. Economists must test their theories using the real world as their laboratory.
  • Abstractions-Economic principles, theories or models are abstractions, simplifications, which attempt to find the important connections and relationships of economic behavior. These models are useful precisely because they strip away the clutter and complexity of reality.
  • Graphical Expression-Many economic relationships are quantitative, and are demonstrated efficiently with graphs. The "key graphs" are the most important.
• Policy economics applies economic facts and principles to help resolve specific problems and to achieve certain economic goals.
  • Steps in formulating economic policy:
    • State goals.
    • Recognize various options that can be used to achieve goals.
    • Evaluate the options on the basis of specific criteria important to decision-makers.
    • Economic goals widely accepted in our economy.
    • Economic growth
    • Full employment
    • Economic efficiency
    • Price level stability
    • Economic freedom
    • Equitable distribution of income
    • Economic security
    • Balance of trade
  • Goals may be complementary (full employment and economic security).
  • Some goals may conflict (efficiency and equity). (Key Question 6)
  • All goals cannot be achieved, so priorities must be set.

Macroeconomics and Microeconomics

• Macroeconomics examines the economy as a whole.
  • It includes measures of total output, total employment, total income, aggregate expenditures, and the general price level.
  • It is a general overview examining the forest, not the trees.
• B.Microeconomics looks at specific economic units.
  • It is concerned with the individual industry, firm or household and the price of specific products and resources.
  • It is an examination of trees, and not the forest.
• C.Positive and Normative Economics.
  • Positive economics describes the economy as it actually is, avoiding value judgments and attempting to establish scientific statements about economic behavior.
  • Normative economics involves value judgments about what the economy should be like and the desirability of the policy options available.
  • Most disagreements among economists involve normative, value-based questions.

Pitfalls to Objective Thinking

• Biases-Preconceptions that are not based on facts.
• Loaded terminology.
  • Terms that contain the prejudice and value judgments of others.
  • It is very difficult for a person to describe economic behavior without letting their options about that behavior creep into their discussion.The distinction between positive and normative statements is not always clearly apparent.
  • Often, however, there is a deliberate attempt to sway opinion by using loaded terminology.(greedy owners, obscene profits, exploited workers, mindless bureaucrats, costly regulations, creeping socialism)
• Definitions
  • Economics is a second language.
  • It is often difficult for students to recognize terms as new vocabulary that needs to be studied as diligently as though they had never before encountered the words.
  • Students in a physics class encountering terms like erg, ohm, or foot-pound recognize the need to investigate.Students that are reading a text filled with words like rent, capital, or investment assume that they already have an adequate working definition.
• Causation Fallacies
  • Post hoc fallacy:When two events occur in time sequence, the first event is not necessarily the cause of the second event.
  • Correlation versus causation:Events may be related without a causal relationship.
  • The positive relationship between education and income does not tell us which causes the increase in the other. (Which is the independent variable and which is the dependent variable?)
  • It may be that the increase income that occurs with increased education is due to some other third factor that is not under direct consideration.

A Look Ahead

• Chapter 2 builds the production possibilities model that visually demonstrates the basic economic principles of scarcity, choice, opportunity cost, and the law of increasing costs.
• Chapter 3 builds the supply and demand model for individual markets.
• Chapter 4 combines all the markets in the economy and observes the coordination of economic activity through market prices.
• Chapters 5 and 6 examine the important sectors of the economy (households, businesses, government, and the international sector) discussing their role and interaction.

LAST WORD: Fast Food Lines-An Economic Perspective

• People choose the shortest line to reduce time cost.
• Lines tend to have equal lengths as people shift from longer to shorter lines in effort to save time.
• Lines are chosen based on length without much other information-cost of obtaining more information is not worth the benefit.
  • Imperfect information may lead to an unexpected wait.
  • Imperfect information may cause some people to leave when they see a long line.
• When a customer reaches the counter, other economic decisions are made about what to order.From an economic perspective, these choices will be made after the consumer compares the costs and benefits of possible choices.

The foundation of economics is the economizing problem: society's material wants are unlimited while resources are limited or scarce.

• Unlimited wants (the first fundamental fact):
  • Economic wants are desires of people to use goods and services that provide utility, which means satisfaction.
  • Products are sometimes classified as luxuries or necessities, but division is subjective.
  • Services satisfy wants as well as goods.
  • Businesses and governments also have wants.
  • Over time, wants change and multiply.
• Scarce resources (the second fundamental fact):
  • Economic resources are limited relative to wants.
  • Economic resources are sometimes called factors of production and include four categories:
    • Land or natural resources,
    • Capital or investment goods which are all manufactured aids to production like tools, equipment, factories, transportation, etc.,
    • Labor or human resources, which include physical and mental abilities used in production,
    • Entrepreneurial ability, a special kind of human resource that provides four important functions:
      • Combines resources needed for production,
      • Makes basic business policy decisions,
      • Is an innovator for new products, production techniques, organizational forms,
      • Bears the risk of time, effort, and funds.
      • Resource payments correspond to resource categories:
      • Rent and interest to suppliers of property resources,
      • Wages and salaries to labor resources,
      • Profits to entrepreneurs.
      • Quantities of resources are limited relative to the total amount of goods and services desired.

Economics: Employment and Efficiency

• Basic definition:Economics is the social science concerned with the problem of using scarce resources to attain the greatest fulfillment of society's unlimited wants.
• Economics is a science of efficiency in the use of scarce resources. Efficiency requires full employment of available resources and full production.
  • Full employment means all available resources should be employed.
  • Full production means that employed resources are providing maximum satisfaction of our economic wants.Underemployment occurs if this is not so.
• Full production implies two kinds of efficiency:
  • Allocative efficiency means that resources are used for producing the combination of goods and services most wanted by society-for example, producing compact discs instead of long-playing records with productive resources or computers with word processors rather than manual typewriters.
  • Productive efficiency means that least costly production techniques are used to produce wanted goods and services.
• Full production means producing the "right" goods (allocative efficiency) in the "right" way (productive efficiency).(Key Question 5)

Production possibilities tables and curves are a device to illustrate and clarify the economizing problem.

• Assumptions:
  • Economy is operating efficiently (full employment and full production).
  • Available supply of resources is fixed in quantity and quality at this point in time.
  • Technology is constant during analysis.
  • Economy produces only two types of products.
• Choices will be necessary because resources and technology are fixed.A production possibilities table illustrates some of the possible choices (see Table 2-1).
• A production possibilities curve is a graphical representation of choices.
  • Points on the curve represent maximum possible combinations of robots and pizza given resources and technology.
  • Points inside the curve represent underemployment or unemployment.
  • Points outside the curve are unattainable at present.
• Optimal or best product-mix:
  • It will be some point on the curve.
  • The exact point depends on society; this is a normative decision.
• Law of increasing opportunity costs:
  • The amount of other products that must be foregone to obtain more of any given product is called the opportunity cost.
  • Opportunity costs are measured in real terms rather than money (market prices are not part of the production possibilities model.)
  • The more of a product produced the greater is its (marginal) opportunity cost.
  • The slope of the production possibilities curve becomes steeper, demonstrating increasing opportunity cost.This makes the curve appear bowed out, concave from the origin.
  • Economic Rationale:
    • Economic resources are not completely adaptable to alternative uses.
    • To get increasing amounts of pizza, resources that are not particularly well suited for that purpose must be used. Workers that are accustomed to producing robots on an assembly line may not do well as kitchen help.

• Allocative efficiency revisited:
  • How does society decide its optimal point on the production possibilities curve?
  • Recall that society receives marginal benefits from each additional product consumed, and as long as this marginal benefit is more than the additional cost of the product, it is advantageous to have the additional product.
  • Conversely, if the additional (marginal) cost of obtaining an additional product is more than the additional benefit received, then it is not "worth" it to society to produce the extra unit.
  • Figure 2‑2 reminds us that marginal costs rise as more of a product is produced.
  • Marginal benefits decline as society consumes more and more pizzas.In Figure 2‑2 we can see that the optimal amount of pizza is 200,000 units, where marginal benefit just covers marginal cost.
    • Beyond that, the added benefits would be less than the added cost.
    • At less than 200,000, the added benefits will exceed the added costs, so it makes sense to produce more.
  • Generalization: The optimal production of any item is where its marginal benefit is equal to its marginal cost. In our example, for robots this must occur at 7,000 robots.

Unemployment, Growth, and the Future

• Unemployment and productive inefficiency occur when the economy is producing less than full production or inside the curve (point U in Figure 2-3).
• In a growing economy, the production possibilities curve shifts outward.
  • When resource supplies expand in quantity or quality.
  • When technological advances are occurring.
• Present choices and future possibilities:Using resources to produce consumer goods and services represents a choice for present over future consumption.Using resources to invest in technological advance, education, and capital goods represents a choice for future over present goods.The decision as to how to allocate resources in the present will create more or less economic growth in the future.(Key Questions 10 and 11)

(See for example Global Perspective 2-1 where various countries are compared with respect to their economic growth rates relative to the share of GDP devoted to investment.)

• Qualification:International Trade
  • A nation can avoid the output limits of its domestic Production Possibilities through international specialization and trade.
  • Specialization and trade have the same effect as having more and better resources of improved technology.
• Examples and Applications
  • Unemployment and Productive Inefficiency:
    • Depression
    • Discrimination in the labor market.
  • Tradeoffs and Opportunity Costs
    • Logging and mining versus wilderness.
    • Allocation of tax resources.
  • Shifts of Production Possibilities Curve
    • Technological advances in the U.S.
    • The effects of war.

• See the Last Word on how a large increase in the number of women in the labor force has shifted the production possibilities curve outward.

Economic systems differ in two important ways: Who owns the factors of production and the method used to coordinate economic activity.

• The market system:
  • There is private ownership of resources.
  • Markets and prices coordinate and direct economic activity.
  • Each participant acts in his or her own self-interest.
  • In pure capitalism the government plays a very limited role.
  • In the U.S. version of capitalism, the government plays a substantial role.
• Command economy, socialism or communism:
  • There is public (state) ownership of resources.
  • Economic activity is coordinated by central planning.

The Circular Flow Model for a Market-Oriented System (Key Graph 2-6)

• There are two groups of decision makers in private economy (no government yet):households and businesses.
  • The market system coordinates these decisions.
  • What happens in the resource markets?
    • Households sell resources directly or indirectly (through ownership of corporations).
    • Businesses buy resources in order to produce goods and services.
    • Interaction of these sellers and buyers determines the price of each resource, which in turn provides income for the owner of that resource.
    • Flow of payments from businesses for the resources constitutes business costs and resource owners' incomes.
  • What happens in the product markets?
    • Households are on the buying side of these markets, purchasing goods and services.
    • Businesses are on the selling side of these markets, offering products for sale.
    • Interaction of these buyers and sellers determines the price of each product.
    • Flow of consumer expenditures constitutes sales receipts for businesses.
  • Circular flow model illustrates this complex web of decision-making and economic activity that give rise to the real and money flows.

• Limitations of the model:
  • Does not depict transactions between households and between businesses.
  • Ignores government and the "rest of the world" in the decision-making process.
  • Does not explain how prices of products and resources are actually determined, but this is explained in Chapter 3.

LAST WORD: Women and Expanded Production Possibilities

• An increase in women's wage rates.
• Greater access to jobs.
• Changes in preferences and attitudes.
• Declining birthrates.
• Increasing divorce rates.
• Slower growth in male wages.

Characteristics of the Market System

• Private individuals and firms own most of the private property (land and capital).
  • Private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, control, use, and dispose of this property.
  • Private property rights encourage investment, innovation, exchange of assets, maintenance of property, and economic growth.
  • Property rights extend to intellectual property through patents, copyrights, and trademarks.
• Freedom of enterprise and choice exist.
  • Freedom of enterprise means that entrepreneurs and businesses have the freedom to obtain and use resources, to produce products of their choice, and to sell these products in the markets of their choice.
  • Freedom of choice means:
    • Owners of property and money resources can use resources as they choose.
    • Workers can choose the training, occupations, and job of their choice.
    • Consumers are free to spend their income in such a way as to best satisfy their wants (consumer sovereignty).

• Self-interest
  • Self interest is one of the driving forces in a market system. Entrepreneurs try to maximize profits or minimize losses; resource suppliers try to maximize income; consumers maximize satisfaction.
  • As each tries to maximize profits, income, satisfaction, the economy will benefit if competition is present.

• Competition among buyers and sellers is a controlling mechanism.
  • Large numbers of sellers mean that no single producer or seller can control the price or market supply.
  • Large number of buyers means that no single consumer or employer can control the price or market demand.
  • Depending upon market conditions, producers can enter or leave industry easily.
• Markets and prices
  • A market system conveys the decisions of the many buyers and sellers of the product and resource markets.Recall the demand and supply model in Chapter 3.
  • A change in the market price signals that a change in the market has occurred.
  • Those who respond to the market signals will be rewarded with profits and income.
• Reliance on technology and capital goods
  • Competition, freedom of choice, self-interest, and the potential of profits provide the incentive for capital accumulation (investment).
  • Advanced technology and capital goods uses the more efficient roundabout method of technology.

• Specialization
  • Division of labor allows workers to specialize.
    • People can take advantage of differences in abilities and skills.
    • People with identical skills may still benefit from specialization and improving certain skills
    • Specialization saves time involved in shifting from one task to another.
  • Geographic specialization: Regional and international specialization take advantage of localized resources.
• Use of money as a medium of exchange
  • Money substitutes for barter, which requires a coincidence of wants. (I may want what you produce but you may not want to exchange for what I have.)
  • Willingness to accept money in place of goods permits 3-way trades (or multilateral trades). See Figure 4-1 and examples in text.
    • Floridians give money to Nebraskans for wheat who give money to Idahoans for potatoes who give money to Florida for oranges.
    • Foreign exchange markets permit Americans, Japanese, Germans, Britons, and Mexicans to complete international exchanges of goods and services.
    • Detroit autoworker produces crankshafts for Buicks. If the worker were paid in crankshafts, he would have to find grocers, clothing retailers, etc., who would be willing to exchange their products for a crankshaft. It is much more efficient to use money wages than to accept one's wages in crankshafts!
    • Active, but limited government
  • Although the market system promotes efficiency, it has certain shortcomings (over production of goods with social costs, under production of goods with social benefits, tendency for business to increase monopoly power, macro instability).
  • Chapter 5 deals with how the government can increase the overall effectiveness of the market system.

The Market System at Work

• The market system is made up of millions of individual decision makers who make trillions of decisions all of which are attempting to maximize their individual or business self-interest.
• The market is a mechanism by which the consumers and producers can come together to respond to each other's desires and wants in an efficient way.
• Although the focus of this chapter is on the market system, the four fundamental questions must be answered by all economic systems.
  • What goods and services will to be produced?
  • How will these goods and services be produced?
  • Who will get the goods and services?
  • How will the system accommodate change?
• What will be produced?
  • In order to be profitable, businesses must respond to consumers' (individuals, other businesses, and the government) wants and desires.
  • When businesses allocate resources in a way that is responsive, businesses will be profitable and allocative efficiency will be achieved.
  • Accounting profits are total revenue minus total accounting costs.
  • In economics, the return to the entrepreneur is treated just like the return to the worker, i.e., it is an economic cost and must be received if the entrepreneur is going to continue to produce in that industry.
  • Normal profits are the return to the entrepreneur that is necessary for him/her to continue to produce that product.Any revenue received beyond normal profits is pure or economic profit.
  • If producers in an industry are receiving pure or economic profits, additional producers will move into the industry, the industry supply will increase, and the price will decrease thus squeezing out the economic profits. Refer to Figure 3-6(c).
  • If producers in an industry are experiencing economic losses, some of these producers will exit the industry, the industry supply will decrease, and the price will increase thus eliminating the economic losses. Refer to 3-6(d).
  • Consumer sovereignty is the key to determining the types and quantities of the various products that will be produced. "Dollar votes" for a product when purchases are made and "dollar votes" against a product when products are ignored will determine which industries continue to exist and which individual products survive or fail.
  • Businesses are not really "free" to produce what they wish. They must match their production choices with consumer choices or face losses and eventual bankruptcy. Profit-seeking firms must consider the allocation of the "dollar votes" when they make their production decisions.
  • Resource demand is a "derived" demand, i.e., it depends on the demand for the products produced by the resource.

• How will the goods and services be produced?
  • The market system encourages and rewards those producers who are achieving productive efficiency, i.e., least-cost production.
  • Least-cost production techniques include: locating firms in the optimum location considering resource prices, resource productivity, and transportation costs, available technology, and resource prices in general.
  • The most efficient technique will be the one that produces a given amount of output with the smallest input of scarce resources when both inputs and outputs are measured in dollars and cents.(Key Question 7)
• Who will get the goods and services?
  • The answer to this question is directly related to how the income is distributed among the individuals and the households and the tastes and preferences of consumers.
  • Products go to those who are willing and able to pay for them.
  • The productivity of the resources, the relative supply of particular resources, and the ownership of the resources will determine the income of individuals and households.
  • The resource markets, which determine income, are linked to this decision.
• How will the system accommodate change?
  • Accommodating changes in consumer tastes and the guiding function of prices:
  • An increase in demand for some products will lead to higher prices in those markets.
  • A decrease in demand for other products will lead to lower prices in those markets.
  • Increased demand leads to higher prices that induce greater quantities of output. The opposite is true for a decrease in demand.
  • Higher prices lead to more profits and new firms entering the market.
  • Lower prices lead to losses and firms leaving the industry.
  • The market system promotes technological improvements and capital accumulation.
    • An entrepreneur or firm that introduces a popular new product will be rewarded with increased revenue and profits.
    • New technologies that reduce production costs, and thus product price, will spread throughout the industry as a result of competition.
    • Creative destruction occurs when new products and production methods destroy the market positions of firms that are not able or willing to adjust.

Competition and the "Invisible Hand":

• Competition is the mechanism of control for the market system.It not only guarantees that industry responds to consumer wants, but it also forces firms to adopt the most efficient production techniques.
• Adam Smith talked of the "invisible hand" which promotes public interest through a market system where the primary motivation is self‑interest.By attempting to maximize profits, firms will also be producing the goods and services most wanted by society.

LAST WORD: Shuffling the Deck

• If one thoroughly shuffles a deck of cards, there is a virtual 100% chance that the resulting arrangement of cards will be unlike any previous arrangement.
• Yet, even though there are tens of billions of resources in the world, these resources are arranged in such a way as to produce the products and services that serve human needs.
• Private property eliminates the possibility that resource arrangements will be random because each resource owner will choose a particular course of action if it promises rewards to the owner that exceed the rewards promised by all other available actions.
• The result is a complex and productive arrangement of countless resources.

Goals of Chapter

• To acquire basic factual information about the household and business components of the private sector economy.
• To acquire basic factual information about the public (or government) sector in the U.S. economy.
• To understand the role of the public sector in the U.S. economy.

Households as Income Receivers

• Functional distribution of income is shown in Figure 5‑1.(This figure is based on NI-National Income.)
  • Wages and salaries are 70 percent of total.
  • Proprietors' income (income to self‑employed business owners, doctors, lawyers, etc.) is under 10 percent of total.(This is a combination of wage and profit income.)
  • Capitalist income-corporation profits, rent, interest-is less than one-fifth of total.(Note: rent may be negative because of the depreciation charged against rental income.)
• Personal distribution of income is shown in Figure 5‑2.(This figure is based on PI-Personal Income.)
  • It is often described by dividing the population into quintiles or five numerically equal parts.
  • Proportions of total income going to each quintile are then compared.
  • Comparison shows unequal distribution of income.For example, see how many times greater the share of income going to the top quintile is relative to the bottom fifth.(Key Question 2)

Households As Spenders (Figure 5-3) (Figure is based on PI-Personal Income)

• Use Figure 5.3 or most recent data from Survey of Current Business, January issue of current year, to describe the following.
• How do households dispose of their income?
  • Personal taxes, of which Federal personal income tax is the major component, has increased over the years.
  • Saving (dissaving if spending exceeds income) is the smallest fraction of personal income disposition.
  • Most of household income goes to consumer spending (Figure 5.3).There are several categories of spending categories (Figure 5.4):
    • Durable goods are those with life of three or more years.
    • Nondurable goods include things such as food and clothing.
    • Services are today more than one‑half of all consumer spending, which demonstrates that ours is a service-oriented economy.

The Business Population

• Related definitions:
  • Plant:physical establishment where production or distribution takes place (factory, farm, store).
  • Firm:business organization that owns and operates the plants.(The legal entity.)
  • Industry: a group of related firms, producing the same or similar products.
    • Examples include the automobile industry or the tobacco industry.
    • Confusion often occurs because many businesses are multiproduct firms.
  • Types of multiplant firms:
    • Horizontal integrated: a multiplant firm with plants in the same stage, like a retail chain store such as J. C. Penney or Safeway.
    • Vertical integrated: a multiplant firm in which the company owns plants at different production stages. Example: A steel company may own ore and coal mines as well as different plants in different stages of the manufacturing process.
    • Conglomerate: a firm that owns plants in different industries or markets.

• Legal forms of businesses(Figure 5.5):
  • Definition:
    • Sole proprietorship: a business owned by a single individual.
    • Partnership: two or more individuals own and operate the business in a partnership agreement.
    • Corporation: a legal entity distinct from its individual owners. The organization acts as "legal person."
  • Discussion of Figure 5-5 relative to most important - percentage of firms versus percentage of sales.
  • Sole proprietorship
    • Advantages: easy to set up; proprietor is his/her own boss; because profit is proprietor's income, there is an incentive to operate the business efficiently.
    • Disadvantages: financial resources are limited and insufficient; the proprietor is responsible for all of management functions; the proprietor is subject to unlimited liability.
  • Partnership
    • Advantages: easy to organize; greater specialization; better access to financial resources than proprietorships.
    • Disadvantages: some of the same shortcomings of the proprietorship; possible difficulties in sharing management responsibilities; still limited financial resources; problems if one of the partners leaves; still unlimited liabilities.
  • Corporations
    • Advantages: improved ability to raise financial capital (money); defining and comparing stocks and bonds; limited liabilities; corporations have a permanence that is conducive to long-run planning and growth.
    • Disadvantages: red tape and expense in obtaining a corporate charter; unscrupulous business owners sometimes avoid responsibility for questionable business activities.
  • Hybrid structures
  • Principle-agent problem

The Public Sector: Government's Role

• Providing the legal structure:
  • Government ensures property rights, provides enforcement of contracts, acts as a referee and imposes penalties for foul play.
  • Government intervention improves the allocation of resources by supplying a medium of exchange, ensuring product quality, defining ownership rights, and enforcing contracts.
  • These interventions widen the market and foster greater specialization in the use of property and human resources.
  • The appropriate amount of regulation is at the level where the marginal benefit and marginal cost are equal.
• Maintain competition:
  • Competition is the market mechanism that encourages producers and resource suppliers to respond to consumer sovereignty.
  • If producers (and/or resource suppliers) have monopoly power, the monopolist can charge higher-than-competitive prices and supplant consumer sovereignty with producer sovereignty (or economic rent).
  • If "natural monopoly" exists, government regulates price and service.(Natural monopoly exists when technology or economic realities make a monopoly more efficient than competition.)
  • Where competitive markets are more efficient, anti‑monopoly laws (Sherman Act of 1890; Clayton Act of 1913) are designed to regulate business behavior and promote competition.
• Redistribution of income:
  • Transfer payments provide relief to the poor, dependent, handicapped, and unemployment compensation to those unemployed who qualify for benefits.Social Security and Medicare programs support the sick and aged.
  • Government intervenes in markets by modifying prices.Price support programs for farmers; minimum wage laws are examples.
  • Taxation takes a larger proportion of incomes of the rich than the poor.
• Reallocation of resources:
  • Market failure occurs when the competitive market system produces the "wrong" amounts of certain goods or services or fails to provide any at all.
  • Spillovers and externalities
    • Spillovers or externalities occur when some of the benefits or costs of production are not fully reflected in market demand or supply schedules. Some of the benefits or costs of a good may "spill over" to third parties.
    • An example of a spillover cost is pollution, which allows polluters to enjoy lower production costs because the firm is passing along the cost of pollution damage or cleanup to society. Because the firm does not bear the entire cost, it will overallocate resources.
    • Correcting for spillover costs requires that government get producers to internalize these costs.
  • Legislation can limit or prohibit pollution, which means the producer must bear costs of antipollution effort.
  • Specific taxes on the amounts of pollution can be assessed, which causes the firm to cut back on pollution as well as provide funds for government cleanup.
    • Spillover benefits occur when direct consumption by some individuals impacts third parties. Public health vaccinations and education are two examples. Because some of the benefits accrue to others, individuals will demand too little for themselves and resources will be underallocated by the market.
    • Correcting for spillover benefits requires that the government somehow increase demand to increase benefits to socially desirable amounts.
  • Government can increase demand by providing subsidies like food stamps and education grants to subsidize consumers.
  • Government can finance production of good or service such as public education or public health.
  • Government can increase supply by subsidizing production, such as higher education, immunization programs, or public hospitals.
  • Government provides public goods and quasi-public goods and services.
    • Private goods are produced through the market because they are divisible and come in units small enough to be afforded by individual buyers. Private goods are subject to the exclusion principle, the idea that those unable and unwilling to pay are excluded from the benefits of the product.
    • Public or social goods would not be produced through the market, because they are indivisible and are not subject to the exclusion principle.
  • A lighthouse is a good example of a public good. The light is there for all to see whether or not they paid for it. Those who receive benefits without paying are part of the so‑called free‑rider problem.
  • Other examples include national defense, flood‑control, public health.
    • Producers would not be able to find enough paying buyers for "public goods" because of the free‑rider problem mentioned above. Therefore, "public goods" are not produced voluntarily through the market but must be provided by the public sector and financed by compulsory taxes.
    • Quasi‑public goods are those that have large spillover benefits, so government will sponsor their provision. Otherwise, they would be underproduced. Medical care, education, and public housing are examples.
    • Resources are reallocated from private to public use by levying taxes on households and businesses, thus reducing their purchasing power and using the proceeds to purchase public and quasi‑public goods. This can bring about a significant change in the composition of the economy's total output.

• Promoting stability:
  • An economy's level of output is dependent on its level of total spending relative to its productive capacity.
  • The government may promote macroeconomic stability through changes in government spending and taxation.
    • When total spending is too low, the government may increase its spending and/or lower taxes to reduce unemployment.
    • When total spending is excessive, the government may cut its spending and/or raise taxes to foster price stability.

Circular Flow Revisited

• Figure 5.6 shows the circular flow model with the addition of the government sector.
• There are several modifications to the Chapter 2 model.
  • Flows (5) through (8) illustrate that government makes purchases and expenditures in both the product and resource markets.
  • Flows (9) and (10) illustrate that the government provides public good and services to households and businesses.
  • Flows (11) and (12) illustrate that government receives taxes from and distributes subsidies to households and businesses.
• These flows suggest ways that the government might alter the distribution of income, reallocate resources, and change the level of economic activity.

Government Finance

• Government expenditures on goods and services and transfer payments.
  • Government purchases directly use or employ resources to produce goods or services measured in domestic output.
  • Government transfer payments are not directly part of domestic output, but include payments like social security, unemployment compensation, welfare payments.
• Changes in government purchases of goods and services, expenditures on transfer payments, and total spending as percentages of U.S. output, 1960 and 2000 (Figure 5.7).
• Major growth in government spending since the 1960s has been in transfer payment area.

Federal Finance (see Figure 5.8)

• Expenditures emphasize four important areas.
  • Income security,
  • National defense,
  • Health, and
  • Interest on national debt.
• Receipts come from several sources.
  
  • Personal income tax is a major source.
    • The Federal personal income tax is progressive. People with higher incomes pay a higher percentage of that income as tax than do people with lower incomes.
    • A marginal tax rate is the rate at which the tax is paid on each additional unit of taxable income (Table 5.1).
    • The average tax rate is the total tax paid divided by total taxable income.
    • A tax whose average tax rises as income increases is progressive.
  • Payroll taxes, such as social security contributions, are a close second as source of revenue.
  • Corporate income taxes on corporation profits are the third largest source of revenue.
  • Excise taxes are similar to sales taxes on specific commodities, like alcoholic beverages, tobacco, and gasoline. They are levied at the wholesale level, so are hidden from the consumer.
  • Global Perspective 5-2 shows that Australia, the United States, and Japan enjoy relatively low tax burdens.

State and Local Finance

• State expenditures and receipts for all states in 1998 are illustrated in Figure 5.9.
  • State revenues primarily come from sales taxes and secondly from personal income taxes.
  • State spending goes for public welfare, education, highways, and health care.
• Local expenditures and receipts for all local governmental units in 1996 are shown in Figure 5.10.
  • Revenue is primarily from property taxes.
  • Spending is primarily on education.
  • Gap between local tax revenues and spending is largely filled by grants from state and Federal government.(This system of intergovernmental transfers is called fiscal federalism.)

LAST WORD: The Financing of Corporate Activity

• A major advantage of corporate form of organization is the ability to finance operations through sale of stock and bonds.This Last Word examines corporate finance in more detail.
• There are three ways to finance corporate activity:
  • Internally out of undistributed profits,
  • Borrowing from financial institutions, and
  • Issuing stocks and/or bonds.
    • Common stock is a share of ownership in the corporation and gives the holder a voting right and share of dividends.
    • A bond is an IOU whereby the corporation promises to pay the holder a fixed amount in the future plus annual interest.

• Differences between stocks and bonds:
  • Bondholder is not an owner, only a lender.
  • Bonds are less risky usually because of certain factors.
    • Bondholders can claim interest payments before stockholder dividends are calculated.
    • Interest is guaranteed as long as company is healthy, whereas dividends depend on profits.
  • Risks involved with bonds include:
    • Capital risk, which means that the market price of a bond can change if market interest rates change and a holder needs to sell a bond before its maturity date. Note that the market price of a bond varies inversely with market interest rates.
    • Risk of unexpected inflation means that the purchasing power of the bond will fall because its interest rate is less than the inflation rate.

Assessing the Economy's Performance

• National income accounting measures the economy's performance by measuring the flows of income and expenditures over a period of time.
• National income accounts serve a similar purpose for the economy, as do income statements for business firms.
• Consistent definition of terms and measurement techniques allows us to use the national accounts in comparing conditions over time and across countries.
• The national income accounts provide a basis for of appropriate public policies to improve economic performance.

Gross Domestic Product

• GDP is the monetary measure of the total market value of all final goods and services produced within a country in one year.
  • Money valuation allows the summing of apples and oranges; money acts as the common denominator.
  • GDP includes only final products and services; it avoids double or multiple counting, by eliminating any intermediate goods used in production of these final goods or services.
  • GDP is the value of what has been produced in the economy over the year, not what was actually sold.
• GDP Excludes Nonproduction Transactions
  • GDP is designed to measure what is produced or created over the current time period.Existing assets or property that sold or transferred, including used items, are not counted.
  • Purely financial transactions are excluded.
    • Public transfer payments, like social security or cash welfare benefits.
    • Private transfer payments, like student allowances or alimony payments.
    • The sale of stocks and bonds represent a transfer of existing assets. (However, the brokers' fees are included for services rendered.)
  • Secondhand sales are excluded, they do not represent current output.

• Two Ways to Look at GDP:Spending and Income.
  • What is spent on a product is income to those who helped to produce and sell it.
  • This is an important identity and the foundation of the national accounting process.
• Expenditures Approach(See Figure 7.1 and Table 7.3)
  • GDP is divided into the categories of buyers in the market; household consumers, businesses, government, and foreign buyers.
  • Personal Consumption Expenditures-(C)-includes durable goods, nondurable goods and services.
  • Gross Private Domestic Investment-(I_g)
    • All final purchases of machinery, equipment, and tools by businesses.
    • All construction (including residential).
    • Changes in business inventory.
      • If total output exceeds current sales, inventories build up.
      • If businesses are able to sell more than they currently produce, this entry will be a negative number.
    • Net Private Domestic Investment-(I_n).
      • Each year as current output is being produced, existing capital equipment is wearing out and buildings are deteriorating; this is called depreciation or capital consumption allowance.
      • Gross Investment minus depreciation (capital consumption allowance) is called net investment.
      • If more new structures and capital equipment are produced in a given year than are used up, the productive capacity of the economy will expand.
      • When gross investment and depreciation are equal, a nation's productive capacity is static.
      • When gross investment is less than depreciation, an economy's production capacity declines.
  • Government Purchases (of consumption goods and capital goods) - (G)
    • Includes spending by all levels of government (federal, state and local).
    • Includes all direct purchases of resources (labor in particular).
    • This entry excludes transfer payments since these outlays do not reflect current production.
  • Net Exports-(X_n)
    • All spending on goods produced in the U.S. must be included in GDP, whether the purchase is made here or abroad.
    • Often goods purchased and measured in the U.S. are produced elsewhere (Imports).
    • Therefore, net exports, (Xn) is the difference: (exports minus imports) and can be either a positive or negative number depending on which is the larger amount.
  • Summary: GDP = C + I_g + G + X_n

• Income Approach to GDP(See Table 7.3):Demonstrates how the expenditures on final products are allocated to resource suppliers.
  • Compensation of employees includes wages, salaries, fringe benefits, salary and supplements, and payments made on behalf of workers like social security and other health and pension plans.
  • Rents:payments for supplying property resources (adjusted for depreciation it is net rent).
  • Interest:payments from private business to suppliers of money capital.
  • Proprietors' income:income of incorporated businesses, sole proprietorships, partnerships, and cooperatives.
  • Corporate profits:After corporate income taxes are paid to government, dividends are distributed to the shareholders, and the remainder is left as undistributed corporate profits.
  • The sum of the above entries equals national income:all income earned by American supplied resources, whether here or abroad.
  • Adjustments required to balance both sides of the account.
    • Indirect business taxes: general sales taxes, excise taxes, business property taxes, license fees and customs duties (the seller treats these taxes as a cost of production).
    • Depreciation Consumption of Fixed Capital: The firm also regards the decline of its capital stock as a cost of production. The capital consumption allowance is set aside to replace the machinery and equipment used up. In addition to the depreciation of private capital, public capital (government buildings, port facilities, etc.), must be included in this entry.
    • Net foreign factor income: National income measures the income of Americans both here and abroad. GDP measures the output of the geographical U.S. regardless of the nationality of the contributors. To make this final adjustment, the income of foreign nationals must be added and American income earned abroad must be subtracted. Sometimes this entry is a negative number.

Other National Accounts (see Table 7.4)

• Net domestic product (NDP) is equal to GDP minus depreciation allowance (consumption of fixed capital).
• National income (NI) is income earned by American‑owned resources here or abroad.Adjust NDP by subtracting indirect business taxes and adding net American income earned abroad.(Note:This may be a negative number if foreigners earned more in U.S. than American resources earned abroad.)
• Personal income (PI) is income received by households.To calculate, take NI minus payroll taxes (social security contributions), minus corporate profits taxes, minus undistributed corporate profits, and add transfer payments.
• Disposable income (DI) is personal income less personal taxes.

Circular Flow Revisited (see Figure 7.3)

• Compare to the simpler model presented in earlier chapters.Now both government and foreign trade sectors are added.
• Note that the inside covers of the text contain a useful historical summary of national income accounts and related statistics.

Nominal Versus Real GDP

• Nominal GDP is the market value of all final goods and services produced in a year.
  • GDP is a (P ¥ Q) figure including every item produced in the economy.Money is the common denominator that allows us to sum the total output.
  • To measure changes in the quantity of output, we need a yardstick that stays the same size.To make comparisons of length, a yard must remain 36 inches.To make comparisons of real output, a dollar must keep the same purchasing power.
  • Nominal GDP is calculated using the current prices prevailing when the output was produced but real GDP is a figure that has been adjusted for price level changes.
• The adjustment process in a one-good economy (Table 7.5).Valid comparisons can not be made with nominal GDP alone, since both prices and quantities are subject to change.Some method to separate the two effects must be devised.
  • One method is to first determine a price index, (see equation 1) and then adjust the nominal GDP figures by dividing by the price index (in hundredths) (see equation 1).
  • An alternative method is to gather separate data on the quantity of physical output and determine what it would sell for in the base year.The result is Real GDP.The price index is implied in the ratio:Nominal GDP/Real GDP.Multiply by 100 to put it in standard index form (see equation 3).
• Real World Considerations and Data
  • The actual GDP price index in the U.S. is called the chain-type annual weights price index, and is more complex than can be illustrated here.
  • Once nominal GDP and the GDP price index are established, the relationship between them and real GDP is clear (see Table 7.7).
  • The base year price index is always 100, since Nominal GDP and Real GDP use the same prices.Because the long-term trend has been for prices to rise, adjusting Nominal GDP to Real GDP involves inflating the lower prices before the base year and deflating the higher prices after the base year.
  • Real GDP values allow more direct comparison of physical output from one year to the next, because a "constant dollar" measuring device has been used.(The purchase power of the dollar has been standardized at the base year level.)

The Consumer Price Index (CPI)

• Characteristics of the CPI
  • The CPI is designed to measure the changes in the cost of a constant standard of living for a typical urban consumer.This fixed weight approach means that the items in the market basket remain the same.
  • The market basket of goods is changed about every 10 years.The present composition was determined from a survey of urban consumers in the 1993-1995 period and contains about 300 goods and services purchased by the typical urban consumer.
• The CPI differs from the GDP price index, which is broader and changes its market basket each year to reflect the current composition of output.

Shortcomings of GDP

• GDP doesn't measure some very useful output because it is unpaid (homemakers' services, parental child care, volunteer efforts, home improvement projects).
• GDP does not measure improvements in product quality or make allowances for increased leisure time.
• GDP doesn't measure improved living conditions as a result of more leisure.
• GDP makes no value adjustments for changes in the composition of output or the distribution of income.
  • Nominal GDP simply adds the dollar value of what is produced; it makes no difference if the product is a semi-automatic rifle or a jar of baby food.
  • Per capital GDP may give some hint as to the relative standard of living in the economy; but GDP figures do not provide information about how the income is distributed.
• The Underground Economy
  • Illegal activities are not counted in GDP.
  • Legal economic activity may also be part of the "underground," usually in an effort to avoid taxation.
• GDP and the environment.
  • The harmful effects of pollution are not deducted from GDP (oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view).
  • GDP does include payments made for cleaning up the oil spills, and the cost of health care for the cancer victim.
• Per Capita GDP (GDP per person) is a better measure of standard of living than total GDP.
• Noneconomic Sources of Well-Being like courtesy, crime reduction, etc., are not covered in GDP.

LAST WORD: Feeding the GDP Accounts

• U.S. Customs Service data on exports and imports.
• BEA surveys on service exports and imports.

Introduction: This chapter provides an introductory look at trends of real GDP growth and the macroeconomic problems of the business cycle, unemployment and inflation.

Economic Growth-how to increase the economy's productive capacity over time.

• Two definitions of economics growth are given.
  • The increase in real GDP, which occurs over a period of time.
  • The increase in real GDP per capita, which occurs over time.This definition is superior if comparison of living standards is desired.For example, China's GDP is $744 billion compared to Denmark's $155 billion, but per capita GDP's are $620 and $29,890 respectively.
• Growth is an important economic goal because it means more material abundance and ability to meet the economizing problem.Growth lessens the burden of scarcity.
• The arithmetic of growth is impressive.Using the "rule of 70," a growth rate of 2 percent annually would take 35 years for GDP to double, but a growth rate of 4 percent annually would only take about 18 years for GDP to double.(The "rule of 70" uses the absolute value of a rate of change, divides it into 70, and the result is the number of years it takes the underlying quantity to double.)
• Main sources of growth are increasing inputs or increasing productivity of existing inputs.
  • About one-third of U.S. growth comes from more inputs.
  • About two-thirds comes from increased productivity.
• Growth Record of the United States (Table 8-1) is impressive.
  • Real GDP has increased more than sixfold since 1940, and real per capita GDP has risen almost fourfold.(See columns 2 and 4, Table 8-1)
  • Rate of growth record shows that real GDP has grown 3.1 percent per year since 1950 and real GDP per capita has grown about 2 percent per year.But the arithmetic needs to be qualified.
    • Growth doesn't measure quality improvements.
    • Growth doesn't measure increased leisure time.
    • Growth doesn't take into account adverse effects on environment or human security.
    • International comparisons are useful in evaluating U.S. performance. For example, Japan grew more than twice as fast as U.S. until the 1990s when the U.S. far surpassed Japan. (see Global Perspective 8-1).

Overview of the Business Cycle

• Historical record:
  • The United States' impressive long‑run economic growth has been interrupted by periods of instability.
  • Uneven growth has been the pattern, with inflation often accompanying rapid growth, and declines in employment and output during periods of recession and depression (see Figure 8‑1 and Table 8-2).
• Four phases of the business cycle are identified over a several‑year period.(See Figure 8-1)
  • A peak is when business activity reaches a temporary maximum with full employment and near-capacity output.
  • A recession is a decline in total output, income, employment, and trade lasting six months or more.
  • The trough is the bottom of the recession period.
  • Recovery is when output and employment are expanding toward full‑employment level.
• There are several theories about causation.
  • Major innovations may trigger new investment and/or consumption spending.
  • Changes in productivity may be a related cause.
  • Most agree that the level of aggregate spending is important, especially changes on capital goods and consumer durables.
• Cyclical fluctuations:Durable goods output is more unstable than non-durables and services because spending on latter usually can not be postponed.

Unemployment (One Result of Economic Downturns)

• Types of unemployment:
  • Frictional unemployment consists of those searching for jobs or waiting to take jobs soon; it is regarded as somewhat desirable, because it indicates that there is mobility as people change or seek jobs.
  • Structural unemployment:due to changes in the structure of demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs changes.
    • Glass blowers were replaced by bottle-making machines.
    • Oil-field workers were displaced when oil demand fell in 1980s.
    • Airline mergers displaced many airline workers in 1980s.
    • Foreign competition has led to downsizing in U.S. industry and loss of jobs.
    • Military cutbacks have led to displacement of workers in military-related industries.
  • Cyclical unemployment is caused by the recession phase of the business cycle, which is sometimes called deficient demand unemployment.

• Definition of "Full Employment"
  • Full employment does not mean zero unemployment.
  • The full‑employment unemployment rate is equal to the total frictional and structural unemployment.
  • The full‑employment rate of unemployment is also referred to as the natural rate of unemployment.
  • The natural rate is achieved when labor markets are in balance; the number of job seekers equals the number of job vacancies.At this point the economy's potential output is being achieved.The natural rate of unemployment is not fixed, but depends on the demographic makeup of the labor force and the laws and customs of the nations.The recent drop in the natural rate from 6% to 5.5% has occurred mainly because of the aging of the work force and increased competition in product and labor markets.
  • The natural rate of unemployment is not fixed but depends on the demographic makeup of the labor force and the laws and customs of the nations.
  • The recent drop in the natural rate of 6% to 5.5% has occurred mainly because of the aging of the work force and increased competition in product and labor markets.
• Measuring unemployment (see Figure 8-4 for 1994):
  • The population is divided into three groups:those under age 16 or institutionalized, those "not in labor force," and the labor force that includes those age 16 and over who are willing and able to work.
  • The unemployment rate is defined as the percentage of the labor force that is not employed.
  • The unemployment rate is calculated by random survey of 60,000 households nationwide.
  • Part‑time workers are counted as "employed."
  • "Discouraged workers" who want a job, but are not actively seeking one, are not counted as being in the labor force, so they are not part of unemployment statistic.

• Economic cost of unemployment:
  • GDP gap and Okun's Law:GDP gap is the difference between potential and actual GDP.(See Figure 8-5)Economist Okun quantified relationship between unemployment and GDP as follows:For every 1 percent of unemployment above the natural rate, a 2 percent GDP gap occurs.This has become known as "Okun's law."
  • Unequal burdens of unemployment exist.(See Table 8-2)
    • Rates are lower for white‑collar workers.
    • Teenagers have the highest rates.
    • Blacks have higher rates than whites.
    • Rates for males and females are comparable, though females had a lower rate in 1992.
    • Less educated workers, on average, have higher unemployment rates than workers with more education.
    • "Long‑term" (15 weeks or more) unemployment rate is much lower than the overall rate.

• Noneconomic costs include loss of self‑respect and social and political unrest.
• International comparisons.(See Global Perspective 8-1)

Inflation: Defined and Measured

• Definition:Inflation is a rising general level of prices (not all prices rise at the same rate, and some may fall).
• To measure inflation, subtract last year's price index from this year's price index and divide by last year's index; then multiply by 100 to express as a percentage.
• "Rule of 70" permits quick calculation of the time it takes the price level to double:Divide 70 by the percentage rate of inflation and the result is the approximate number of years for the price level to double.If the inflation rate is 10 percent, then it will take about ten years for prices to double.(Note: You can also use this rule to calculate how long it takes savings to double at a given compounded interest rate.)
• Facts of inflation:
  • In the past, deflation has been as much a problem as inflation.For example, the 1930s depression was a period of declining prices and wages.
  • All industrial nations have experienced the problem (see Global Perspective 8-2).
  • Some nations experience astronomical rates of inflation (Angola's was 4,145 percent in 1996).
  • The inside covers of the text contain historical rates for the U.S.
• Causes and theories of inflation:
  • Demand‑pull inflation:Spending increases faster than production.(See Figure 8‑7)Inflation will occur in range 2 and range 3 of this illustration.Bottlenecks occur in some industries in range 2, and output cannot expand to meet demand in these industries so producers raise prices; in Range 3 full employment has been reached and resource prices will rise with increasing demand, causing producers to raise prices.Note:Chapter 7's distinction between nominal and real GDP is helpful here.
  • Cost‑push or supply‑side inflation:Prices rise because of rise in per-unit production costs (Unit cost = total input cost/units of output).
    • Wage‑push can occur as result of union strength.
    • Supply shocks may occur with unexpected increases in the price of raw materials.
  • Complexities: It is difficult to distinguish between demand‑pull and cost‑push causes of inflation, although cost‑push will die out in a recession if spending does not also rise.

Redistributive effects of inflation:

• Fixed‑income groups will be hurt because their real income suffers.Their nominal income does not rise with prices.
• Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation.Their savings will lose purchasing power.
• Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation.Interest payments may be less than the inflation rate, so borrowers receive "dear" money and are paying back "cheap" dollars that have less purchasing power for the lender.
• If inflation is anticipated, the effects of inflation may be less severe, since wage and pension contracts may have inflation clauses built in, and interest rates will be high enough to cover the cost of inflation to savers and lenders.
  • "Inflation premium" is amount that interest rate is raised to cover effects of anticipated inflation.
  • "Real interest rate" is defined as nominal rate minus inflation premium.(See Figure 8-6)
• Final points
  • Unexpected deflation, a decline in price level, will have the opposite effect of unexpected inflation.
  • Many families are simultaneously helped and hurt by inflation because they are both borrowers and earners and savers.
  • Effects of inflation are arbitrary, regardless of society's goals.
  • See Quick Review 8-4.

Output Effects of Inflation

• Cost‑push inflation, where resource prices rise unexpectedly, could cause both output and employment to decline.Real income falls.
• Mild inflation (<3%) has uncertain effects.It may be a healthy by-product of a prosperous economy, or it may have an undesirable impact on real income.
• Danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless spending, and more inflation (see examples in text of Hungary and Japan following World War II, and Germany following World War I).

LAST WORD: The Stock Market and The Economy: How, if at all, do changes in stock prices relate to macroeconomic stability?

• Do changes in stock prices and stock market wealth cause instability?The answer is yes, but usually the effect is weak.
  • There is a wealth effect:Consumer spending rises as asset values rise and vice versa if stock prices decline substantially.
  • Also, there is an investment effect:Rising share prices lead to more capital goods investment and the reverse in true for falling share prices.
• Stock market "bubbles" can hurt the economy by encouraging reckless speculation with borrowed funds or savings needed for other purposes.A "crash" can cause unwarranted pessimism about the underlying economy.
• A related question concerns forecasting value of stock market averages.Stock price averages are included as one of ten "Leading Indicators" used to forecast the future direction of the economy.(See Last Word, Chapter 12).However, by themselves, stock values are not a reliable predictor of economic conditions.

Introduction-What Determines GDP?

• This chapter and the next focus on the aggregate expenditures model.We use the definitions and facts from previous chapters to shift our study to the analysis of economic performance.The aggregate expenditures model is one tool in this analysis.Recall that "aggregate" means total.
• As explained in this chapter's Last Word, the model originated with John Maynard Keynes (Pronounced Canes).
• The focus is on the relationship between income and consumption and savings.
• Investment spending, an important part of aggregate expenditures, is also examined.
• Finally, these spending categories are combined to explain the equilibrium levels output and employment in a private (no government), domestic (no foreign sector) economy.Therefore, GDP=NI=PI=DI in this very simple model.

Simplifying Assumptions for this Chapter

• We assume a "closed economy" with no international trade.
• Government is ignored; focus is on private sector markets until next chapter.
• Although both households and businesses save, we assume here that all saving is personal.
• Depreciation and net foreign income are assumed to be zero for simplicity.
• There are two reminders concerning these assumptions.
  • They leave out two key components of aggregate demand (government spending and foreign trade), because they are largely affected by influences outside the domestic market system.
  • With no government or foreign trade, GDP,national income (NI), personal income (PI), and disposable income (DI) are all the same.

Tools of Aggregate Expenditures Theory: Consumption and Saving

• The theory assumes that the level of output and employment depend directly on the level ofaggregate expenditures.Changes in output reflect changes in aggregate spending.
• Consumption and saving:Since consumption is the largest component of aggregate spending, we analyze its determinants.
  • Disposable income is the most important determinant of consumer spending (see Figure 9-1 in text which presents historical evidence).
    • What is not spent is called saving.
    • Therefore, DI - C = S or C + I = DI
  • In Figure 9-1 we see a 45-degree line which represents all points where consumer spending is equal to disposable income; other points represent actual C, DI relationships for each year from 1980-2000.
  • If the actual graph of the relationship between consumption and income is below the 45-degree line, then the difference must represent the amount of income that is saved.
  • Look at 1996 where consumption was $5238 billion and disposable income was $5678 billion. Hence, saving was $440 billion.
  • The graph illustrates that as disposable income increases both consumption and saving increase.
  • Some conclusions can be drawn:
    • Households consume a large portion of their disposable income.
    • Both consumption and saving are directly related to the level of income.

• The consumption schedule:
  • The dots in Figure 9-1 represent actual historical data.
  • A hypothetical consumption schedule (Table 9‑1 and Key Graph 9-2a) shows that households spend a larger proportion of a small income than of a large income.
  • A hypothetical saving schedule (Table 1, column 3) is illustrated in Key Graph 9-2b.
  • Note that "dissaving" occurs at low levels of disposable income, where consumption exceeds income and households must borrow or use up some of their wealth.
• Average and marginal propensities to consume and save:
  • Define average propensity to consume (APC) as the fraction or %of income consumed(APC = consumption/income).See Column 4 in Table 9-1.
  • Define average propensity to save (APS) as a the fraction or %of income saved(APS = saving/income).See Column 5 in Table 9-1.
  • Global Perspective 9-1 shows the APCs for several nations in 1999.Note the high APC for both U.S. and Canada.
  • Marginal propensity to consume (MPC) is the fraction or proportion of any change in income that is consumed. (MPC = change in consumption/change in income.)See Column 6 in Table 9-1.
  • Marginal propensity to save (MPS) is the fraction or proportion of any change in income that is saved. (MPS = change in saving/change in income.)See Column 7 in Table 9-1.
  • Note that APC + APS = 1 and MPC + MPS = 1.
  • Note that Figure 9-3 illustrates that MPC is the slope of the consumption schedule, and MPS is the slope of the saving schedule.
  • Test Yourself:Try the Self-Quiz below Key Graph 9-2.
• Nonincome determinants of consumption and saving can cause people to spend or save more or less at various income levels, although the level of income is the basic determinant.
  • Wealth:An increase in wealth shifts the consumption schedule up and saving schedule down.In recent years major fluctuations in stock market values have increased the importance of this wealth effect.
  • Expectations: Changes in expected inflation or future wealth can affect consumption spending today.
  • Household debt:Lower debt levels shift consumption schedule up and saving schedule down.
  • Taxation:Lower taxes will shift both schedules up since taxation affects both spending and saving, and vice versa for higher taxes.
• Shifts and stability:See Figure 9-4.
  • Terminology:Movement from one point to another on a given schedule is called a change in amount consumed; a shift in the schedule is called a change in consumption schedule.
  • Schedule shifts:Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change.
  • Stability:Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action.
• Review these aggregate expenditures concepts with Quick Review 9-1.

Investment

• Investment, the second component of private spending, consists of spending on new plants, capital equipment, machinery, inventories, construction, etc.
  • The investment decision weighs marginal benefits and marginal costs.
  • The expected rate of return is the marginal benefit and the interest rate represents the marginal cost.
• Expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to cost of investment to get expected rate of return.The text's example gives $100 expected profit, $1000 investment for a 10% expected rate of return.Thus, the business would not want to pay more than 10% interest rate on investment.
• The real interest rate, i (nominal rate corrected for expected inflation), is the cost of investment.
  • Interest rate is either the cost of borrowed funds or the cost of investing your own funds, which is income forgone.
  • If real interest rate exceeds the expected rate of return, the investment should not be made.
• Investment demand schedule, or curve, shows an inverse relationship between the interest rate and amount of investment.
  • As long as expected return exceeds interest rate, the investment is expected to be profitable (see Table 9‑2 example).
  • Key Graph 9-5 shows the relationship when the investment rule is followed.Fewerprojects are expected to provide high return, so less will be invested if interest rates are high.
  • Test yourself with Quick Quiz 9-5.
• Shifts in investment demand occur when any determinant apart from the interest rate changes.
  • Greater expected returns create more investment demand; shift curve to right.The reverse causes a leftward shift.
    • Acquisition, maintenance, and operating costs of capital goods may change.
    • Business taxes may change.
    • Technology may change.
    • Stock of capital goods on hand will affect new investment.
    • Expectations can change the view of expected profits.

• In addition to the investment demand schedule, economists also define aninvestment schedule that shows the amounts business firms collectively intend to invest at each possible level of GDP or DI.
  • In developing the investment schedule, it is assumed that investment is independent of the current income.The line I_g (gross investment) in Figure 9‑7b shows this graphically related to the level determined by Figure 9-7a.
  • The assumption that investment is independent of income is a simplification, but will be used here.
  • Table 9-3 shows the investment schedule from GDP levels given in Table 9-1.
• Investment is a very unstable type of spending; I is more volatile than GDP(See Figure 9-8).
  • Capital goods are durable, so spending can be postponed or not.This is unpredictable.
  • Innovation occurs irregularly.
  • Profits vary considerably.
  • Expectations can be easily changed.

Equilibrium GDP: Expenditures-Output Approach

• Look at Table 9-4, which combines data of Tables 9-1 and 9-3.
• Real domestic output in column 2 shows ten possible levels that producers are willing to offer, assuming their sales would meet the output planned.In other words, they will produce $370 billion of output if they expect to receive $370 billion in revenue.
• Ten levels of aggregate expenditures are shown in column 6.The column shows the amount of consumption and planned gross investment spending (C + I_g) forthcoming at each output level.
  • Recall that consumption level is directly related to the level of income and that here income is equal to output level.
  • Investment is independent of income here and is planned or intended regardless of the current income situation.
• Equilibrium GDP is the level of output whose production will create total spending just sufficient to purchase that output.Otherwise there will be a disequilibrium situation.
  • In Table 9-4, this occurs only at $470 billion.
  • At $410 billion GDP level, total expenditures (C + I_g) would be $425 = $405(C) + $20 (I_g) and businesses will adjust to this excess demand by stepping up production.They will expand production at any level of GDP less than the $470 billion equilibrium.
  • At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP.At $510 billion level, C + I_g = $500 billion.Businesses will have unsold, unplanned inventory investment and will cut back on the rate of production.As GDP declines, the number of jobs and total income will also decline, but eventually the GDP and aggregate spending will be in equilibrium at $470 billion.
• Graphical analysis is shown in Figure 9-9 (Key Graph).At $470 billion it shows the C + I_g schedule intersecting the 45-degree line which is where output = aggregate expenditures, or the equilibrium position.
  • Observe that the aggregate expenditures line rises with output and income, but not as much as income, due to the marginal propensity to consume (the slope) being less than 1.
  • A part of every increase in disposable income will not be spent but will be saved.
  • Test yourself with Quick Quiz 9-9.

Two Other Features of Equilibrium GDP

• Savings and planned investment are equal.
  • It is important to note that in our analysis above we spoke of "planned" investment.At GDP = $470 billion in Table 9-4, both saving and planned investment are $20 billion.
  • Saving represents a "leakage" from spending stream and causes C to be less than GDP.
  • Some of output is planned for business investment and not consumption, so this investment spending can replace the leakage due to saving.
    • If aggregate spending is less than equilibrium GDP as it is in Table 9-4, line 8 when GDP is $510 billion, then businesses will find themselves with unplanned inventory investment on top of what was already planned. This unplanned portion is reflected as a business expenditure, even though the business may not have desired it, because the total output has a value that belongs to someone-either as a planned purchase or as an unplanned inventory.
    • If aggregate expenditures exceed GDP, then there will be less inventory investment than businesses planned as businesses sell more than they expected. This is reflected as a negative amount of unplanned investment in inventory. For example, at $450 billion GDP, there will be $435 billion of consumer spending, $20 billion of planned investment, so businesses must have experienced a $5 billion unplanned decline in inventory because sales exceed that expected.

• In equilibrium there are no unplanned changes in inventory.
  • Consider row 7 of Table 9-4 where GDP is $490 billion, here C + Ig is only $485 billion and will be less than output by $5 billion.Firms retain the extra $5 billion as unplanned inventory investment.Actual investment is $25 billion or more than $20 billion planned. So $490 billion is an above-equilibrium output level.
  • Consider row 5, Table 9-4.Here $450 billion is a below-equilibrium output level because actual investment will be $5 billion less than planned.Inventories decline below what was planned.GDP will rise to $470 billion.
• Quick Review:Equilibrium GDP is where aggregate expenditures equal real domestic output.(C + planned Ig = GDP)
  • A difference between saving and planned investment causes a difference between the production and spending plans of the economy as a whole.
  • This difference between production and spending plans leads to unintended inventory investment or unintended decline in inventories.
  • As long as unplanned changes in inventories occur, businesses will revise their production plans upward or downward until the investment in inventory is equal to what they planned.This will occur at the point that household saving is equal to planned investment.
  • Only where planned investment and saving are equal will there be no unintended investment or disinvestment in inventories to drive the GDP down or up.

Last Word: Say's Law, The Great Depression, and Keynes

• Until the Great Depression of the 1930, most economists going back to Adam Smith had believed that a market system would ensure full employment of the economy's resources except for temporary, short-term upheavals.
• If there were deviations, they would be self-correcting.A slump in output and employment would reduce prices, which would increase consumer spending; would lower wages, which would increase employment again; and would lower interest rates, which would expand investment spending.
• Say's law, attributed to the French economist J. B. Say in the early 1800s, summarized the view in a few words:"Supply creates its own demand."
• Say's law is easiest to understand in terms of barter.The woodworker produces furniture in order to trade for other needed products and services.All the products would be traded for something, or else there would be no need to make them.Thus, supply creates its own demand.
• Reformulated versions of these classical views are still prevalent among some modern economists today.
• The Great Depression of the 1930s was worldwide.GDP fell by 40 percent in U.S. and the unemployment rate rose to nearly 25 percent (when most families had only one breadwinner).The Depression seemed to refute the classical idea that markets were self-correcting and would provide full employment.
• John Maynard Keynes in 1936 in his General Theory of Employment, Interest, and Money, provided an alternative to classical theory, which helped explain periods of recession.
  • Not all income is always spent, contrary to Say's law.
  • Producers may respond to unsold inventories by reducing output rather than cutting prices.
  • A recession or depression could follow this decline in employment and incomes.
• The modern aggregate expenditures model is based on Keynesian economics or the ideas that have arisen from Keynes and his followers since.It is based on the idea that saving and investment decisions may not be coordinated, and prices and wages are not very flexible downward.Internal market forces can therefore cause depressions and government should play an active role in stabilizing the economy.

Introduction

• This chapter examines why real GDP might be unstable and subject to cyclical fluctuations.
• The revised model adds realism by including the foreign sector and government in the aggregate expenditures model.
• Applications of the new model include two U.S. historical periods and the current situation in Japan. The focus remains on real GDP.

Changes in Equilibrium GDP and the Multiplier

• Equilibrium GDP changes in response to changes in the investment schedule or to changes in the consumption schedule.Because investment spending is less stable than the consumption schedule, this chapter's focus will be on investment changes.
• Figure 10-1 shows the impact of changes in investment.Suppose investment spending rises (due to a rise in profit expectations or to a decline in interest rates).
  • Figure 10-1 shows the increase in aggregate expenditures from (C + I_g)₀ to (C + I_g)₁.In this case, the $5 billion increase in investment leads to a $20 billion increase in equilibrium GDP.
  • Conversely, a decline in investment spending of $5 billion is shown to create a decrease in equilibrium GDP of $20 billion to $450 billion.
• The multiplier effect:
  • A $5 billion change in investment led to a $20 billion change in GDP.This result is known as the multiplier effect.
  • Multiplier = change in real GDP / initial change in spending.In our example M = 4.
  • Three points to remember about the multiplier:
    • The initial change in spending is usually associated with investment because it is so volatile.
    • The initial change refers to an upshift or downshift in the aggregate expenditures schedule due to a change in one of its components, like investment.
    • The multiplier works in both directions (up or down).

• The multiplier is based on two facts.
  
  • The economy has continuous flows of expenditures and income-a ripple effect-in which income received by Jones comes from money spent by Smith.
  • Any change in income will cause both consumption and saving to vary in the same direction as the initial change in income, and by a fraction of that change.
    • The fraction of the change in income that is spent is called the marginal propensity to consume (MPC).
    • The fraction of the change in income that is saved is called the marginal propensity to save (MPS).
    • This is illustrated in Table 10-1 and Figure 10-2 which is derived from the Table.
  • The size of the MPC and the multiplier are directly related; the size of the MPS and the multiplier are inversely related. See Figure 10-3 for an illustration of this point. In equation form M = 1 / MPS or 1 / (1-MPC).
  • The significance of the multiplier is that a small change in investment plans or consumption-saving plans can trigger a much larger change in the equilibrium level of GDP.
  • The simple multiplier given above can be generalized to include other "leakages" from the spending flow besides savings.For example, the realistic multiplier is derived by including taxes and imports as well as savings in the equation.In other words, the denominator is the fraction of a change in income not spent on domestic output.(Key Question 2.)

International Trade and Equilibrium Output

• Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports expand and imports contract aggregate spending on domestic output.
  • Exports (X) create domestic production, income, and employment due to foreign spending on U.S. produced goods and services.
  • Imports (M) reduce the sum of consumption and investment expenditures by the amount expended on imported goods, so this figure must be subtracted so as not to overstate aggregate expenditures on U.S. produced goods and services.
• The net export schedule (Table 10-2):
  • Shows hypothetical amount of net exports (X - M) that will occur at each level of GDP given in Tables 9-1 and 9-4.
  • Assumes that net exports are autonomous or independent of the current GDP level.
  • Figure 10-4b shows Table 10-2 graphically.
    • Xn1 shows a positive $5 billion in net exports.
    • Xn2shows a negative $5 billion in net exports.

• The impact of net exports on equilibrium GDP is illustrated in Figure 10-4.
  • Positive net exports increase aggregate expenditures beyond what they would be in a closed economy and thus have an expansionary effect.The multiplier effect also is at work.In Figure 10-4a we see that positive net exports of $5 billion lead to a positive change in equilibrium GDP of $20 billion (to $490 from $470 billion).This comes from Table 9-4 and Figure 9-9.
  • Negative net exports decrease aggregate expenditures beyond what they would be in a closed economy and thus have a contractionary effect.The multiplier effect also is at work here.In Figure 10-4a we see that negative net exports of $5 billion lead to a negative change in equilibrium GDP of $20 billion (to $450 from $470 billion).
• Global Perspective 10-1 shows 1999 net exports for various nations.
• International economic linkages:
  • Prosperity abroad generally raises our exports and transfers some of their prosperity to us.(Conversely, recession abroad has the reverse effect.)
  • Tariffs on U.S. products may reduce our exports and depress our economy, causing us to retaliate and worsen the situation.Trade barriers in the 1930s contributed to the Great Depression.
  • Depreciation of the dollar (Chapter 6) lowers the cost of American goods to foreigners and encourages exports from the U.S. while discouraging the purchase of imports in the U.S. This could lead to higher real GDP or to inflation, depending on the domestic employment situation.Appreciation of the dollar could have the opposite impact.

Adding the Public Sector

• Simplifying assumptions are helpful for clarity when we include the government sector in our analysis.(Many of these simplifications are dropped in Chapter 12, where there is further analysis on the government sector.)
  • Simplified investment and net export schedules are used.We assume they are independent of the level of current GDP.
  • We assume government purchases do not impact private spending schedules.
  • We assume that net tax revenues are derived entirely from personal taxes so that GDP, NI, and PI remain equal.DI is PI minus net personal taxes.
  • We assume tax collections are independent of GDP level.
  • The price level is assumed to be constant unless otherwise indicated.
• Table 10-3 gives a tabular example of a $20 billion increase in government spending and Figure 10-5 gives the graphical illustration.
  • Increases in government spending boost aggregate expenditures.
  • Government spending is subject to the multiplier.
• Table 10-4 and Figure 10-6 show the impact of a tax increase.(Key Question 8)
  • Taxes reduce DI and, therefore, consumption and saving at each level of GDP.
  • An increase in taxes will lower the aggregate expenditures schedule relative to the 45-degree line and reduce the equilibrium GDP.
  • Table 10-4 confirms that, at equilibrium GDP, the sum of leakages equals the sum of injections.Saving + Imports + Taxes = Investment + Exports + Government Purchases.
• Balanced-budget multiplier is a curious result of this effect. (See Figure 10-7)
  • Equal increases in government spending and taxation increase the equilibrium GDP.
    • If G and T are each increased by a particular amount, the equilibrium level of real output will rise by that same amount.
    • In the text's example, an increase of $20 billion in G and an offsetting increase of $20 billion in T will increase equilibrium GDP by $20 billion (from $470 billion to $490 billion).
  • The example reveals the rationale.
    • An increase in G is direct and adds $20 billion to aggregate expenditures.
    • An increase in T has an indirect effect on aggregate expenditures because T reduces disposable incomes first, and then C falls by the amount of the tax times MPC.
    • The overall result is a rise in initial spending of $20 billion minus a fall in initial spending of $15 billion (.75 ¥ $20 billion), which is a net upward shift in aggregate expenditures of $5 billion. When this is subject to the multiplier effect, which is 4 in this example, the increase in GDP will be equal to 4 ¥ $5 billion or $20 billion, which is the size of the change in G.
    • It can be seen, therefore, that the balanced-budget multiplier is equal to 1.
    • This can be verified by using different MPCs .

Equilibrium vs. Full-Employment GDP

• A recessionary gap exists when equilibrium GDP is below full-employment GDP.(See Figure 10-8a)
  • Recessionary gap of $5 billion is the amount by which aggregate expenditures fall short of those required to achieve the full-employment level of GDP.
  • In Table 10-4, assuming the full-employment GDP is $510 billion, the corresponding level of total expenditures there is only $505 billion.The gap would be $5 billion, the amount by which the schedule would have to shift upward to realize the full-employment GDP.
  • Graphically, the recessionary gap is the vertical distance by which the aggregate expenditures schedule (C_a + I_g + X_n + G)₁ lies below the full-employment point on the 45-degree line.
  • Because the multiplier is 4, we observe a $20-billion differential (the recessionary gap of $5 billion times the multiplier of 4) between the equilibrium GDP and the full-employment GDP.This is the $20 billion GDP gap we encountered in Chapter 8's Figure 8-4.
• An inflationary gap exists when aggregate expenditures exceed full-employment GDP.
  • Figure 10-8b shows that a demand-pull inflationary gap of $5 billion exists when aggregate spending exceeds what is necessary to achieve full employment.
  • The inflationary gap is the amount by which the aggregate expenditures schedule must shift downward to realize the full-employment noninflationary GDP.
  • The effect of the inflationary gap is to pull up the prices of the economy's output.
  • In this model, if output can't expand, pure demand-pull inflation will occur (Key Question 10).
• Table 10-5 gives steps needed to determine the recessionary or inflationary gap.
• Try Quick Quiz 10-8.

Historical Applications

• The Great Depression of the 1930s provides a significant case study.In the U.S. a major factor was the decline in investment spending, which fell by about 90% in the 1930s.Global Perspective 10-2 shows the depression was worldwide.
  • In the U.S. overcapacity and business indebtedness had resulted from excessive expansion by businesses in the 1920s, during a period of prosperity.Expansion of the auto industry ended as the market became saturated, and this affected related industries of petroleum, rubber, steels, glass, and textiles.
  • A decline in residential construction followed the boom of the 1920s, which had resulted from population growth and a need for housing following World War I.
  • In October 1929, a dramatic crash in stock market values occurred, causing pessimism and highly unfavorable conditions for acquiring additional investment funds.
  • The nation's money supply fell as a result of Federal Reserve monetary policies and other forces.
• The Vietnam War era inflation provides an example of an inflationary gap period.
  • The policies of the Kennedy and Johnson administrations had called for fiscal incentives to increase aggregate demand.A tax credit encouraged investment spending.
  • Unemployment levels had fallen from 5.2 percent in 1964 to 4.5 percent in 1965.
  • The Vietnam War resulted in a 40 percent rise in government defense expenditures and a draft that removed young people from potential unemployment.The unemployment rate fell below 4 percent from 1966 to 1969.
  • In terms of Figure 10-8, the boom in investment and government spending boosted the aggregate expenditures schedule upward and created a sizable inflationary gap.
• The End of the Japanese Growth "Miracle."
  • Japanese economic growth was high, 9.7% annual average from 1966-1974 and 3.9% annually from 1974-1990.Unemployment was very low.
  • In 1990s its economy slowed to a halt.
  • Why did growth stop?Japan has a high saving rate, and when planned investment fell below saving, aggregate expenditures were below output.An unplanned inventory rise led firms to cut back production and a recessionary gap results.
  • It is difficult to reverse this cycle.

Limitations of the Model

• The aggregate expenditures model has four limitations.
  • The model can account for demand-pull inflation, but it does not indicate the extent of inflation when there is an inflationary gap.It doesn't measure inflation.
  • It doesn't explain how inflation can occur before the economy reaches full employment.
  • It doesn't indicate how the economy could produce beyond full-employment output for a time.
  • The model does not address the possibility of cost-push type of inflation.
• In Chapter 11, these deficiencies are remedied with a related aggregate demand-aggregate supply model.

LAST WORD: Squaring the Economic Circle

• Humorist Art Buchwald illustrates the concept of the multiplier with this funny essay.
• Hofberger, a Chevy salesman in Tomcat, Va., called up Littleton of Littleton Menswear & Haberdashery, and told him that a new Nova had been set aside for Littleton and his wife.
• Littleton said he was sorry, but he couldn't buy a car because he and Mrs. Littleton were getting a divorce.
• Soon afterward, Bedcheck the painter called Hofberger to ask when to begin painting the Hofbergers' home.Hofberger said he couldn't, because Littleton was getting a divorce, not buying a new car, and, therefore, Hofberger could not afford to paint his house.
• When Bedcheck went home that evening, he told his wife to return their new television set to Gladstone's TV store.When she returned it the next day, Gladstone immediately called his travel agent and canceled his trip.He said he couldn't go because Bedcheck returned the TV set because Hofberger didn't sell a car to Littleton because Littletons are divorcing.
• Sandstorm, the travel agent, tore up Gladstone's plane tickets, and immediately called his banker, Gripsholm, to tell him that he couldn't pay back his loan that month.
• When Rudemaker came to the bank to borrow money for a new kitchen for his restaurant, the banker told him that he had no money to lend because Sandstorm had not repaid his loan yet.
• Rudemaker called his contractor, Eagleton, who had to lay off eight men.
• Meanwhile, General Motors announced it would give a rebate on its new models.Hofberger called Littleton to tell him that he could probably afford a car even with the divorce.Littleton said that he and his wife had made up and were not divorcing.However, his business was so lousy that he couldn't afford a car now.His regular customers, Bedcheck, Gladstone, Sandstorm, Gripsholm, Rudemaker, and Eagleton had not been in for over a month!

Introduction to AD-AS Model

• AD-AS model is a variable price model.The aggregate expenditures model in Chapters 9 and 10 assumed constant price.
• AD-AS model provides insights on inflation, unemployment and economic growth.

Aggregate demand is a schedule that shows the various amounts of real domestic output that domestic and foreign buyers will desire to purchase at each possible price level.

• The aggregate demand curve is shown in Figure 11-1.
  • It shows an inverse relationship between price level and domestic output.
  • The explanation of the inverse relationship is not the same as for demand for a single product, which centered on substitution and income effects.
    • Substitution effect doesn't apply in the aggregate case, since there is no substitute for "everything."
    • Income effect also doesn't apply in the aggregate case, since income now varies with aggregate output.
  • What is the explanation of inverse relationship between price level and real output in aggregate demand?
    • Real balances effect: When price level falls, the purchasing power of existing financial balances rises, which can increase spending.
    • Interest‑rate effect: A decline in price level means lower interest rates which can increase levels of certain types of spending.
    • Foreign purchases effect: When price level falls, other things being equal, U.S. prices will fall relative to foreign prices, which will tend to increase spending on U.S. exports and also decrease import spending in favor of U.S. products that compete with imports.

• Deriving AD-curve from aggregate expenditures model.(See Figure 11-2)
  • Both models measure real GDP on horizontal axis.
  • Suppose initial price level is P₁ and aggregate expenditures AE₁ as shown in Figure 11-2a.Then equilibrium GDP is GDP₁.This is shown in Figure 11-2b.
  • If price rises to P₂, aggregate expenditures will fall to AE₂ because purchasing power of wealth falls, interest rates may rise, and net exports fall.(See Figure 11-2a)Then new equilibrium is at GDP₂ shown also in Figure 11-2b.
  • If price rises to P₃, real asset balance value falls, interest rates rise again, net exports fall and new equilibrium is at GDP₃.Again see Figures 11-2a and 11-2b.
• Determinants of aggregate demand:Determinants are the "other things" (besides price level) that can cause a shift or change in demand (see Figure 11-3 in text).Effects of the following determinants are discussed in more detail in the text.
  • Changes in consumer spending, which can be caused by changes in several factors.
    • Consumer wealth,
    • Consumer expectations,
    • Consumer indebtedness, and
    • Taxes.
  • Changes in investment spending, which can be caused by changes in several factors.
    • Interest rates,
    • Profit expectations,
    • Business taxes,
    • Technology, and
    • Amount of excess capacity.
  • A change in government spending is another determinant.
  • Changes in net export spending unrelated to price level, which may be caused by changes in other factors such as:
    • Income abroad, and
    • Exchange rates: Depreciation of the dollar encourages U.S. exports since U.S. products become less expensive when foreign buyers can obtain more dollars for their currency. Conversely, dollar depreciation discourages import buying in the U.S. because our dollars can't be exchanged for as much foreign currency.

• Aggregate demand shifts and the aggregate expenditures model:
  • When there is a change in one of the determinants of aggregate demand, there will be a change in the aggregate expenditures as well.Look at Figure 11-4.
  • If price level remains constant, then a change in aggregate expenditures is multiplied and the real output rises by more than the initial change in spending (see the lower part of Figure 11-4).The text illustrates the multiplier effect of a change in investment spending.

Aggregate supply is a schedule showing level of real domestic output available at each possible price level.

• Aggregate supply curve may be viewed as having three distinct segments.See Figure 11-5.
  • Horizontal range:where the price level remains constant with substantial output variation.In this range substantial unemployment and excess capacity exist.Economy is far below full-employment output level.
  • Intermediate (upsloping) range:where the expansion of real output is accompanied by rising price level, near to where the full-employment level of output exists.Per unit production costs rise in this stage because as resource markets near full employment their prices will be bid up and, therefore, producer costs rise.
  • Vertical range:where absolute full capacity is assumed, and any attempt to increase output will bid up resource and product prices.We assume full-employment occurs at the "natural rate of unemployment."
• Determinants of aggregate supply:Determinants are the "other things" besides price level that cause changes or shifts in aggregate supply (see Figure 11-6 in text).The following determinants are discussed in more detail in the text.
  • 1. A change in input prices, which can be caused by changes in several factors.
    • Availability of resources (land, labor, capital, entrepreneurial ability),
    • Prices of imported resources, and
    • Market power in certain industries.
  • 2. Change in productivity (productivity = real output / input) can cause changes in per-unit production cost (production cost per unit = total input cost / units of output). If productivity rises, unit production costs will fall. This can shift aggregate supply to the right and lower prices. The reverse is true when productivity falls. Productivity improvement is very important in business efforts to reduce costs.
  • 3. Change in legal‑institutional environment, which can be caused by changes in other factors.
    • Business taxes and/or subsidies,
    • Government regulation.

Equilibrium: Real Output and the Price Level

• Equilibrium price and quantity are found where the aggregate demand and supply curves intersect.(See Key Graph 11-7a,b for illustration of why quantity will seek equilibrium where curves intersect.)(Key Questions 4 and 7)
• Try Quick Quiz 11-7.
• Shifting aggregate demand when a determinant changes will change the equilibrium.
  • Demand-pull inflation: Shifts in the intermediate and vertical ranges will cause demand‑pull inflation with an increase in aggregate demand (Figures 11-8b and c).
  • Shifts in the horizontal range will cause quantity changes but not price level (Figure 11-8a).
• The multiplier effect is weakened with price level changes in intermediate and vertical ranges of aggregate supply.Real GDP does not change as much in Figure 11-8c as it does in Figures 11-8a even though the aggregate demand shifts are of equal magnitude.Figure 11-9 combines the effects of Figures 11-8a and b.Conclusion:The more price level increases, the less effect any increase in aggregate demand will have in increasing real GDP.
• Decreases in AD:If AD decreases, recession and cyclical unemployment may result.See Figure 11-10.Prices don't fall easily.
  • Wage contracts are not flexible so businesses can't afford to reduce prices.
  • Also, employers are reluctant to cut wages because of impact on employee effort, etc.
  • Minimum wage laws keep wages above that level.
  • So-called menu costs are difficult to change.
  • Fear of price wars keep prices from being reduced also.
• Shifting aggregate supply occurs when a supply determinant changes.(See Key Questions 5, 7, 8):
  • Leftward shift in curve illustrates cost‑push inflation (see Figure 11-11).
  • Rightward shift in curve will cause a decline in price level (see Figure 11-12).See text for discussion of this desirable outcome.

LAST WORD: Why Is Unemployment in Europe So High?

• Several European economies have had high rates of unemployment in the past several years, even before their recessions.
  • In 2000:France, 9.7 percent; Italy, 10.7 percent; Germany, 8.3 percent.
  • These rates compare to a 4.0 percent unemployment rate at the same time in U.S.
• Reasons for high European unemployment rates:
  • High natural rates of unemployment exist due to frictional and structural unemployment.This results from government policies and union contracts, which increase the costs of hiring and reduce the cost of being unemployed.
    • High minimum wages exist.
    • Generous welfare benefits exist for unemployed.
    • Restrictions against firings discourage employment.
    • Thirty to forty days of paid vacation and holidays boost the cost of hiring.
    • High worker absenteeism reduces productivity.
    • High employer cost of fringe benefits discourages hiring.
  • 2. Deficient aggregate demand may also be a cause as shown in Figure 11-7b. European governments have feared inflation and have not undertaken expansionary monetary or fiscal policies. If they did, aggregate demand would expand, and unemployment rates might drop without inflation.
  • 3. Conclusion: Economists in Europe are not sure whether aggregate demand is near full-employment (Figure 11-7a) or is below full employment.

Introduction

• One major function of the government is to stabilize the economy (prevent unemployment or inflation).
• Stabilization can be achieved in part by manipulating the public budget-government spending and tax collections-to increase output and employment or to reduce inflation.
• This chapter will examine a number of topics.
  • It will look at the legislative mandates given government to pursue stabilization.
  • It explores the tools of government fiscal stabilization policy using AD-AS model.
  • Both discretionary and automatic fiscal adjustments are examined.
  • The problems, criticisms, and complications of fiscal policy are addressed.

Legislative mandates-The Employment Act of 1946

• Congress proclaimed government's role in promoting maximum employment, production, and purchasing power.
• The Act created the Council of Economic Advisers to advise the President on economic matters.
• It created the Joint Economic Committee of Congress to investigate economic problems of national interest.

Fiscal Policy and the AD/AS Model

• Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth."Discretionary" means the changes are at the option of the Federal government.
• Simplifying assumptions:
  • Assume initial government purchases don't depress or stimulate private spending.
  • Assume fiscal policy affects only demand, not supply, side of the economy.
• Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples illustrated in Figure 12-1).
  • Expansionary Policy needed: In Figure 12-1, a decline in investment has decreased AD from AD₁ to AD₂ so real GDP has fallen and also employment declined.Possible fiscal policy solutions follow:
    • An increase in government spending (shifts AD to right by more than change in G due to multiplier),
    • A decrease in taxes (raises income, and consumption rises by MPC ¥ change in income; AD shifts to right by a multiple of the change in consumption).
    • A combination of increased spending and reduced taxes.
    • If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.
  • Contractionary fiscal policy needed: When demand‑pull inflation occurs as illustrated by a shift from AD₃ to AD₄ in the vertical range of aggregate supply in Figure 12-2. Then contractionary policy is the remedy:
    • A decrease government spending shifts AD4 back to AD3 once the multiplier process is complete. Here price level returns to its preinflationary level P3 but GDP remains at full-employment level.
    • An increase in taxes will reduce income and then consumption at first by MPC ¥ fall in income, and then multiplier process leads AD to shift leftward still further. In Figure 12-2 a tax increase of $6.67 billion decreases consumption by 5 and multiplier causes eventual shift to AD3.
    • A combined spending decrease and tax increase could have the same effect with the right combination ($2 billion decline in G and $4 billion rise in T will have this effect).

• Financing deficits or disposing of surpluses: The method used influences fiscal policy effect.
  • Financing deficits can be done in two ways.
  • Borrowing: The government competes with private borrowers for funds and could drive up interest rates; the government may "crowd out" private borrowing, and this offsets the government expansion.
  • Money creation: When the Federal Reserve loans directly to the government by buying bonds, the expansionary effect is greater since private investors are not buying bonds. (Note: Monetarists argue that this is monetary, not fiscal, policy that is having the expansionary effect in such a situation.)
  • Disposing of surpluses can be handled two ways.
    • Debt reduction is good but may cause interest rates to fall and stimulate spending. This could be inflationary.
    • Impounding or letting the surplus funds remain idle would have greater anti‑inflationary impact. The government holds surplus tax revenues which keeps these funds from being spent.

• Policy options:G or T?
  • Economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure.
  • Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.

Built-In Stability

• Built‑in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP (recall that taxes reduce incomes and therefore, spending).It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary.Figure 12-3 illustrates how the built-in stability system behaves.
  • Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls.
  • Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP.
• The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP:The more progressive the tax system, the greater the economy's built‑in stability.In Figure 12-3 line T is steepest with a progressive tax system.
  • A 1993 law increased the highest marginal tax rate on personal income from 31 percent to 39.6 percent and corporate income tax rate to 35% by 1 percentage.This helped prevent demand-pull inflation.
  • Automatic stability reduces instability, but does not correct economic instability.

Evaluating Fiscal Policy

• A full‑employment budget in Year 1 is illustrated in Figure 12-4(a) because budget revenues equal expenditures when full-employment exists at GDP1.
• At GDP₂ there is unemployment and assume no discretionary government action, so lines G and T remain as shown.
  • Because of built‑in stability, the actual budget deficit will rise with decline of GDP; therefore, actual budget varies with GDP.
  • The government is not engaging in expansionary policy since budget is balanced at F.E. output.
  • The full-employment budget measures what the Federal budget deficit or surplus would be with existing taxes and government spending if the economy is at full employment.
  • Actual budget deficit or surplus may differ greatly from full‑employment budget deficit or surplus estimates.
• In Figure 12-4b, the government reduced tax rates from T1 to T2, now there is a F.E. deficit.
  • Structural deficits occur when there is a deficit in the full‑employment budget as well as the actual budget.
  • This is expansionary policy because true expansionary policy occurs when the full‑employment budget has a deficit.
• If the F.E. deficit of zero was followed by a F.E. budget surplus, fiscal policy is contractionary.
• Recent U.S. fiscal policy is summarized in Table 12-1.
  • Observe that F.E. deficits are less than actual deficits.
  • Column 3 indicates expansionary fiscal policy of early 1990s became contractionary in the later years shown.
  • Actual deficits have disappeared and the U.S. budget has actual surpluses since 1999.(Key Question 7)
• Global Perspectives 12-1 gives a fiscal policy snapshot for selected countries.

Problems, Criticisms and Complications

• Problems of timing
  • Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.
  • Administrative lag is the difficulty in changing policy once the problem has been recognized.
  • Operational lag is the time elapsed between change in policy and its impact on the economy.
• Political considerations:Government has other goals besides economic stability, and these may conflict with stabilization policy.
  • A political business cycle may destabilize the economy:Election years have been characterized by more expansionary policies regardless of economic conditions.
    • political business cycle?
  • State and local finance policies may offset federal stabilization policies. They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending making the recession possibly worse. In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus.
  • The crowding‑out effect may be caused by fiscal policy.
    • "Crowding‑out" may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy. (See Figure 12‑5)
      • Some economists argue that little crowding out will occur during a recession.
      • Economists agree that government deficits should not occur at F.E., it is also argued that monetary authorities could counteract the crowding‑out by increasing the money supply to accommodate the expansionary fiscal policy.

• With an upward sloping AS curve, some portion of the potential impact of an expansionary fiscal policy on real output may be dissipated in the form of inflation.(See Figure 12‑5c)

Fiscal Policy in an Open Economy (See Table 12-2)

• Shocks or changes from abroad will cause changes in net exports which can shift aggregate demand leftward or rightward.
• The net export effect reduces effectiveness of fiscal policy:For example, expansionary fiscal policy may affect interest rates, which can cause the dollar to appreciate and exports to decline (or rise).

Supply‑Side Fiscal Policy

• Fiscal policy may affect aggregate supply as well as demand (see Figure 12‑6 example).
• Assume that AS is upward sloping for simplicity.
• Tax changes may shift aggregate supply.An increase in business taxesraises costs and shifts supply to left; decrease shifts supply to the right.
  • Also, lower taxes could increase saving and investment.
  • Lower personal taxes may increase effort, productivity and, therefore, shift supply to the right.
  • Lower personal taxes may also increase risk‑taking and, therefore, shift supply to the right.
• If lower taxes raise GDP, tax revenues may actually rise.
• Many economists are skeptical of supply-side theories.
  • Effect of lower taxes on a supply is not supported by evidence.
  • Tax impact on supply takes extended time, but demand impact is more immediate.

LAST WORD: The Leading Indicators

• This index comprises 10 variables that have indicated forthcoming changes in real GDP in the past.
• The variables are the foundation of this index consisting of a weighted average of ten economic measurements.A rise in the index predicts a rise in the GDP; a fall predicts declining GDP.
• Ten components comprise the index:
  • Average workweek:A decrease signals future GDP decline.
  • Initial claims for unemployment insurance:An increase signals future GDP decline.
  • New orders for consumer goods:A decrease signals GDP decline.
  • Vendor performance:Better performance by suppliers in meeting business demand indicates decline in GDP.
  • New orders for capital goods:A decrease signals GDP decline.
  • Building permits for houses:A decrease signals GDP decline.
  • Stock market prices:Declines signal GDP decline.
  • Money supply:A decrease is associated with falling GDP.
  • Interest-rate spread: when short-term rates rise, there is a smaller spread between short-term and long-term rates which are usually higher.This indicates restrictive monetary policy.
  • Index of consumer expectations:Declines in consumer confidence foreshadow declining GDP.
• None of these factors alone is sufficient to predict changes in GDP, but the composite index has correctly predicted business fluctuations many times (although not perfectly).The index is a useful signal, but not totally reliable.

Functions of Money

• Medium of exchange:Money can be used for buying and selling goods and services.
• Unit of account:Prices are quoted in dollars and cents.
• Store of value:Money allows us to transfer purchasing power from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth.

Supply of Money

• Narrow definition of money:M1 includes currency and checkable deposits (see Table 13-1).
  
  • Currency (coins + paper money) held by public.
    • Is "token" money, which means its intrinsic value is less than actual value. The metal in a dime is worth less than 10¢.
    • All paper currency consists of Federal Reserve Notes issued by the Federal Reserve.
  • Checkable deposits are included in M1, since they can be spent almost as readily as currency and can easily be changed into currency.
    • Commercial banks are a main source of checkable deposits for households and businesses.
    • Thrift institutions (savings & loans, credit unions, mutual savings banks) also have checkable deposits.
  • Qualification: Currency and checkable deposits held by the federal government, Federal Reserve, or other financial institutions are not included in M1.
  • Money Definition: M2 = M1 + some near-monies which include: (See Table 13-1)
    • Savings deposits and money market deposit accounts.
    • Certificates of deposit (time accounts) less than $100,000.
    • Money market mutual fund balances, which can be redeemed by phone calls, checks, or through the Internet.
  • Money Definition: M3 = M2 + large certificates of deposit (time accounts) $100,000 or more (See Table 13-1)
  • Which definitions are used?M1 will be used in this text, but M2 is watched closely by the Federal Reserve in determining monetary policy.
    • M2 and M3 are important because they can easily be changed into M1 types of money and influence people's spending of income.
    • The ease of shifting between M1, M2, and M3 complicates the task of controlling spendable money supply.
    • The definition becomes important when authorities attempt to measure control and the money supply.
  • Credit cards are not money, but their use involves short‑term loans; their convenience allows you to keep M1 balances low because you need less for daily purchases.

What "backs" the money supply?

• The government's ability to keep its value stable provides the backing.
• Money is debt; paper money is a debt of Federal Reserve Banks and checkable deposits are liabilities of banks and thrifts because depositors own them.
• Value of money arises not from its intrinsic value, but its value in exchange for goods and services.
  • It is acceptable as a medium of exchange.
  • Currency is legal tender or fiat money.It must be accepted by law.(Note that checks are not legal tender but, in fact, are generally acceptable in exchange for goods, services, and resources.)
  • The relative scarcity of money compared to goods and services will allow money to retain its purchasing power.
• Money's purchasing power determines its value.Higher prices mean less purchasing power.(Key Question #6) (See Figure 13-1)
• Excessive inflation may make money worthless and unacceptable.An extreme example of this was German hyperinflation after World War I, which made the mark worth less than 1 billionth of its former value within a four-year period.
  • Worthless money leads to use of other currencies that are more stable.
  • Worthless money may lead to barter exchange system.
• Maintaining the value of money
  • The government tries to keep supply stable with appropriate fiscal policy.
  • Monetary policy tries to keep money relatively scarce to maintain its purchasing power, while expanding enough to allow the economy to grow.

The Demand for Money : Two Components

• Transactions demand, Dt, is money kept for purchases and will vary directly with GDP (Figure 13‑1a).
• Asset demand, Da, is money kept as a store of value for later use.Asset demand varies inversely with the interest rate, since that is the price of holding idle money (Figure 13‑1b).
• Total demand will equal quantities of money demanded for assets plus that for transactions (Figure 13‑1c).

The Money Market: Interaction of Money Supply and Demand

• Key Graph 13-1c illustrates the money market.It combines demand with supply of money.
• Figure 13‑2 illustrates how equilibrium changes with a shift in the supply of money.
• If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get money.This causes bond supply to rise, bond prices to fall, and a higher market rate of interest.
• If the quantity supplied exceeds the quantity demanded, people reduce money holdings by buying other assets like bonds.Bond prices rise, and lower market rates of interest result (see example in text).
• Monetary authorities can shift supply to affect interest rates, which in turn affect investment and consumption and aggregate demand and, ultimately, output, employment, and prices.(Key Question #7)
• Try Quick Quiz 13-2.

The Federal Reserve and the Banking System

• The Federal Reserve System (the "Fed") was established by Congress in 1913 and holds power over the money and banking system.
  • Figure 13-3 gives framework of Fed and its relationship to the public.
  • The central controlling authority for the system is the Board of Governors and has seven members appointed by the President for staggered 14‑year terms.Its power means the system operates like a central bank.
  • Assistance and Advice:
    • Federal Open Market Committee includes the seven governors plus five regional Federal Reserve Bank presidents whose terms alternate. They set policy on buying and selling of government bonds, the most important type of monetary policy, and meet several times each year.
    • Three advisory councils exist: Federal Advisory Council includes twelve prominent commercial bankers, one from each Fed district, who act as advisors to the Board, Thrift Institutions Advisory Council advises on thrift institution matters, the Consumer Advisory Council advises on more general issues. (See Figure 13-4)
    • The system has twelve districts, each with its own district bank and two or three branch banks. They help implement Fed policy and are advisory. (See Figure 13-4)
    • Each is quasi‑public: It is owned by member banks but controlled by the government's Federal Reserve Board, and any profits go to the U.S. Treasury.
    • They act as bankers' banks by accepting reserve deposits and making loans to banks and other financial institutions.
  • About 8,600 commercial banks existed in 2001. They are privately owned and consist of state banks (three‑fourths of total) and large national banks (chartered by the Federal government).
  • Thrift institutions consist of savings and loan associations and mutual savings banks. They are regulated by the Treasury Dept. Office of Thrift Supervision, but they may use services of the Fed and keep reserves on deposit at the Fed. See Figure 13-4.
  • Global Perspective 13-1 gives the world's ten largest banks.

• Functions of the Fed and money supply:
  • The Fed issues "Federal Reserve Notes," the paper currency used in the U.S. monetary system.
  • The Fed sets reserve requirements and holds the reserves of banks and thrifts not held as vault cash.
  • The Fed may lend money to banks and thrifts, charging them an interest rate called the discount rate.
  • The Fed provides a check collection service for banks (checks are also cleared locally or by private clearing firms).
  • Federal Reserve System acts as the fiscal agent for the Federal government.
  • The Federal Reserve System supervises member banks.
  • Monetary policy and control of the money supply is the "major function" of the Fed.
• Federal Reserve independence is important but is also controversial from time to time.Advocates of independence fear that more political ties would cause the Fed to follow expansionary policies and create too much inflation, leading to an unstable currency such as that in other countries (see Last Word for this chapter).

Recent Developments in Money and Banking

• Relative decline of banks and thrifts:Several other types of firms offer financial services.
• Consolidation among banks and thrifts:Because of failures and mergers, there are fewer banks and thrifts today.Since 1990, there has been a decline of 5000 banks.
• Convergence of services provided has made financial institutions more similar:See text on new laws of 1996 and 1999 that made many changes possible.
• Globalization of financial markets:Significant integration of world financial markets is occurring and recent advances in computer and communications technology suggest the trend is likely to accelerate.
• Electronic transactions: Internet buying and selling, electronic cash and "smart cards" are examples.
  • In the future, nearly all payments could be made with a personal computer or "smart card."
  • Unlike currency, E‑cash is "issued" by private firms rather than by government.To control the money supply the Fed will need to find ways to control the total amount of E‑cash, including that created through Internet loans.

LAST WORD: The Global Greenback

• Two-thirds of all U.S. currency is circulating abroad.
  • Russians hold about $40 billion because dollar value is stable.
  • Argentina holds $7 billion and fixes its own peso exchange rate to dollar reserves.
• U.S. profits when dollars stay overseas: It costs us 4¢ to print each dollar and to get the dollar; foreigners must sell Americans $1 worth of products.Americans gain 96¢ over cost of printing the dollar. It's like someone buying a travelers check and never cashing it.
• Black markets and illegal activity overseas also are usually conducted in dollars because they are such a stable form of currency.
• Overall, the "global greenback" is a positive economic force.It is a reliable medium of exchange, measure, and store of value that facilitates transactions everywhere and there is little danger that all the dollars will return to U.S.

Introduction: Although we are fascinated by large sums of currency, people use checkable deposits for most transactions.

• Most transaction accounts are "created" as a result of loans from banks or thrifts.
• This chapter demonstrates the money‑creating abilities of a single bank or thrift and then looks at that of the system as a whole.
• The term depository institution refers to banks and thrift institutions, but in this chapter the term bank will be often used generically to apply to all depository institutions.

Balance Sheet of a Single Commercial Bank

• A balance sheet states the assets and claims of a bank at some point in time.
• All balance sheets must balance, that is, the value of assets must equal value of claims.
  • The bank owners' claim is called net worth.
  • Nonowners' claims are called liabilities.
  • Basic equation:Assets = liabilities + net worth.

History of Fractional Reserve Banking: The Goldsmiths

• In the 16^th century goldsmiths had safes for gold and precious metals, which they often kept for consumers and merchants.They issued receipts for these deposits.
• Receipts came to be used as money in place of gold because of their convenience, and goldsmiths became aware that much of the stored gold was never redeemed.
• Goldsmiths realized they could "loan" gold by issuing receipts to borrowers, who agreed to pay back gold plus interest.
• Such loans began "fractional reserve banking," because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold.
• Significance of fractional reserve banking:
  • Banks can create money by lending more than the original reserves on hand.(Note:Today gold is not used as reserves).
  • Lending policies must be prudent to prevent bank "panics" or "runs" by depositors worried about their funds.Also, the U.S. deposit insurance system prevents panics.

Money Creation Potential by a Single Bank in the Banking System

• Formation of a commercial bank: Following is an example of the process.
  • In Wahoo, Nebraska, the Wahoo bank is formed with $250,000 worth of owners' capital stock (see Balance Sheet 1).
  • This bank obtains property and equipment with some of its capital funds (see Balance Sheet 2).
  • The bank begins operations by accepting deposits (see Balance Sheet 3).
  • Bank must keep reserve deposits in its district Federal Reserve Bank (see Table 14‑1 for requirements).
    • Banks can keep reserves at Fed or in cash in vaults.
    • Banks keep cash on hand to meet depositors' needs.
    • Required reserves are a fraction of deposits, as noted above.

• Other important points:
  • Terminology:Actual reserves minus required reserves are called excess reserves.
  • Control:Required reserves do not exist to protect against "runs," because banks must keep their required reserves.Required reserves are to give the Federal Reserve control over the amount of lending or deposits that banks can create.In other words, required reserves help the Fed control credit and money creation.Banks cannot loan beyond their fraction required reserves.
  • Asset and liability:Reserves are an asset to banks but a liability to the Federal Reserve Bank system, since now they are deposit claims by banks at the Fed.
• Continuation of Wahoo Bank's transactions:
  • Transaction 5:A $50,000 check is drawn against Wahoo Bank by Mr. Bradshaw, who buys farm equipment in Surprise, Nebraska.(Yes, both Wahoo and Surprise exist).
  • The Surprise company deposits the check in Surprise Bank, which gains reserves at the Fed, and Wahoo Bank loses $50,000 reserves at Fed; Mr. Bradshaw's account goes down, and Surprise implement company's account increases in Surprise Bank.
  • The effects of this transaction are traced in Figure 14‑1 and Balance Sheet 5.
• Money-creating transactions of a commercial bank are shown in the next 3 transactions.
  • Transaction 6:Wahoo Bank grants a loan of $50,000 to Gristly in Wahoo (see Balance Sheet 6a).
    • Money ($50,000) has been created in the form of new demand deposit worth $50,000.
    • Wahoo Bank has reached its lending limit: It has no more excess reserves as soon as Gristly Meat Packing writes a check for $50,000 to Quickbuck Construction (See Balance Sheet 6b).
    • Legally, a bank can lend only to the extent of its excess reserves.
    • Transaction 7: Loan repayments result in a decline in demand deposits and, therefore, a decrease in money supply at the time the loan is repaid (see Balance Sheet 7). Gristly repays its $50,000 loan.
    • Transaction 8: When banks or the Federal Reserve buy government securities from the public, they create money in much the same way as a loan does (see Balance Sheet 8). Wahoo bank buys $50,000 of bonds from a securities dealer. The dealer's checkable deposits rise by $50,000. This increases the money supply in same way as the bank making the loan to Gristly.

o Likewise, when banks or the Federal Reserve sell government securities to the public, they decrease supply of money like a loan repayment does.

• Profits, liquidity, and the federal funds market:
  • Profits:Banks are in business to make a profit like other firms.They earn profits primarily from interest on loans and securities they hold.
  • Liquidity:Banks must seek safety by having liquidity to meet cash needs of depositors and to meet check clearing transactions.
  • Federal funds rate:Banks can borrow from one another to meet cash needs in the federal funds market, where banks borrow from each other's available reserves on an overnight basis.The rate paid is called the federal funds rate.

The Entire Banking System and Multiple‑Deposit Expansion (all banks combined)

• The entire banking system can create an amount of money which is a multiple of the system's excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves.
• Three simplifying assumptions:
  • Required reserve ratio assumed to be 20 percent.(The actual reserve ratio averages 10 percent of checkable deposits.)
  • Initially banks have no excess reserves; they are "loaned up."
  • When banks have excess reserves, they loan it all to one borrower, who writes check for entire amount to give to someone else, who deposits it at another bank.The check clears against original lender.
• System's lending potential:Suppose a junkyard owner finds a $100 bill and deposits it in Bank A.The system's lending begins with Bank A having $80 in excess reserves, lending this amount, and having the borrower write an $80 check which is deposited in Bank B.See further lending effects on Banks C and D.The possible further transactions are summarized in Table 14‑2.
• Monetary multiplier is illustrated in Table 14‑2.
  • Formula for monetary or checkable deposit multiplier is:
  • Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example.
  • Maximum deposit expansion possible is equal to:excess reserves ¥ monetary multiplier, or
  • Figure 14‑2 illustrates this process in a diagram.
  • Modifications to simple monetary multiplier concept reduce the final result and include complications due to "leakages."
    • Currency drains (cash kept by customers) dampen M, because that money is not part of bank reserves so can't be loaned out further.
    • Excess reserves kept on hand by banks also dampen M, because those reserves are not loaned out and therefore not expanded.

• Need for monetary control:
  • During prosperity, banks will lend as much as possible and reserve requirements provide a limit to expansion of loans.
  • During recession, banks may cut lending, which can worsen recession.Federal Reserve has ways to encourage lending in such cases.
  • The conclusion is that profit-seeking bankers will be motivated to expand or contract loans that could worsen business cycle.The Federal Reserve uses monetary policy to counteract such results in order to prevent worsening recessions or inflation.Chapter 15 explains this.

LAST WORD: The Bank Panics of 1930-1933

• Bank panics in 1930‑33 led to a multiple contraction of the money supply, which worsened Depression.
• Many of failed banks were healthy, but they suffered when worried depositors panicked and withdrew funds all at once.More than 9000 banks failed in three years.
• As people withdrew funds, this reduced banks' reserves and, in turn, their lending power fell significantly.
• Contraction of excess reserves leads to multiple contraction in the money supply, or the reverse of situation in Table 14‑2.Money supply was reduced by 25 percent in those years.
• President Roosevelt declared a "bank holiday," closing banks temporarily while Congress started the Federal Deposit Insurance Corporation (FDIC), which ended bank panics on insured accounts.

Introduction to Monetary Policy

• Reemphasize Chapter 13's points:The Fed's Board of Governors formulates policy, and twelve Federal Reserve Banks implement policy.
• The fundamental objective of monetary policy is to aid the economy in achieving full‑employment output with stable prices.
  • To do this, the Fed changes the nation's money supply.
  • To change money supply, the Fed manipulates size of excess reserves held by banks.
• Monetary policy has a very powerful impact on the economy, and the Chairman of the Fed's Board of Governors, Alan Greenspan currently, is sometimes called the second most powerful person in the U.S.

Consolidated Balance Sheet of the Federal Reserve Banks

• The assets on the Fed's balance sheet contains two major items.
  • Securities which are federal government bonds purchased by Fed, and
  • Loans to commercial banks (Note: again commercial banks term is used even though the chapter analysis also applies to other thrift institutions.)
• The liability side of the balance sheet contains three major items.
  • Reserves of banks held as deposits at Federal Reserve Banks,
  • U.S. Treasury deposits of tax receipts and borrowed funds, and
  • Federal Reserve Notes outstanding, our paper currency.

The Fed has Three Major "Tools" of Monetary Policy

• Open‑market operations refer to the Fed's buying and selling of government bonds.
  • Buying securities will increase bank reserves and the money supply (see Figure 15‑1).
  • If the Fed buys directly from banks, then bank reserves go up by the value of the securities sold to the Fed. See impact on balance sheets using text example.
  • If the Fed buys from the general public, people receive checks from the Fed and then deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves rise by the same amount. Follow text example to see the impact.
    • Banks' lending ability rises with new excess reserves.
    • Money supply rises directly with increased deposits by the public.
    • When Fed buys bonds from bankers, reserves rise and excess reserves rise by same amount since no checkable deposit was created.
    • When Fed buys from public, some of the new reserves are required reserves for the new checkable deposits.
    • Conclusion: When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves.
    • Note: When the Fed sells securities, points a‑e above will be reversed. Bank reserves will go down, and eventually the money supply will go down by a multiple of the banks' decrease in reserves.
    • How the Fed attracts buyers or sellers:
      • When Fed buys, it raises demand and price of bonds which in turn lowers effective interest rate on bonds. The higher price and lower interest rates make selling bonds to Fed attractive.
      • When Fed sells, the bond supply increases and bond prices fall, which raises the effective interest rate yield on bonds. The lower price and higher interest rates make buying bonds from Fed attractive.

• The reserve ratio is another "tool" of monetary policy.It is the fraction of reserves required relative to their customer deposits.
  • Raising the reserve ratio increases required reserves and shrinks excess reserves.Any loss of excess reserves shrinks banks' lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves.
  • Lowering the reserve ratio decreases the required reserves and expands excess reserves.Gain in excess reserves increases banks' lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.
  • Changing the reserve ratio has two effects.
  • It affects the size of excess reserves.
  • It changes the size of the monetary multiplier. For example, if ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5.
  • 4. Changing the reserve ratio is very powerful since it affects banks' lending ability immediately. It could create instability, so Fed rarely changes it.
  • 5. Table 15-2 provides illustrations.

• The third "tool" is the discount rate which is the interest rate that the Fed charges to commercial banks that borrow from the Fed.
  • An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves.
  • A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves.
• "Easy" monetary policy occurs when the Fed tries to increase money supply by expanding excess reserves in order to stimulate the economy.The Fed will enact one or more of the following measures.
  • The Fed will buy securities.
  • The Fed may reduce reserve ratio, although this is rarely changed because of its powerful impact.
  • The Fed could reduce the discount rate, although this has little direct impact on the money supply.
• "Tight" monetary policy occurs when Fed tries to decrease money supply by decreasing excess reserves in order to slow spending in the economy during an inflationary period.The Fed will enact one or more of the following policies:
  • The Fed will sell securities.
  • The Fed may raise the reserve ratio, although this is rarely changed because of its powerful impact.
  • The Fed could raise the discount rate, although it has little direct impact on money supply.
• For several reasons, open‑market operations give the Fed most control of the three "tools."
  • Open‑market operations are most important.This decision is flexible because securities can be bought or sold quickly and in great quantities.Reserves change quickly in response.
  • The reserve ratio is rarely changed since this could destabilize bank's lending and profit positions.
  • Changing the discount rate has little direct effect, since only 2‑3 percent of bank reserves are borrowed from Fed.At best it has an "announcement effect" that signals direction of monetary policy.

Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy

• Cause‑effect chain:
  • Money market impact is shown in Key Graph 15‑2.
    • Demand for money is comprised of two parts (Recall Chapter 13).
      • Transactions demand is directly related to GDP.
      • Asset demand is inversely related to interest rates, so total money demands is inversely related to interest rates.
    • Supply of money is assumed to be set by the Fed.
    • Interaction of supply and demand determines the market rate of interest, as seen in Figure 15‑2(a).
    • Interest rate determines amount of investment businesses will be willing to make. Investment demand is inversely related to interest rates, as seen in Figure 15‑2(b).
    • Effect of interest rate changes on level of investment is great because interest cost of large, long-term investment is sizable part of investment cost.
    • As investment rises or falls, equilibrium GDP rises or falls by a multiple amount, as seen in Figure 15‑2(c).
  • Expansionary or easy money policy: The Fed takes steps to increase excess reserves, which lowers the interest rate and increases investment which, in turn, increases GDP by a multiple amount. (See Column 1, Table 15-3)
  • Contractionary or tight money policy is the reverse of an easy policy: Excess reserves fall, which raises interest rate, which decreases investment, which, in turn, decreases GDP by a multiple amount of the change in investment. (See Column 2, Table 15-3)
  • Aggregate supply and monetary policy:
    • Easy monetary policy may be inflationary if initial equilibrium is at or near full-employment.
    • If economy is below full-employment, easy monetary policy can shift aggregate demand and GDP toward full-employment equilibrium.
    • Likewise a tight monetary policy can reduce inflation if economy is near full-employment, but can make unemployment worse in a recession.

Effectiveness of Monetary Policy

• Strengths of monetary policy:
  • It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities daily.
  • It is less political.Fed Board members are isolated from political pressure, since they serve 14‑year terms, and policy changes are more subtle and not noticed as much as fiscal policy changes.It is easier to make good, but unpopular decisions.
  • In the 1980s and 1990s Fed policy is given much credit for achieving a prosperous economy with low inflation and high employment.
• Shortcomings of monetary policy:
  • Control is weakening as technology makes it possible to shift from money assets to other types; also global finance gives nations less power.
  • Cyclical asymmetry may exist: a tight monetary policy works effectively to brake inflation, but an easy monetary policy is not always as effective in stimulating the economy from recession.
  • The velocity of money (number of times the average dollar is spent in a year) may be unpredictable, especially in the short run and can offset the desired impact of changes in money supply.Tight money policy may cause people to spend faster; velocity rises.
  • The impact on investment may be less than traditionally thought.Japan provides a case example.Despite interest rates of zero, investment spending remained low during the recession.
• Currently the Fed communicates changes in monetary policy through changes in its target for the Federal funds rate.(Key Question 5)
  • The Fed does not set either the Federal funds rate or the prime rate; (see Figure 15-3) each is established by the interaction of lenders and borrowers, but rates generally follow the Fed funds rate.
  • The Fed acts through open market operations, selling bonds to raise interest rates and buying bonds to lower interest rates.
• Links between monetary policy and the international economy:
  • Net export effect occurs when foreign financial investors respond to a change in interest rates.
  • Tight monetary policy and higher interest rates lead to appreciation of dollar value in foreign exchange markets; lower interest rates from an easy monetary policy will lead to dollar depreciation in foreign exchange markets (see Figure 12-6d).
  • When dollar appreciates, American goods become more costly to foreigners, and this lowers demand for U.S. This is the desired effect of a tight money policy. Conversely, an easy money policy leads to depreciation of dollar, greater demand for U.S. exports and higher GDP. This policy has the desired outcome for expanding GDP. exports, which tends to lower GDP.
  • Monetary policy works to correct both trade balance and GDP problems together. An easy monetary policy leads to increased domestic spending and increased GDP, but it also leads to depreciated dollar and higher U.S. export demand, which enhances GDP and erases a trade deficit. The reverse is true for a tight monetary policy, which would tend to reduce net exports and worsen a trade deficit.

The Big Picture (see Key Graph, Figure 15-4) Shows Many Interrelationships

• Fiscal and monetary policy are interrelated.The impact of an increase in government spending will depend on whether it is accommodated by monetary policy.For example, if government spending comes from money borrowed from the general public, it may be offset by a decline in private spending, but if the government borrows from the Fed or if the Fed increases the money supply, then the initial increase in government spending may not be counteracted by a decline in private spending.
• Study Key Graph 15-4 and you will see that the levels of output, employment, income, and prices all result from the interaction of aggregate supply and aggregate demand.In particular, note the items shown in red that constitute, or are strongly influenced by, public policy.
• Try Quick Quiz 15-4.

LAST WORD: For the Fed Life is a Metaphor

• The media use colorful terms to describe the Federal Reserve Board and its chair, Alan Greenspan.They may loosen or tighten reins while riding herd on a rambunctious economy!
• The Fed has been depicted as a mechanic, with references to loosening or tightening things, and to the economy running beautifully or acting sluggish, accelerating, or going out of control.
• The warrior metaphor has been used-fighting inflation, plotting strategy, protecting the dollar from attack.
• The Fed has been depicted as the fall guy in terms of administration officials "leaning heavily" on it and telling the Fed to ease up or to relax.
• As a cosmic force, the Fed satisfies three criteria-power, mystery, and a New York office.

Introduction

• Recent focus on the long-run adjustments and economic outcomes has renewed debates about stabilization policy and causes of instability.
• This chapter makes the distinction between short run and long run aggregate supply.
• The extended model is then used to glean new insights on demand-pull and cost-push inflation.
• The relationship between inflation and unemployment is examined; we look at how expectations can affect the economy, and assess the effect of taxes on aggregate supply.

Short-Run and Long-Run Aggregate Supply

• Definition:Short-run and long-run.
  • For macroeconomics the short-run is a period in which nominal wages (and other input prices) remain fixed as the price level changes.
    • Workers may not be fully aware of the change in their real wages due to inflation (or deflation) and thus have not adjusted their labor supply decisions and wage demands accordingly.
    • Employees hired under fixed wage contracts must wait to renegotiate regardless of changes in the price level.
  • Long run aggregate supply (See Figure 16-1b). Formed by long-run equilibrium points a_1, b_1, c_1.
    • In the long run, nominal wages are fully responsive to price level changes.
    • The long run aggregate supply curve is a vertical line at the full employment level of real GDP. (See Figure 16-1b) (b1, a1, c1).

• Short-run aggregate supply curve AS₁, is constructed with three assumptions. (see Figure 16-1a)
  • The initial price level is given at P₁.
  • Nominal wages have been established on the expectation that this specific price level will persist.
  • The price level is flexible both upward and downward.
  • If the price level rises, higher product prices with constant wages will bring higher profits and increased output.(See Figure 16-1a)(The economy moves from a₁ to a₂ on curve AS₁.)
  • If the price level falls, lower product price with constant wages will bring lower profits and decreased output.(See Figure 16-1a)(The economy moves from a₁ to a₃ on curve AS₁.)
• The extended AD-AS makes the distinction between the short run and long run aggregate supply curves.(See Figure 16-2)Equilibrium occurs at point a where aggregate demand intersects both the vertical long run supply curve and the short run supply at full employment output.

Applying the Extended AD-AS Model

• Demand-pull inflation: In the short run it drives up the price level and increases real output; in the long run, only price level rises.(See Figure 16-3)
• Cost push inflation arises from factors that increase the cost of production at each price level; the increase in the price of a key resource, for example.This shifts the short run supply to the left, not as a response to a price level increase, but as its initiating cause.Cost-push inflation creates a dilemma for policymakers.(See Figure 16-4)
  • If government attempts to maintain full employment when there is cost-push inflation an inflationary spiral may occur.
  • If government takes a hands-off approach to cost push inflation, a recession will occur.The recession may eventually undo the initial rise in per unit production costs, but in the meantime unemployment and loss of real output will occur.
• Recession and the extended AD-AS model.
  • When aggregate demand shifts leftward a recession occurs.If prices and wages are downwardly flexible, the price level falls.The decline in the price level reduces nominal wages, which then eventually shifts the aggregate supply curve to the right.The price level declines and output returns to the full employment level.(See Figure 16-5)
  • This is the most controversial application of the extended AD-AS model.The key point of dispute is how long it would take in the real world for the necessary price and wage adjustments to take place to achieve the indicated outcome.

 
The Phillips Curve and the Inflation - Unemployment Tradeoff

• Both low inflation and low unemployment are major goals.But are they compatible?
• The Phillips Curve is named after A.W. Phillips, who developed his theory in Great Britain by observing the British relationship between unemployment and wage inflation.
• The basic idea is that given the short run aggregate supply curve, an increase in aggregate demand will cause the price level to increase and real output to expand, and the reverse for a decrease in AD.(Figure 16-b)
• This tradeoff between output and inflation does not occur over long time periods.
• Empirical work in the 1960s verified the inverse relationship between the unemployment rate and the rate of inflation in the United States for 1961-1969.(See Figure 16-7b)
• The stable Phillips Curve of the 1960s gave way to great instability of the curve in the 1970s and 1980s.The obvious inverse relationship of 1961-1969 had become obscure and highly questionable.(See Figure 16-8)
  • In the 1970s the economy experienced increasing inflation and rising unemployment:stagflation.
  • At best, the date in Figure 16-8 suggests a less desirable combination of unemployment and inflation.At worse, the data imply no predictable trade off between unemployment and inflation.
• Adverse aggregate supply shocks-the stagflation of the 1970s and early 1980s may have been caused by a series of adverse aggregate supply shocks.(Rapid and significant increases in resource costs.)
  • The most significant of these supply shocks was a quadrupling of oil prices by the Organization of Petroleum Exporting Countries (OPEC).
  • Other factors included agricultural shortfalls, a greatly depreciated dollar, wage increases and declining productivity.
  • Leftward shifts of the short run aggregate supply curve make a difference.The Phillips Curve trade off is derived from shifting the aggregate demand curve along a stable short- run aggregate supply curve.(See Figure 16-6)
  • The "Great Stagflation" of the 1970s made it clear that the Phillips Curve did not represent a stable inflation/unemployment relationship.
• Stagflation's Demise.
  • Another look at Figure 16-8 reveals a generally inward movement of the inflation/unemployment points between 1982 and 1989.
  • The recession of 1981-1982, largely caused by a tight money policy, reduced double-digit inflation and raised the unemployment rate to 9.5% in 1982.
  • With so many workers unemployed, wage increases were smaller and in some cases reduced wages were accepted.
  • Firms restrained their price increases to try to retain their relative shares of diminished markets.
  • Foreign competition throughout this period held down wages and price hikes.
  • Deregulation of the airline and trucking industries also resulted in wage and price reductions.
  • A significant decline in OPEC's monopoly power produced a stunning fall in the price of oil.
• Global Perspective 16-1 portrays the "misery index" in 1999-2000 for several nations.The index adds unemployment and inflation rates.

Long-Run Vertical Phillips Curve

• This view is that the economy is generally stable at its natural rate of unemployment (or full-employment rate of output).
  • The hypothesis questions the existence of a long-run inverse relationship between the rate of unemployment and the rate of inflation.
  • Figure 16-9 explains how a short-run tradeoff exists, but not a long-run tradeoff.
  • In the short run we assume that people form their expectations of future inflation on the basis of previous and present rates of inflation and only gradually change their expectations and wage demands.
  • Fully anticipated inflation by labor in the nominal wage demands of workers generates a vertical Phillips Curve.(See Figure 16-9)This occurs over time.
• Interpretations of the Phillips Curve have changed dramatically over the past three decades.
  • The original idea of a stable tradeoff between inflation and unemployment has given way to other views that focus more on long-run effects.
  • Most economists accept the idea of a short-run tradeoff-where the short run may last several years-while recognizing that in the long run such a tradeoff is much less likely.

Taxation and Aggregate Supply

• Economic disturbances can be generated on the supply side, as well as on the demand side of the economy.Certain government policies may reduce the growth of aggregate supply."Supply-side" economists advocate policies that promote output growth.They argue that:
  • The U.S. tax transfer system has negatively affected incentives to work, invest, innovate and assume entrepreneurial risks.
    • To induce more work government should reduce marginal tax rates on earned income.
    • Unemployment compensation and welfare programs have made job loss less of an economic crisis for some people. Many transfer programs are structured to discourage work.
    • The rewards for saving and investing have also been reduced by high marginal tax rates. A critical determinant of investment spending is the expected after-tax return.
  • Lower marginal tax rates may encourage more people to enter the labor force and to work longer. The lower rates should reduce periods of unemployment and raise capital investment, which increases worker productivity. Aggregate supply will expand and keep inflation low.

• There is empirical evidence that the impact on incentives to work, save and invest are small.
• Tax cuts also increase demand, which can fuel inflation.Demand impact exceeds supply impact.
• The Laffer Curve (Figure 16-10) is based on a logical premise, but where the economy is located is an empirical question and difficult to determine.It may be hard to know in advance the impact of a tax cut on supply.

Introduction

• Two definitions of economics growth were given in Chapter 8.
  • The increase in real GDP, which occurs over a period of time.
  • The increase in real GDP per capita, which occurs over time.This definition is superior if comparison of living standards is desired.
• Growth has been impressive in capitalist countries during the past half century.Real GDP in the U.S. increased by 450 percent.
• This chapter explores economic growth in more depth than Chapter 8.

Six Main Ingredients of Growth

• Four supply factors relate to the ability to grow.
  • The quantity and quality of natural resources,
  • The quantity and quality of human resources,
  • The supply or stock of capital goods, and
  • Technology.
• Two demand and efficiency factors are also related to growth.
  • Aggregate demand must increase for production to expand.
  • Full employment of resources and both productive and allocative efficiency are necessary to get the maximum amount of production possible.

Production Possibilities Analysis (Figure 17-1)

• Growth can be illustrated with a production possibilities curve (Figure 17-1), where growth is indicated as an outward shift of the curve from AB to CD.
  • Aggregate demand must increase to sustain full employment at each new level of production possible.
  • Additional resources that shift the curve outward must be employed efficiently to make the maximum possible contribution to domestic output.
  • And for economy to achieve the maximum increase in monetary value, the optimal combination of goods must be achieved (allocative efficiency).
• Focus on the supply side is illustrated in Figure 17-2, where growth depends on labor inputs multiplied by labor productivity.
  • Increased labor inputs depend on size of population and labor force participation rate (the percent of population actually in the labor force).
  • Productivity is determined by technological progress, the availability of capital goods, quality of labor itself, and efficiency with which inputs are allocated, combined, and managed.
• Aggregate demand‑aggregate supply framework can also be used to illustrate growth, as seen in Figure 17-3.Aggregate supply shifts outward with economic growth, and in recent decades aggregate demand has shifted outward by an even greater amount.Nominal GDP rises faster than real GDP.(Key Question 3)
• Extended AD-AD model is shown in figure 17-4 where short-term and long-term aggregate supply are differentiated in Figure 17-4.
  • Long-run potential output is shown at Q₁.It depends on resources and productive efficiency.
  • If potential output increases, the long-run supply curve shifts from AS_LR1 to AS_LR2.
  • If aggregate demand rises from AD₁ to AD₂, real output rises to Q₂ and prices to P₂.
  • At P₂ there will be a different short-run AS curve, AS₂.
  • The result is some mild inflation and increases in real GDP.

Growth Record of the United States (Table 17-5)

• Real GDP has increased more than sixfold since 1940, and real per capita GDP has risen by a multiple of three.
• Rate of growth record shows that real GDP has grown 3.1 percent per year since 1948 and real GDP per capita has grown about 2 percent per year.In last four years of century, U.S. economic growth surged and averaged more than 4 percent per year.But the arithmetic needs to be qualified.
  • Growth doesn't measure quality improvements.
  • Growth doesn't measure increased leisure time.
  • Growth doesn't take into account adverse effects on environment.
  • International comparisons are useful in evaluating U.S. performance.For example, Japan has grown more than twice as fast as U.S. since 1948 (see Global Perspective 17-1) but less in past decade.

Accounting for growth is an attempt to quantify factors contributing to economic growth as shown in Table 17-1. Important research has been done in the area by Edward Denison.

• More labor input is one source of growth.Labor force has grown about 2 million workers per year for past 25 years and accounts for about one-third of total economic growth.
• Technological advance, the most important factor, has been estimated to contribute to about 26 percent of the U.S. growth record since 1929.
• Increases in quantity of capital are estimated to have contributed 18% to economic growth in U.S. since 1929.
• Education and training improve the quality of labor.(See Figure 17-6 and Table 17-1)
• Improved resource allocation and economies of scale also contribute to growth and explain about 12% of total.
  • Improved resource allocation has occurred as discrimination disappears and labor moves where it is most productive, and as tariffs and other trade barriers are lowered.
  • Economies of scale occur as the size of markets and firms that serve them have grown.
• Other factors influence growth and are more difficult to measure.
  • Social cultural environment and political stability are "growth friendly" in U.S.
    • Respect for material success provides incentive to increase incomes.
    • Market system rewards actions that increase output.
    • Property rights and legal system encourage growth.
    • Positive attitudes toward work and flow of energetic immigrants also add to growth.

Productivity Growth and the New Economy (Figure 17-7)

• Improvement in standard of living is linked to labor productivity - output per worker per hour.
• The U.S. is experiencing a resurgence of productivity growth based on innovations in computers and communications, coupled with global capitalism.Since 1995 productivity growth has averaged 2.9% annually - up from 1.4% over 1973-95 period."Rule of 70" projects real income will double in 23 years rather than 50 years.
• Much recent improvement in productivity is due to "new economy" factors such as:
  
  • Microchips and information technology are the basis for improved productivity.Many new inventions are based on microchip technology.
  • New firms and increasing returns characterize the new economy.
    • Some of today's most successful firms didn't exist 25 years ago: Dell, Compaq, Microsoft, Oracle, Cisco Systems, America Online, Yahoo and Amazon.com are just a few of many.
    • Economies of sale and increasing returns in new firms encourage rapid growth. (See Table 17-1)
  • Sources of increasing returns include:
    • More specialized inputs.
    • Ability to spread development costs over large output quantities since marginal costs are low.
    • Simultaneous consumption of many customers at same time.
    • Network effects make widespread use of information goods more valuable as more use the products.
    • Learning increases with practice.
  • Global competition encourages innovation and efficiency.
  • Macroeconomic outcomes include increases in aggregate supply (shift to right).See Figure 17-3.
  • Faster growth without inflation is possible with higher productivity.
  • The natural rate of unemployment seems to be lower (4.5 - 5.0%).
  • Federal revenues increase with economic growth; a 1995 deficit of $160 billion became a $167 billion surplus in 2000.
  • Skepticism about long-term continued growth remains.

Is Growth Desirable and Sustainable?

• An antigrowth view exists.
  • Growth causes pollution, global warming, ozone depletion, and other problems.
  • "More" is not always better if it means dead-end jobs, burnout, and alienation from one's job.
  • High growth creates high stress.
• Others argue in defense of growth.
  • Growth leads to improved standard of living.
  • Growth helps to reduce poverty in poor countries.
  • Growth has improved working conditions.
  • Growth allows more leisure and less alienation from work.
  • Environmental concerns are important, but growth actually has allowed more sensitivity to environmental concerns and the ability to deal with them.
• Is growth sustainable?Yes, say proponents of growth.
  • Resource prices are not rising.
  • Growth today has more to do with expansion and application of knowledge and information, so is limited only by human imagination.

LAST WORD: Some Pleasant Side Effects of the New Economy

• Economists Jason Saving and W. Michael Cox point to other benefits of New Economy besides improved living standards.
• Crime rates are down possible due to better job and income prospects.
• Welfare rolls have fallen from 5.5% of U.S. population in 1995 to 2.5% in 1999.
• Charitable contributions increased an average 9% annually, much higher than previous increases in giving.

Minority well being improved with decreased poverty and unemployment rates

Definitions of deficit, surplus and debt

• A budget deficit is the amount by which government's expenditures exceed its revenues during a particular year.In contrast, a surplus is the amount by which its revenues exceed expenditures.
  • In 1997 there was a Federal deficit of $22 billion.
  • In 1999 there was a surplus of $125 billion.
• The national or public debt is the total accumulation of the Federal government's total deficits and surpluses that have occurred through time.State and local governments historically have a collective budget surplus.

Three Budget Philosophies

• The annually balanced budget was the goal until the 1930s Depression, but this ruled out using fiscal policy as a countercyclical, stabilizing force and even makes recession or depression worse.
  • The balanced budget is not neutral, but is procyclical, that is, it worsens the business cycle.
  • In a recession, the government would have to raise taxes and lower spending to balance the budget as tax revenues fell with recessionary income levels.This policy would worsen recession.
  • In an inflationary boom period, a balanced budget would intensify the inflation.As tax revenues increased, the government would need to cut taxes or raise spending to avoid a budget surplus.This strategy would make the inflation worse.
  • Those who argue for the annually balanced budget want to limit the growth of government.
• The cyclically balanced budget is a spending philosophy which allows for some government stabilization policy over the length of the business cycle.Deficit spending is allowed during a recession, and surpluses during an inflationary period.Over the business cycle, deficits would be offset by surpluses.But in reality, surpluses and deficits do not equally offset each other.
• Functional finance is the third budget philosophy.Advocates argue that the budget is secondary, but the primary purpose of Federal finance is to achieve noninflationary full employment.Government should do what is necessary to achieve this goal regardless of the deficit or surplus in the budget.Proponents offer several responses to critics.

The Public Debt: Facts and Figures

• The public debt in 2000 was $5.7 trillion.This is a large number.One million seconds ago was 12 days back.One trillion seconds ago was around 30,000 B.C.
• Causes of the expansion in debt:
  • National defense and military spending have soared, especially during wartime.During World Wars I and II debt grew rapidly.See Table 18-1 for facts that show World War II debt exceeded GDP.
  • Recessions cause a decline in revenues and growth in government spending on programs for income maintenance.Such periods included 1974-75, 1980-82, 1990-91.
  • Tax cuts are another cause.Tax cuts in the 1980s without equivalent spending cuts led to increasing debt.The Clinton administration in 1993 is an example of how hard it is to reduce spending and raise taxes to reduce the deficit.An unpopular deficit reduction act was passed in that year and many Democrats lost elections later.
• Quantitative aspects of the debt are found in Table 18-1.Note that the absolute level in column 2 is not meaningful without comparison of the relative size of debt and interest payments to the nation's ability to pay, as estimated by GDP and shown in column 5.
  • Comparing the debt to GDP is more meaningful than the absolute level of debt by itself.Use the example of a family or corporate borrowing.For a prosperous family or firm, $100,000 worth of debt may be a small fraction of their income; for others, $100,000 worth of debt may mean they're unable to make payments on the debt.The amount is not as important as the amount relative to the ability to pay.Also, most borrowing is made to purchase physical assets such as buildings, equipment, etc.Another way to judge government debt is to compare it to an estimate of public assets.
  • International comparisons show that other nations have relative public debts as great or greater than that of the U.S. when compared to their GDPs.See Global Perspective 18-1.
  • Interest charges as a percentage of GDP represent the primary burden of the debt today.
  • Who owns the debt is also an important question.About one‑fourth of U.S. debt is held by government agencies and the Federal Reserve; the rest is held by individuals, banks, investment and insurance companies, and about 23 percent was held by foreign investors in 2000.See Figure 18-1.
  • Social Security Trust Fund considerations may obscure the true debt picture.Payroll taxes currently exceed social security payments so the fund's surplus is counted as part of the Federal surplus.Some economists say this fund should not be part of the calculation of Federal deficits or surpluses because social security funds are earmarked for future beneficiaries.For example, the Federal surplus in 2000 would be only $87 billion without the fund surplus of $80 billion.
• False concerns about the federal debt include several popular misconceptions:
  • Can the federal government cannot go bankrupt?There are reasons why it cannot.
    • The government does not need to raise taxes to pay back the debt, but it can refinance bonds when they mature by more borrowing, that is, selling new bonds. Corporations use similar methods-they almost always have outstanding debt.
    • The government has the power to tax, which businesses and individuals do not have when they are in debt.
  • Does the debt impose a burden on future generations? In 2000 the per person federal debt in U.S. was $20,667. But the public debt is a public credit-your grandmother may own the bonds on which taxpayers are paying interest. Some day you may inherit those bonds which are assets to those who have them. The true burden is borne by those who pay taxes or loan government money today to finance government spending. If the spending is for productive purposes, it will enhance future earning power and the size of the debt relative to future GDP and population could actually decline. Borrowing allows growth to occur when it is invested in productive capital.

• Substantive issues do exist.
  • Repayment of the debt affects income distribution.If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality.
  • Since interest must be paid out of government revenues, a large debt and high interest can increase tax burden and may decrease incentives to work, save, and invest for taxpayers.
  • A higher proportion of the debt is owed to foreigners (about 23 percent) than in the past, and this can increase the burden since payments leave the country.But Americans also own foreign bonds and this offsets the concern.
  • Some economists believe that public borrowing crowds out private investment, but the extent of this effect is not clear (see Figure 18-2).
  • There are some positive aspects of borrowing even with crowding out.
    • If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government had not borrowed for this purpose.
    • Public investment makes private investment more attractive. For example, new federal buildings generate private business; good highways help private shipping, etc.

Deficits and Surpluses: 1990-2010

• Figure 18-3 shows huge absolute size of deficits in early 1990s.
• In 1993 Congress passed Deficit Reduction Act to increase tax revenues by $250 billion over 5 years and to reduce spending by a similar amount.
  • Top marginal tax rate went from 31 to 39.6%.
  • Corporate income tax rate went up 1% to 35%.
  • Gasoline excise tax rose by 4.3 cents per gallon.
  • Spending was held at 1993 levels (unless increases already mandated by law).
• By 1998 there was a budget surplus for the first time since 1969.
• There are four main options for the surpluses.
  • Pay off part of the public debt.
  • Less government borrowing could mean more private investment.
  • Critics contend that the debt is shrinking relative to GDP and we need government securities as safe investments, for monetary policy, and for social security trust fund assets.
  • Reduce taxes and reduce surplus.
    • Returns money directly to those who earned it.
    • Helps to limit size of government.
    • Critics fear this surplus may be temporary and tax reduction may be poorly timed if economy is prosperous anyway.
  • Increase government spending and reduce the surplus.
    • Several areas of need exist where federal spending programs could help, especially Medicare drug coverage.
    • Critics say new spending could be inflationary and interfere with private investment.
  • Add to the Social Security trust fund. See Figure 18-4.
    • We could pay off debt and use interest savings for the trust fund.
    • More funds will be needed in future as population ages and fewer workers remain to support larger proportion of retired population.
  • Combine any or all of these four proposals.

Last Word: Debt Reduction and the U.S. Trade Deficit

• Some economists believe the debt and trade deficits are connected.
• Here's why.Higher interest rates may result from government borrowing, which has an international impact because:
  • The dollar will appreciate as foreigners demand more dollars to invest in the U.S. to earn higher interest rates.
  • As the dollar appreciates, American goods become more expensive to foreigners and foreign goods become less costly to Americans.This contributes to the trade deficits more imports and fewer exports.
  • Since net exports are a component of aggregate demand, the net export effect will be negative and slow economic growth.
• If the U.S. pays down the national debt, it will be borrowing less, which should reduce interest rates.Then, the reverse process will occur: the dollar will depreciate and trade deficit will shrink.
• There are other related effects.
  • Foreign investment helps to finance U.S. borrowing so less foreign investment may offset some of the decline in interest rates.
  • Lower U.S. interest rates may reduce the burden on foreign borrowers of U.S. funds as their debt is refinanced at lower rates.This can help developing countries.
  • A trade deficit means we are not exporting enough to pay for the imports.The difference must be paid by borrowing from people and institutions abroad, or by selling U.S. assets to foreigners for the dollars they earned from our import buying.
• However, many factors besides real interest rates affect the trade balance so reducing the debt may not reduce the trade deficit.

Introduction: Disagreements about Macro Theory and Policy

• This chapter contrasts the classical and Keynesian macroeconomic theories.
• Contemporary disagreements on three inter-related questions are considered.
  • What causes instability in the economy?
  • Is the economy self-orrecting?
  • Should government adhere to rules or use discretion in setting economic policy?

Some History: Classical Economics

• Classical economics dominated the discipline from Adam Smith (1776) until the 1930s.It maintained that full employment was normal and that a "laissez-faire" (let it be) policy by government is best.
• Keynes observed in the 1930s that laissez-faire capitalism is subject to recurring recessions or depressions with widespread unemployment, and contended that active government stabilization policy is required to avoid the waste of idle resources.
• Classical View.
  • The aggregate supply curve is vertical and located at the full-employment level of real output.
  • Stress that classical economists believed that real output does not change in response to changes in the price level because wages and other input prices would be flexible.
  • The economy would operate at its full employment level of output because of:
    • Say's law (See Chapter 9) which states "supply creates its own demand."
    • responsive, flexible prices and wages in cases where there might be temporary over-supply.
  • Money underlies aggregate demand. Classical economists theorize that aggregate demand will be stable as long as the supply of money is controlled with limited growth.
  • The downward sloping demand curve is stable and is solely responsible for setting the price level. (See Figure 19-1a)
  • Changes in the money supply would shift AD right for an increase and left for decrease, but responsive, flexible prices and wages will insure that full employment output is maintained.

• Keynesian View.
  • The core of Keynesianism is that product prices and wages are downwardly inflexible (don't fall easily).This is graphically represented as a horizontal aggregate supply curve.(See Figure 19-1b)
  • A decline in real output will have no impact on the price level.Once full employment is reached at Q_f, the aggregate supply curve is vertical.
  • Keynesian economists view aggregate demand as unstable from one period to the next, even without changes in the money supply.
  • The investment component of aggregate demand is especially likely to fluctuate and the sole impact is on output and employment, while the price level remains unchanged.(See shift AD₁, to AD₂ in Figure 19-1)
  • Active government policies are essential to increase aggregate demand and move the economy back toward full employment.

What Causes Macro Instability such as Great Depression, Recessions, Inflationary Periods?

• Mainstream View: This term is used to characterize prevailing perspective of most economists.
  • Mainstream macroeconomics is Keynesian-based, and focuses on aggregate demand and its components.C(a) + I(g) + X(n) + G = GDP (Aggregate expenditures) = (real output)
  • Any change in one of the spending components in the aggregate expenditure equation shifts the aggregate demand curve.This, in turn, changes equilibrium real output, the price level or both.
    • Investment spending is particularly subject to variation.
    • Instability can also arise from the supply side. Artificial supply restriction, wars, or increased costs of production can decrease supply, destabilizing the economy by simultaneously causing cost-push inflation and recession.

• Monetarist View:This label is applied to a modern form of classical economics.
  • Money supply is the focus of monetarist theory.
  • Monetarism argues that the price and wage flexibility provided by competitive markets cause fluctuations in product and resource prices, rather than output and employment.
  • Therefore, a competitive market system would provide substantial macroeconomic stability if there were no government interference in the economy.
    • It is government that has caused downward inflexibility through the minimum wage law, pro‑union legislation, and guaranteed prices for some products as in agriculture.
    • Monetarists say that government also contributes to the economy's business cycles through clumsy, mistaken, monetary policies.
  • The fundamental equation of monetarism is the equation of exchange. MV = PQ
    • The left side, MV, represents the total amount spent [M, the money supply x V, the velocity of money, (the number of times per year the average dollar is spent on final goods and services)]
    • The right side, PQ, equals the nation's nominal GDP [P is the price level or more specifically, the average price at which each unit of output is sold x Q is the physical volume of all goods and services produced.]
    • Monetarists say that velocity, V, is stable, meaning that the factors altering velocity change gradually and predictably. People and firms have a stable pattern to holding money.
    • If velocity is stable, the equation of exchange suggests there is a predictable relationship between the money supply and nominal GDP (PQ).
  • Monetarists say that inappropriate monetary policy is the single most important cause of macroeconomic instability. An increase in money supply will increase aggregate demand.
  • Mainstream economists view instability of investment as the main cause of the economy's instability. They see monetary policy as a stabilizing factor since it can adjust interest rates to keep investment and aggregate demand stable.

• Real Business Cycle View:A third perspective on macroeconomic stability focuses on a aggregate supply.(See Figure 19-2)
  • The view that business cycles are caused by real factors affecting aggregate supply such as a decline in productivity, which causes a decline in AS.
  • In the real‑business cycle theory declines in GDP mean less demand for money.Here, the supply of money is decreased after the demand declines.AD falls, but price level is the same because AS also declined.
• Coordination Failures:A fourth view relates to so-called coordination failures.
  • Macroeconomic instability can occur "when people do not reach a mutually beneficial equilibrium because they lack some way to jointly coordinate their actions."
  • There is no mechanism for firms and households to agree on actions that would make them all better off if such a failure occurs.The initial problem may be due to expectations that are not justified, but if everyone believes that a recession may come, they reduce spending, firms reduce output and the recession occurs.The economy can be stuck in a recession because of a failure of households and businesses to coordinate positive expectations.

Does the Economy "Self-Correct"?

• New Classical View of Self-Correction
  • Monetarist and rational expectation economists believe that the economy has automatic, internal mechanisms for self‑correction.
  • Figure 19a-b demonstrates the adjustment process, which retains full employment output according to this view.
  • The disagreement among new classical economists is over the speed of the adjustment process.
    • Monetarists usually hold the adaptive expectations view of gradual change. The supply curve shifts, show in figure 19‑3 may take 2 or 3 years or longer.
    • Rational expectations theory (RET) holds that people anticipate some future outcomes before they occur, making change very quick, even instantaneous.
      • Where there is adequate information, people's beliefs about future outcomes accurately reflect the likelihood that those outcomes will occur.
      • RET assumes that new information about events with known outcomes will be assimilated quickly.
  • In RET unanticipated price‑level changes do cause temporary changes in real output. Firms mistakenly adjust their production levels in response to what they perceive to be a relative price change in their product alone. Any change in GDP is corrected as prices are flexible and firms readjust output to its previous level.
  • In RET fully anticipated price‑level changes do not change real output, even for short periods. Firms are able to maintain profit and production levels.

• Mainstream View of Self‑Correction
  • There is ample evidence that many prices and wages are inflexible downward for long periods of time.However, some aspects of RET have been incorporated into the more rigorous model; of the mainstream.
  • Graphical analysis shown in Figure 19‑3b demonstrates the adjustment process along a horizontal aggregate supply curve.
  • Downward wage inflexibility may occur because firms are unable to cut wages due to contracts and the legal minimum wage.Firms may not want to reduce wages if they fear problems with morale effort, and efficiency.
  • An efficiency wage is one that minimizes the firm's labor cost per unit of output.Firms may discover that paying higher than market wages lowers wage cost per unit of output.
    • Workers have an incentive to retain an above‑market wage job and may put forth greater work effort.
    • Lower supervision costs prevail if workers have more incentive to work hard.
    • An above‑market wage reduces job turnover.
  • Some economists believe wages don't fall easily because already employed workers (insiders) keep their jobs even though unemployed outsiders might accept lower pay. Employers prefer a stable work force. (Key Question 7)

Rules or Discretion?

• Monetarists and other new classical economists believe that policy rules would reduce instability in the economy.
  • A monetary rule would direct the Fed to expand the money supply each year at the same annual rate as the typical growth of GDP.(See Figure 19‑4)
    • The rule would tie increases in the money supply to the typical rightward shift of long‑run aggregate supply, and ensure that aggregate demand shifts rightward along with it.
    • A monetary rule, then, would promote steady growth of real output along with price stability.
  • A few economists favor a constitutional amendment to require the federal government to balance its budget annually.
    • Others simply suggest that government be "passive" in its fiscal policy and not intentionally create budget deficits of surpluses.
    • Monetarists and new classical economists believe that fiscal policy is ineffective. Expansionary policy is bad because it crowds out private investment.
    • RET economists reject discretionary fiscal policy for the same reason they reject active monetary policy. They don't believe it works because the effects are fully anticipated by private sector.

• Mainstream economists defend discretionary stabilization policy.
  • In supporting discretionary monetary policy, mainstream economists argue that the velocity of money is more variable and unpredictable, in short run monetary policy can help offset changes in AD than monetarists contend.
  • Mainstream economists oppose requirements to balance the budget annually because it would require actions that would intensify the business cycle, such as raising taxes and cutting spending during recession and the opposite during booms.They support discretionary fiscal policy to combat recession or inflation even if it causes a deficit or surplus budget.
• The U.S. economy has been about one‑third more stable since 1946 than in earlier periods. Discretionary fiscal and monetary policy were used during this period and not before.This makes a strong case for its success.
• A summary of alternative views presents the central ideas and policy implications of four main macroeconomic theories: Mainstream macroeconomics, monetarism, rational expectations theory and supply side economics.(See Table 19‑1 )

Last Word: The Taylor Rule: Could a Robot Replace Alan Greenspan?

• Macroeconomist John Taylor of Stanford University calls for a new monetary rule that would institutionalize appropriate Fed policy responses to changes in real output and inflation.
• Traditional "monetarist rule" is passive.It required Fed to expand money supply at a fixed annual rate regardless of economic conditions.
• "Discretion" is associated with the opposite: an active monetary policy where Fed changes the money supply and interest rates in response to changes in the economy or to prevent undesirable results.
• Taylor's policy proposal would dictate active monetary actions that are precisely defined.It combines monetarism and the more mainstream view.
• Taylor's rule has three parts:
  • If real GDP rises 1% above potential GDP, the Fed should raise the Federal funds rate by 0.5% relative to the current inflation rate.
  • If inflation is 1% above its target of 2%, the Fed should raise Federal funds rate by 0.5% above the inflation rate.
  • If real GDP equals potential GDP and inflation is 2%, the Federal funds rate should be about 4% implying real interest rate of 2%.
• Taylor would retain Fed's power to override rule, so a robot really couldn't replace the Board.But a rule increases predictability and credibility.

Critics of the proposal see no reason for this rule given the success of monetary policy in the past decade.