the health of the economy what is wrong and what can be done?
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The Health of the Economy What is wrong and what can be done?. Measuring the Health of the Economy. Fixing the Economy. Unit 4. TC. Gross Domestic Production. Unemployment rate. Inflation. Enduring Understandings. Real and Nominal, per capita. Consumer Price Index. - PowerPoint PPT PresentationTRANSCRIPT
The Health of the Economy
What is wrong and what can be done?
Measuring the Health of the Economy
Fixing the Economy
Unit 4
Government actions affect economic activity.
Economic decisions require the government to evaluate the costs and benefits of actions.
Enduring Understandings
Essential QuestionsHow should the U.S. government carry out its economic roles? How healthy is the American economy
Terms
Gross Domestic Production Unemployment rate Inflation
Consumer Price Index Real and Nominal, per capita
Draw and identify phases of the business cycle Aggregate
Aggregate Supply- describe both the Keynesian and Classical models
Aggregate Demand Fiscal Policy Monetary Policy
Progressive Tax Rate Stagflation
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Circular Flow Model
Business Government Individuals
Investors Government Consumer
Product Markets
Resource Markets
Financial
Goods and Services Goods and Services
SpendingRevenue
Resources- factors of productionLand Labor capital entrepreneurship
Resources- factors of production
Cost
Income
Goods and Services
Gov’tSpending
Resources and labor
Gov’tSpending
Taxes and loansTaxes
Subsidies Transfer Payments
Public Goods/Services Public Goods/Services
Supply Demand
SupplyDemand
Marginal- additional, MB= Marginal Benefit, MC= Marginal Cost, MR- Marginal Revenue, MRP- Revenue product, MRC- Resource cost,MSB- Marginal Social Benefit, MSC- Marginal Social Cost
MB= MCUtility Maximization
MR= MCProfit Maximizing Rule
(MC) S= D (MB) or (MR)
Profit maximizing rule of hiring MRP= MRC
Loans
Interest
Consumers+
Investors+
Government+
Net Exports__________
Gross Domestic Production
MSB= MSC
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Identify Key terms and answer the associated questionsPart 1 (GDP)
G.D.P. (Gross Domestic Product)-
What factors contribute to the GDP? On another piece of paper chart the US GDP from 2000- 2011 (by year)
What goods and service are not calculated in the GDP? Next chart US real GDP from 2008-2011 by quarter
Explain:Nominal GDP
Real GDP
GDP per Capita
Explain how unemployment is it related to GDP?
Part 2 (Unemployment)
Explain the different types of unemployment and what is the natural rate of unemployment?
FrictionalStructuralCyclicalSeason
What is the natural rate of unemployment? Why is this ok?
If our current unemployment rate is 9% how much is the cyclical unemployment?
What groups of the population is not counted toward unemployment rates?
What is real unemployment? What is our current unemployment rate?
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Part 3: The purchasing power of money
What is inflation?
What does higher inflation do the purchasing power of money?
How does this impact price?
What is CPI (Consumer Price Index)
How does the Consumer price index measure inflation?
Part 4: The Business Cycle
Diagram and Identify the different phases of the business cycle:
If the business cycle is natural and unavoidable should the government become involved? Explain your answer
To economist when is the business cycle officially in a recession?
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Part 5: Government Role and the Recession:
Aggregate Supply and Demand (AS/AD)
What is Aggregate Demand
What is LRAS?
What is Aggregate Supply
Part 6:
What is the difference between Classical vs Keynesian Approach to Aggregate Supply?
How would an economist who believed in the classical approach draw Aggregate Supply? Why?
What would Keynesian economists say the Aggregate Supply , Aggregate Demand, and Price?
How does the Aggregate Supply depending on what model you are looking at? What are the three different phases?
What is Keynesian economics and what does it say about the government’s role in getting the economy out of a recession?
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Part 8: Fiscal Policy and Monetary policy
Explain Fiscal Policy:
Explain Monetary policy:
How do both try to fix recessions and inflation?
Recession
Fiscal
Monetary
Inflation
Fiscal
Monetary
Part 7: Phillips Curve (inflation and unemployment) (Long and Short Run)
Explain the Phillips Curve and explain how we get short run and long run Phillip’s Curve
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Measuring The
Health of the Economy
Economic IndicatorsMeasure health of economy
Regardless of what you learn for the next two weeks
Remember these some important points:
1. Economics is the Allocation of scarce resources to their most useful purpose.
2. Remember the key lesson on economics- don’t look at policy in isolation, look at future phases, and measure policy by consequences and outcomes and not by intentions. This will come into play when we learn about “fixing” the health of the economy.
3. What is unseen is just as important as what is seen!!!!
4. Regardless of statistics and numbers the most important thing to consider is standard of living. Very difficult to measure happiness.
5. Correlation does not mean Causation!!!!!!
6. Money is not Wealth- Only true production increases standard of living. All the money in the world will not help an economy if goods and services are unavailable. Only the production of valued goods and services in a market which reflects the consumer’s wishes can relieve poverty and promote prosperity.
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Gross Domestic ProductGross Domestic Product- the market value for all final goods and services produced within a country during a given period of time.
A steadily growing GDP is generally considered a sign of economic health.
The Department of Commerce’s Bureau of Economic Analysis determine the GDP.
Click here to find our current GDP. http://www.bea.gov/
Terms:
Final Good- a new good ready to be used by a consumer- cereal, cars, toys
Intermediate good- a good that is used in the production of a final good- not counted toward GDP. Example- grains, steel, rubberWhat else is not counted. . .
The buying of financial assets are not counted because they do not reflect current production.
Secondhand sales do not count because the counted for the GDP of some previous year.
Intermediate goods are not counted in order to avoid double counting
Market Value- price buyers are willing to pay in the market place
Film on G.D.P. (Gross Domestic Product)
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Gross Domestic ProductHow do we calculate GDP?
CHousehold Consumption/Consumer spending
IBusiness Investment
GGovernment Spending
Imports
Exports
NXNet Exports
GDP
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Gross Domestic ProductTypes of GDP
Nominal GDP: Measuring GDP with today’s prices
Real GDP: Measuring GDP using a base year’s value of the dollar- this compensates for inflation
(Nominal GDP/GDP Price index) * 100
GDP per Capita:GDP per person, dividing GDP by the population
GDP Deflator= Nominal/Real *100
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Gross Domestic Product TC
Gross Domestic Product TC
Gross Domestic Product
GDP growth rate by nation 2011
http://www.tradingeconomics.com/gdp-growth-rates-list-by-country
Nominal GDP by nation 2011
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Gross Domestic ProductGross Domestic Product- maps
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Gross Domestic ProductGross Domestic Product- maps
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Gross Domestic Product
Real Growth rate
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Gross Domestic Product TC
Gross Domestic Product TC
Gross Domestic ProductDistribution of wealth 0 = total equality 1= total inequality
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Gross Domestic ProductThere are some important correlations (associations/relationships)
Remember correlation does not mean causation!!!
Nations with high GDP’s generally have the following. . .
High Literacy Rates
Improved health, nutrition, and high life expectancy
Lower infant mortality rates
Higher standards of living
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Gross Domestic ProductThere are some limitations to GDP
1. GDP leaves out unpaid work such as households and volunteer work
Volunteer firefighters, charity
2. GDP leaves out informal and illegal exchanges
Babysitting, working under the table, black markets, barter
3. GDP counts negatives as positives.
rebuilding after a hurricane, war efforts, over- exploiting resources
4. GDP does not reflect negative externalities
Pollution, people buying bottle water because of pollution
5. GDP places no value on leisure time or happiness
6. GDP says nothing about income distribution
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Gross Domestic ProductThere are other limitations to GDP
For example GDP measures things that were once done at home but now are considered work.
Housekeeping or gardening
Also it literally tries attempts to compare apples and oranges or more accurately bananas and oil.
It says nothing about the time it takes to create a product.
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Gross Domestic Product"The Gross National Product includes air pollution and advertising for cigarettes, and ambulance to clear our highways of carnage.
It counts special locks for our doors, and jails for the people who break them. GNP includes the destruction of the redwoods and the death of Lake Superior.
It grows with the production of napalm and missiles and nuclear warheads... And if GNP includes all this, there is much that it does not comprehend.
It does not allow for the health of our families, the quality of their education, or the joy of their play. It is indifferent to the decency of our factories and the safety of our streets alike.
It does not include the beauty of our poetry or the strength of our marriages, or the intelligence of our public debate or the integrity of our public officials...
GNP measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country.
It measures everything, in short, except that which makes life worthwhile; and it can tell us everything about America - except whether we are proud to be Americans."
- Senator Robert Kennedy. 1968
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Gross Domestic Product TC
Gross Domestic Product TC
Gross Domestic Product TC
Evaluate the following quote from Milton Friedman
“Spending isn’t good, what is good is producing. What we want to have is more goods and services. Government spending is ok for those things, those services that we believe that we can get more usefully and more effectively through government. If people are getting their money’s worth- fine. That’s why it is very desirable to have government expenditures occur as much at the local level as possible, because you as a citizen of a local community can judge if you are getting your money’s worth and you can decide if you want to spend it. But when it comes to the federal government you tend to think that you are spending someone else’s money. In a way you are, but he is spending yours.
The Broken Window Fallacy
What is the problem with using adding up total spending to find total production?
Spending and Production are not the same thing
Unemployment rateThe Bureau of Labor Statistics tracks the unemployment rate.
Click here to track our current unemployment rate. http://www.bls.gov/
The unemployment rate is used to measure the overall health of the economy.
In general a high unemployment rate indicates an unhealthy economy.
The BLS will conduct a random survey to determine the unemployment rate.
The are 3 classifications of people in the country.
1. Employed- members of the labor force who have jobs.
2. Unemployed- members of the labor force who don’t have jobs but are looking for work
3. Not in the labor force- those who are eligible to be in the labor force but don’t have jobs and are not looking for jobs. This includes full time students, disabled, retired, and those prevented by family responsibilities.
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Unemployment rateThe labor force is found by adding all employed and unemployed workers together.
To find the unemployment rate the BLS divides the unemployed by the labor force and multiples the number by 100.
number unemployedUnemployment rate = ______________________________ X 100
number in labor force
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Unemployment rateIn 2008, The Phillies won the World Series
Based on the data below and using the equation provided calculate the unemployment rate
U.S. Unemployment rate October 2008
Adult population (234.4 million)
Unemployment rate = ______________________ x 100 = 9.5 million
154.8 million
6.1%
Employed (145.3 million) Unemployed (9.5 million) Not in labor force (79.6 million)
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Unemployment rateTypes of Unemployment and Full employment
Frictional Unemployment- When a worker enters the workforce or quits a job to find a better job.
Structural/Technological Unemployment- when advances in technology eliminate jobs
Unemployment lesson
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Unemployment rateTypes of Unemployment and Full employment
Seasonal Unemployment- When a business shuts down during part of the year
Cyclical Unemployment- Occurs when there is a decline in business because of the economic downturn
Unemployment lesson
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Unemployment rateTypes of Unemployment and Full employment Unemployment lesson
There will always be Frictional, Structural, and Seasonal unemployment.
This is the natural rate of unemployment- NRU
The NRU is about 5%.
This is also considered Full Employment
It is Cyclical Unemployment that we need to be the most concerned with.
This happens during down periods of the economy. Currently we have a 9% unemployment rate.
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Unemployment rateUnemployment lesson
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Unemployment rate
1. Unemployment does not count discouraged workers or in other words those who have given up looking for work. Some say that if we counted these people in the unemployment calculations the our real unemployment rate is 17%.
2. Additionally, involuntary part-time workers are not counted as part of the unemployment rate. These are the people who would like full time jobs but can only get part-time hours. They are partially employed.
3. Does not count under the table workers or illegal activity.
Economic cost of Unemployment
1. Lost of potential output.
2. Loss of income by workers
3. The unemployed do not contribute to taxes and in fact usually collect unemployment insurance
4. If the number of unemployed becomes too large, money from other programs must be shifted to unemployment programs or taxes are raised on those who have jobs.
Problems with Unemployment rate as an indicator
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More important than unemployment rate is production.
Providing jobs for the sake of employment and not production is one of the biggest fallacies.
Inflation RateThe inflation rate is the percent of increase in the average price level of goods and services from one month or year to the next.
In other words inflation reduces the purchasing power of money.
It is tracked by the Bureau of Labor Statistics.
http://www.bls.gov/bls/inflation.htm
Imagine living in a country where if you ate breakfast at a café your second cup of coffee would cost more than the first or if you burned you cash because it was worth more as fuel than as currency.
Excessive Inflation can send a nation’s economy into a tailspin.
What is inflation?
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Inflation RateInflation is measured by using a price index.
A price index measures the average change in price of a type of good over time.
The Consumer Price index (CPI) is a price index for a “market basket” od consumer goods and services. Changes in the average prices of these items approximate the change in the cost of living.
Also know as the Cost of living index.
The CPI is determined by consumer and store surveys.
The current prices are compared to a base period. 1982-1984
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Inflation RateBase 100- 1982-1984TC
Inflation RateCPI is found by finding the total price of a consistent “market basket”
Item 2009 2010 2011
Hot Sausage 3.00 4.00 4.50
Pasta 1.00 1.50 2.00
Ice Cream 3.00 3.50 5.00
Eggs 1.00 1.50 2.00
Milk 3.00 3.00 4.50
Bread 1.00 1.50 2.00
Total: 12.00 15.00 20.00(Market Basket)
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Inflation Rate
Market basket price for year_____________________________ x 100= CPI
Market basket price for base year
What is CPI (Consumer Price Index)
Year Market Basket Base year 2009 Base year 2010 Base year 2011
2009 12
2010 15
2011 20
100
100
100
Base year is always 100Example
Market price for 2009 _______________________ x 100 = CPI
Base year 2009
Base year is always 100Example
12 _______________________ x 100 = 1
12
Now complete the chart
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Inflation Rate
Market basket price for year_____________________________ x 100= CPI
Market basket price for base year
What is CPI (Consumer Price Index)
Year Market Basket Base year 2009 Base year 2010 Base year 2011
2009 $ 12
2010 $ 15
2011 $ 20
100 %
100 %
100%
Example:
To find the increase in inflation from 2009 to 2010
15 ______ x 100= 125%
12
125%
167%
80
133%
60%
75%
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Inflation Rate
Limitations of CPI as a measure:
1. Substitution Bias- People buy substitutes if prices are too high. CPI doesn’t take this into consideration.
2. Outlet/Discount store bias- CPI doesn’t take into account that people may buy goods at a discount store.
Acme- average price of a chicken fryer (small whole Chicken)- $7.41Bottom Dollar – same item or similar item- $4.00
3. New Product biasMobile phones in 1983- $3995, 1998 $200- but mobile phones were not included in the CPI until 1998.
4. Quality change bias- technological improvements make items better and last longer.
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Inflation RateNominal cost of living- the cost in current dollars of the basic good and service that people need.
Real cost living- the nominal cost of basic goods and services, adjusted for inflation
Nominal wages- wages based on current prices
Real wages- nominal wages that have been adjust for inflation.
Wages need to keep up with the cost of living if the standard of living is to remain the same.
The cost of living is indeed going up—in money terms. What really matters, though, isn't what something costs in money; it's what it costs in time. Making money takes time, so when we shop, we're really spending time. The real cost of living isn't measured in dollars and cents but in the hours and minutes we must work to live.
American essayist Henry David Thoreau (1817-62) noted this in his famous book, Walden: "The cost of a thing is the amount of. . .life which is required to be exchanged for it, immediately or in the long run."
http://dallasfed.org/fed/annual/1999p/ar97.cfm
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Inflation Rate TC
Inflation Rate
In 2010, Sally started her new job making $40,000.
In 2011, Sally earned a $1,000 raise.
From 2010 to 2011 prices have increased 4%.
Should Sally be happy or disappointed? Why?
or
Sally received a 2.5% raise but her purchasing power dropped because inflation increased 4.
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Inflation Rate
Types of inflations
Creeping inflation- gradual inflation, in the United States the annual rate of inflation is 3.4 percent since 1914. The rate has varied widely but this is on average what we can expect.
Hyperinflation- when inflation goes into overdrive. Prices can double within days, the standard of living collapses.
Germany in the 1920’s
Zimbabwean 2008
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Inflation Rate
Types of inflations
Deflation- Inflation rate always rises. It either speeds up or slows down. It never drops.
If the rate becomes negative it is call Deflation. Deflation is caused when prices drop over time.
Sounds good for consumers and savers.
Every dollar saved will have an increased purchasing power in the future.
Who does this hurt?
This hurts borrowers- this hurts everybody because if people aren’t borrowing they aren’t investing and this slows down the economy.
Business will slow down production and there will be an decrease in wages and an increase in job cuts.
This is actually a very bad spiral – early days of the great depression saw deflation
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Inflation Rate
Causes of Inflation
1. Increase in money supply- too many dollars too few goods
2. Demand Pull- If the sectors of the economy try to buy more than the economy can produce. The extra demand pulls up prices
3. Cost-Push- The rising cost of labor, land, or capital pushes up the overall price in future transactions.
Or course a company does not have to extend the cost to the buyer and the companies that don’t get the business. But to do so they will need to make cuts in other places.
4. Wage-price spiral- higher wages result in higher prices and higher prices result in more people asking for higher wages.
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Inflation Rate
Economic cost of inflation
1. Loss of purchasing power
If the price of a guitar was $200 one year. A student saved his money for an entire year to buy the guitar. He came back to the store the following year to see that the price is now $220.
- Hurts those on fixed incomes the most.
- Wages have to keep up with inflation
2. Higher interest rates- real interest rate is the
nominal interest rate- the inflation rate= a real interest rate10% interest rate- 4% inflation rate= 6 % real interest rateDollars worth less tomorrow than today- slows lending
3. Loss of efficiency- many economist consider uncertainty about prices to be a bigger problem than the others. Buyers and sellers don’t have enough information to make the most efficient decisions.
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The Business CycleEconomies are always changing
There are periods of growth and decline. Booms and Bust
This is the business cycle.
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Movie The Business Cycle
The Business Cycle TC
The Business Cycle
The name business cycle makes it sound like the cycle is very predictable.
The opposite is true.
Peaks and Trough are extremely difficult to predict.
The leading indicators are GDP, Unemployment, and Inflation.
Other leading indicators:
Housing construction- an increase signals confidence and a decrease slows a lack of confidence and an increase in savings.
Others:
Real GDP
Lagging indicators are indicators that lag behind or happen after contraction or expansion
Unemployment rate
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The Business Cycle
Other names.
Recession- a decline in GDP lasting 6 months or 2 quarters
Depression- Severe contraction
When GDP grows – there will be inflation and low unemployment- naturalWhen GDP shrinks- there will be less inflations and higher unemployment- natural
Stagflation – is the worst of both worlds- high unemployment and high inflation- unnatural
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The Business Cycle
What causes the dip?
1. Negative shock to the economy- rapidly rising oil prices, stock market crash, uncertainty with regards to government actions, terrorist attacks
2. Increase in interest rates making it more difficult to borrow money.
3. When supply is less than demand – natural or man-made
4. Some say an increase in savings leads to an increase in inventories. Increased inventories force firms to cut back production and layoff workers.
What causes Growth?
5. Confidence in market caused by knowledge- uncertainty is the worst enemy.
6. Increased production causes firms to hirm
7. New technology
8. Government??????- this is the question that needs to be answered for the unit.
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Now that we know how to measure the health
The Question is how do we fix the economy?
Just like doctors, economist will have different opinions
Some will say, “Do nothing it needs to run its course.” (Classical)
Other will say, “The Government needs to do something.”
While other may agree with doing “something” that “something” depends on the economist
Keynesians Monetarist Classical
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Fixing the Economy
Does fixing the Indicators fix the economy?
Remember . . .
Economics – The allocation of scarce resources that have alternative uses.
Money measures wealth but it is not wealth.
Does adjusting the indicators improve standard of living and increase production?
What is the Government’s Role?Remember . . .
The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.
What is unseen is just as important as what is seen!!
Video Clips for Presentation
Broken Window Fallacy
Stimulus Hearing
Hayek vs Keynes Raps
19:00 Economist Against Stimulus Package45:50 Economist speaking about net gain of Stimulus Package1 hour 32 min. Economist in favor of the Stimulus Package
Round 1- Fear the Boom and Bust
Fight of Century Keynes vs. Hayek Round 2
Deck the Halls with Macro Follies
http://econstories.tv/
http://www.econedlink.org/lessons/index.php?lid=593&type=educator
Price
Q
Supply
Demand
Q e
P e
Supply and Demand graphs- The Basics
The purpose of this graph is to look at markets. Free Market Price and Quantity
Price Level
Measure of
Inflation
G.D.P real
employment
Aggregate Supply (AS)
Aggregate Demand (AD)
Q e
P e
Aggregate- all together (total)
The Aggregate Market- The Basics
Long Run Aggregate Supply (LRAS)
Qy
Qy= Quantity at full employment
The purpose of this graph is to look at countries. Total supply and demand at full employment
You may find it amazing how a graph can be interpreted in so many different ways.
Learning the basics of the graph will provide you an opportunity to learn fiscal and monetary policy in different ways.
The law of demand is the same.
There is an inverse relationship- PL up, AD down, PL down AD up
The law of supply is the same
There is a direct relationship- PL up, AS up, PL down AS down
AD= Aggregate Demand
AD= GDP= C + I + G + NX
Conflicting Views
Classical Views Keynesian Views
1. Prices and Wages are flexible – markets quickly and efficiently achieve equilibrium. When applied to the resource market full employment is maintained- unemployment is not a long term problem
2. Say’s Law- supply creates it own demand- aggregate product of goods and service produces enough income to exactly purchase all output
3. Savings-investment equality-any decrease in output because of savings is offset an increase in the demand for investment
This creates a different market – the money market
Investment is demandSavings is Supply
Interest rates create equilibrium- Monetarist
1. Prices and Wages are Sticky- Prices and wages respond slowly to changes in supply and demand and this results in shortages and surplus- especially with labor.2. Increase Aggregate Demand to increase GDP- is influenced by a host of economic decisions both public and private.- savings hurt The paradox of thrift
3. “In the Long Run we are all dead”- care more about Short run and not so much about the long run. Changes in AD have greater short run effect on real GDP and employment but not as much on price. What is true in the short run isn’t always true in the long run
4. The multiplier- increases in spending will increase consumption and increase output- which will lead to more spending 5. Steer the Market- advocated stabilization policies such as tax, government spending, laws, and regulation in order to defend against the sudden and unpredictable changes in the business cycle
Less Government
Equilibrium of market
Increase consumer or InvestmentsSAVINGS!!!!!
F.A. HayekNeo-ClassicalAustrianSupply-sidersReal Production= real wealth
John M. Keynes More GovernmentMacro not Micro
Keynesians Multiplier Neo-Keynesians Increase Gov’tDemand-siders spending!!!!!!!!
Fiscal Policy
4. Individualism5. Savings leads to investments, which lead to stronger business,
which leads to more supply and more employment6. The Animal Spirits- believed growth and contraction had much to do with confidence and trust
Keynesian’s Paradox of thriftA Prisoner’s Dilemma for Savings
A Prisoners Dilemma between individuals in a society who want to save.
It is smart to save during the good times , but if everybody saves than Aggregate demand drops and GDP drops now we are in a recession.
How does the government attempt to avoid this?
Save Spend
Save
Spend
10, 3
3, 10
5, 5
7, 7
Summary
To Hayek:
Only real savings should lower interest rates, not the Fed. Interest rates drop as private savings increase.
During recession: We will stay at full employment if prices and wages are allowed to be flexible.
To Keynes:
Spending!!!!!!!
During a recession: Only prices and wages will stay (prices and wages are sticky) and employment drops. Government spending during a recession will increase employment, GDP, and AD and will not have an impact on price level until full employment is reached.
How to fix the economy? According to . . .
Fiscal Policy Monetary Policy Supply Side Policy
During aRecession
With high unemployment
During Expansion
With high inflation
Increase Government Spending
Decrease Taxes
Buy Securities from banks or dealers
Decrease Discount Rate
Reduce Reserve requirements
All ideas intended to lower interest rate
Cut tax on Business
Reduce Regulation
Give business a chance to expand and hire
Decrease Government Spending
Increase Tax
Sell securities to banks
Increase Discount Rate
Increase Reserve Requirements
All ideas intended to increase interest rates
Do nothing the market will take care of itself.
No capital gains tax or marginal (progressive income tax)
Wages
Employment
(AS)
(AD)
Q
W e
AS/AD/LRAS graphs- Classical vs Keynesian models Labor Market
(AD) 1
Classical- believe that when demand for employment decreases- wages will fall and the market will clear (return to equilibrium). Some people will choose not to work but most will eventually lower their wages.
W 1
Q 1
Keynesians- say- no when demand for employment falls- wages and prices are sticky. We simply get a new quantity at the same wage. This creates a surplus of supply of workers which will remain until demand increases.
Quantity demanded is less than the quantity supplied.
Q 2
P.L.
G.D.P real
(AS) much like the LRAS
(AD)
Q y
P e
The whole purpose of these graphs is to find the Price level, GDP, and unemployment
AS is vertical and at the same point of full employment
Classical economist believe that resources prices and wages are flexible
This model says that the government doesn’t need to get involved because the market will fix itself.
Aggregate Supply (The classical model)
What will happen to price as AD falls?
(AD) 1
P 1The classical model suggest that the economy fixes itself and that prices and resources price will fall to create a new equilibrium.
When Aggregate demand falls what happens to. . .
Price?
Employment?
Wage (remember wages are price)?
GDP real?
P.L.
G.D.P real
LRAS
(AD)
Q y
P e
Aggregate Supply (The classical model)
SRAS
(AD) 1
If there is a decrease in ADThere will be a reduction in price level and higher unemployment
P 1
Q 1
SRAS 1
Q 2
According to classical economist the SRAS will eventually increase as wages decrease and the price of resources decrease
This will give you a new quantity demanded back at full employment
This will occur as long as wages can adjust. What can keep wages artificially elevated? Or in other words what can keep the market from clearing?
Unions
Min. Wage laws
Unemployment benefits
Whether or not the market will clear will also depend on the worker’s wage expectations.
Rational Expectations
Workers will revise their expectations instantaneously
Adapted Expectations
It may take workers weeks, months, or years but eventually they will adapt their wage expectations.
P.L.
G.D.P real
LRAS
(AD)
Q yfull
P e
Aggregate Supply (The Keynesian Model)
Y1
According to Keynes, it is possible for the economy to be in a recession permanently. Prices/wages won’t change and output will remain low.
When output is below full employment, the price level doesn’t fall because wages/resource prices don’t fall (wages are sticky)
(AD) 1
P.L.
G.D.P real
LRAS
Q yfull
P e
Aggregate Supply (The Keynesian Model)
Y1
According to Keynes, only with the help of the help of the government can Aggregate demand increase.
Demand side economics- focus on demand
Fiscal approach- government spending and taxationMonetarist approach is to increase investments
(AD) 1
(AD) 2 (AD) 3
Any aid past Qy- is purely inflationary
(AD) 4
(AD) 5
P.L.
G.D.P real
LRAS
Q yfull
P e
Aggregate Supply – So what Model is correct?
They Both have some valid points
Keynesian Phase
AD
When in the Keynesian Phase
Output can increase with no change in price.No increase in price level, no inflationary pressure, spare room to grow.
Intermediate Phase
AD
When in the Intermediate Phase
As AD approaches the curve
An increase in AD and decrease in unemployment
Result in a gradual increase of price and some inflationary pressure
ClassicalPhase
AD
When in the Classical Phase
The economy is operating at full employment
Any and all increase in AD will result in an increase in price and in increase in inflation
P.L.
G.D.P real
(AS)
(AD)
Q e
P e
If Aggregate Demand increases
AS/AD/LRAS graphs- how it works during Expansion
(LRAS)
Qy
(AD) 1
P 1
Q 1
Both Prices and GDP will increase.
In the long run – an increase in price will not lead to an increase in output.
Why?
Because as prices increase so does the price of resources including labor, wages, and materials.
(AS) 1
As a result the Aggregate supply will shift to the left (decrease) and we will find ourselves back at full employment.
A
B
CP 2
P.L.
G.D.P real
(AS)
(AD)
Q e
P e
If Aggregate Demand decreases.
AS/AD/LRAS graphs- how it works during Recession
(LRAS)
Qy
(AD) 1
Q 1
P 1
Both Price Level and output will decrease.
In the long-run a decrease in price will not lead to a decrease in output.
Why?
Because as prices decrease so does the price of resources including labor, wages, and materials.
As a result the Aggregate supply will shift to the right (increase) and we will find ourselves back at full employment.
(AS 1)
P 2
A
B
C
Inflationary and Recessionary Gaps- Steering the Market
Economic Activity
Time (years)
Potential GDP
Inflationary Gap
Recessionary Gap
The Government can steer the economy in different ways1. Laws and Regulations- stabilizers2. Fiscal Policy- changes in government spending or taxation to influence the economy3. Monetary policy- changes in monetary supply to influence the interest rates that influence economy
(Full Employment)
AS/AD/LRAS graphs- Inflationary Gap
AS
AD 1
GDP real
Price Level
Q1
Fiscal Policy:
Monetary Policy:
LRAS
Q yFE
Actual GDP > Potential GDPOutput is beyond full employment
Unemployment very lowPrices very high
P1
Government wants to limit inflation by reducing demand
AD 2
P2
How do they do it?
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE
Federal Reserve can decrease money supply or increase interest rates. AD = C + I + G + NE
AS/AD/LRAS graphs- Recessionary Gap
AS
AD 1
GDP real
Price Level
Q1
Fiscal Policy:
Monetary Policy:
LRAS
Q yFE
P1
Actual GDP < Potential GDPOutput is below full employment
High unemployment
Government wants to limit unemployment by increasing demand
AD 2
P2 How do they do it?
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE
Federal Reserve can increase money supply or decrease interest rates. AD = C + I + G + NE
Fiscal Policy:
Monetary Policy:
Actual GDP > Potential GDP Output is beyond full employment
Unemployment very low
Prices very high
Government wants to limit inflation by reducing demand
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE
Federal Reserve can decrease money supply or increase interest rates. AD = C + I + G + NE
Summary
Inflationary Gap
Fiscal Policy:
Monetary Policy:
Actual GDP < Potential GDP Output is below full employment
High unemployment
Government wants to limit unemployment by increasing demand
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE
Federal Reserve can increase money supply or decrease interest rates. AD = C + I + G + NE
Summary
Recessionary Gap
How Much is Too Much?
Fiscal Policy (Demand side)
Keynesians and Democrats
Keynesian economics
President sets the budget, Congress develops programs- they can tax and borrowCommerce clause – etc.
Raising Revenue- Tax or Borrow
Spending- increase of Decrease (discretionary and nondiscretionary)
Monetary Policy (Demand side)Leading advocates- Monetarist
Milton Friedman showed that people’s annual consumption is a function of their “permanent income,” a term he introduced as a measure of the average income people expect over a few years.
Monetarist believe that price level depends on money supply
Friedman stated that in the long run, increased monetary growth increases prices but has little or no effect on output. In the short run, he argued, increases in money supply growth cause employment and output to increase, and decreases in money supply growth have the opposite effect.
Friedman’s solution to the problems of INFLATION and short-run fluctuations in employment and real GDP was a so-called money-supply rule. If the Federal Reserve Board were required to increase the money supply at the same rate as real GDP increased, he argued, inflation would disappear.
He argued that the Great Depression was caused by the Federal Reserves poor management of money. Most monetarist do not support the idea of using money supply to fix the economy- too much lag
To keep unemployment permanently lower, he said, would require not just a higher, but a permanently accelerating inflation rate – increase with rate of increase of real GDP
AD
Q
PriceInterest Rate
Supply and Demand of Money
Interest rate at supply
Q1
I1
Decreasing the supply of money will increase the interest rate
Increasing the supply of money will decrease the interest rate
I2
Q2
I3
Q3
If we increase the supply of money what will happen to the value of the currency?
Devaluation
In theory what should happen to our net exports?
GDP= C + G + I + NE
In theory they will increase. Why?
Below is a simple example:
If 1 U.S. dollar = 1 Euro how many Euro’s what would a $20,000 American car cost?
In America? In Germany?
If the dollar was devalued so that 1 U.S. dollar = .5 Euros what would a $20,000 American car cost?
In America? In Germany?
In what situation would an American car be more appealing to the German?In theory why does this not impact the American car manufacturer?
Sounds good.
But what is the problem?
Money is not wealth it measures wealth. If there is a devaluation of currency the Federal Reserve is telling people that you have less than you really do.
The car example is only taking into account the final product, what it is not factoring in is the fact that we have a global economy and that the car manufacturer must spend more dollars on imported raw materials.
Not good for global relations, in our example European companies could impose tariffs, devalue their currency, or even have embargos to protect their own car companies.
Open Market Operations:
The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.
$$ and Treasury Securities $$ and Treasury Securities
If the Federal Reserve buys Treasury Securities from banks or market
The banks will have more in their reserves
and they will be able to lead at a lower interest rate
$$
Results:
Reserves increase
Excesses reserves increase
Loans increase
Money Supply increases
Interest rates decrease
More consumer and investment spending
If the Fed. Easy money policy
Open Market Operations:
The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.
$$ and Treasury Securities $$ and Treasury Securities
If the Federal Reserve sell Treasury Securities to banks or market
The banks will have less in their reserves
and they will have to lead at a higher interest rate
$$
Results:
Reserves decrease
Excesses reserves decrease
Loans decrease
Money Supply decreases
Interest rates increase
Less inflation
If the Fed. Tight money policy
Discount Rate:
The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.
Easy money policy
Fed Reserve lowers discount rate (interest rate it charges banks)
Banks Borrow more reserves
There is an increase in the money supply
There is a lower interest rates because banks can compete with other banks
There is an increase in spending by consumers and investors
3.0%
3.0%3.0%3.0%
3.0%
Discount Rate:
The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.
Tight money policy
Fed Reserve increases discount rate (interest rate it charges banks)
Banks Borrow less reserves
There is an decrease in the money supply
There is a higher interest rate
There is an decrease in spending which will slow down inflation
11.0%
11.0%11.0%11.0%
11.0%
Reserve Requirements:
The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve requirements, then banks can use existing reserves to make more loans and thus increase the money supply. If the Fed raises reserve requirements, then banks can use existing reserves to fewer more loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply.
A depository institution's reserve requirements vary by the dollar amount of net transaction accounts held at that institution. Effective December 30, 2010, institutions with net transactions accounts:
Of less than $10.7 million have no minimum reserve requirement;Between $10.7 million and $58.8 million must have a liquidity ratio of 3%;Exceeding $58.8 million must have a liquidity ratio of 10%.
Monetary Policy (Demand side)
Who- the Federal ReserveWhat- increasing or decreasing the amount of money in circulationGoal- full employment, stability, and growth
Easy Money Supply- increasing money supply and decreasing interest rates
Open Market Operations- buy securitiesDiscount Rates- lower discount rateReserve Requirements- lessen requirements
Decrease interest rates
Tight Money Supply – decreasing the money supply and increasing interest rates
Open Market operations- sell securitiesDiscount Rates- increase discount ratesReserve Requirements- increase requirements
Prisoner’s Dilemma between Monetary and Fiscal Policy.
Normally, high expenditures and is a dominate strategy for Congress and tight money for the Fed. When each selects its preferred strategy will be deficit spending with tight money.
It is important that both the Fed and Congress aligned their ideas, but they are independent of each other and have different goals. The goal’s of the Fed can vary but the goals representatives in Congress is the same- get reelected.
If the Fed and Congress oppose follow their dominate strategies they will find themselves in a prisoner’s dilemma- this happen a lot in the 1980’s
Congress
The Fed.
Payoffs (Utility) 1-10
1 being least desirable10 being most desirable
High Expenditures
Low Expenditures
Easy Money
Tight Money 10, 0
0, 10
4, 4
6, 6
Supply-side theory in AS/AD/LRAS
v v v
LRAS 1 LRAS 2 LRAS 3
Supply side economics
Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.
This increases potential output (Increase abundance, decreases price). Price drops= Increase in demandSupply creates its own demand
There are a number of methodsa. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment benefitsb. Invest in educationc. Advancements in technology – lowers production cost and creates new marketsd. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)e. Lower corporate tax ratesf. Invest in infrastructure g. reduce regulations and oversighth. Remove barriers of entry (licenses, certs. Etc.)
Eliminate safety nets and allow for profit and loss
AD
AS 1AS 2
P 1
P 2
Q1 Q2
How to fix the economy? According to . . .
Fiscal Policy Monetary Policy Supply Side Policy
During aRecession
With high unemployment
During Expansion
With high inflation
Increase Government Spending
Decrease Taxes
Buy Securities from banks or dealers
Decrease Discount Rate
Reduce Reserve requirements
All ideas intended to lower interest rate
Cut tax on Business
Reduce Regulation
Give business a chance to expand and hire
Decrease Government Spending
Increase Tax
Sell securities to banks
Increase Discount Rate
Increase Reserve Requirements
All ideas intended to increase interest rates
Do nothing the market will take care of itself.
No capital gains tax or marginal (progressive income tax)
The Problem with Lag.
Knowledge lag- knowledge and recognition lag, it takes time to recognize and correctly understand the problem.
Procedure or Action Lag- In the United States our legislative process can take long and there can be many hold ups.
Change or impact Lag- By the time change has taken place or the impacts are felt we may have been past the initial phase of the business cycle
Deficit Spending- annually – When the government spends more that it brings in as tax revenue.
Deficits make good politics, why?
It is popular to cut taxes and to increase spending.
How do we pay for the deficit? Borrowing
Debt- Accumulation of Deficits over the years
Surplus- when Revenue exceeds spending (annually)
Progressive Tax
Laffer Curve
Practice Quiz
1. List the top 3 indicators of economic health
2. GDP= ______+______+______+_____= GDP
3. Aggregate Market
A
B
C
DE
F
4. List and explain 2 ideas of classical economistList and explain 2 ideas of Keynesian economist
5. Draw the AS for classical economist, Keynesian economist, current model
6. Fiscal policy and monetary policy for a recession and inflationary period
1. GDP potential
AB
Time
Classical Keynesian
Increase Government Spending to increase AD
Saving= investment
Wage/Price are sticky
Wage and price are flexible
Save
Spend
Supply creates its own demand
Multiplier
GDP Potential(Full Employment)
GDP real
EconomicActivity
Time
A
GDPADUnemploymentInflation rate
Monetary Policy?
Expect Outcomes
Fiscal Policy
Expect Outcomes
What Phase on the newKeynesian model
GDP Potential(Full Employment)
GDP real
EconomicActivity
Time
GDP Increase or DecreaseAD Increase or DecreaseUnemployment Increase or DecreaseInflation rate Increase or Decrease
Monetary Policy?
Expect Outcomes: increase or decrease
Fiscal Policy?
Expect Outcomes:
What Phase on the newKeynesian model
B
Supply-Side
Idea to increase GDP
Classical Keynesian
Increase Government Spending to increase AD
Saving= investment
Wage/Price are sticky
Wage and price are flexible
Save
Spend
Supply creates its own demand
Multiplier
GDP Potential(Full Employment)
GDP real
EconomicActivity
Time
A
GDP Increase or DecreaseAD Increase or DecreaseUnemployment Increase or DecreaseInflation rate Increase or Decrease
Monetary Policy?Money Supply Increase or decreaseInterest rates ? Increase or decrease
Expect Outcomes: increase or decrease
C G I
Fiscal Policy? Tax Increase or decreaseGovernment Spending ? Increase or decrease
Expect Outcomes: increase or decrease
C G I
What Phase on the newKeynesian model
Recession
GDP Potential(Full Employment)
GDP real
EconomicActivity
Time
GDP Increase or DecreaseAD Increase or DecreaseUnemployment Increase or DecreaseInflation rate Increase or Decrease
Monetary Policy?Money Supply ? Increase or decreaseInterest rates ? Increase or decrease
Expect Outcomes: increase or decrease
C G I
Fiscal PolicyTax ? Increase or decreaseGovernment Spending ? Increase or decrease
Expect Outcomes: increase or decrease
C G I
What Phase on the newKeynesian model
BExpansion
Supply-Side
Idea to increase GDP
Classical Keynesian
Increase Government Spending to increase AD
Saving= investment
Wage/Price are sticky
Wage and price are flexible
Save
Spend
Supply creates its own demand
Multiplier
GDP Potential(Full Employment)
GDP real
EconomicActivity
Time
A
GDP Increase or DecreaseAD Increase or DecreaseUnemployment Increase or DecreaseInflation rate Increase or Decrease
Monetary Policy?Money Supply Increase or decreaseInterest rates ? Increase or decrease
Expect Outcomes: increase or decrease
C G I
Fiscal Policy? Tax Increase or decreaseGovernment Spending ? Increase or decrease
Expect Outcomes: increase or decrease
C G I
What Phase on the newKeynesian model
Recession
GDP Potential(Full Employment)
GDP real
EconomicActivity
Time
GDP Increase or DecreaseAD Increase or DecreaseUnemployment Increase or DecreaseInflation rate Increase or Decrease
Monetary Policy?Money Supply ? Increase or decreaseInterest rates ? Increase or decrease
Expect Outcomes: increase or decrease
C G I
Fiscal PolicyTax ? Increase or decreaseGovernment Spending ? Increase or decrease
Expect Outcomes: increase or decrease
C G I
What Phase on the newKeynesian model
BExpansion
Supply-Side
Idea to increase GDP