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Please revise everything based on comments and guide. My professor was critical and gave input asking for the corrections needed. I will pay you $15 more for making corrections on everything by Sunday evening. Please look over handouts before making corrections because it will help you a lot especially saving time. Thanks!!!!
Welcome to Macroeconomics in Middle Earth!
Part 2*
Fernanda Matos De Oliveira
Page 32 of 46 1/30/13
*Quotes from The Lord of the Rings,
or
The Hobbit by JRR Tolkien. Nothing written in italics applies to the questions—it’s there just for Tolkien fun. Go forth and read!!!
Section 9
Treebeard runs the MENB (Middle Earth National Bank) with “branches” all over the Shire. Merry Brandybuck makes a deposit in the Shire’s MENB of $100 from the loot he brought back from his travels in Wilderland.
‘One felt as if there was an enormous well behind them, filled up with ages of memory and long, slow steady thinking; but their surface was sparkling with the present: like sun shimmering on the outer leaves of a vast tree, or on the ripples of a very deep lake. I don’t know, but it felt as if something that grew in the ground — asleep, you might say, or just feeling itself as something between root-tip and leaf-tip, between deep earth and sky — had suddenly waked up, and was considering you with the same slow care that it had given to its own inside affairs for endless years.’
a) If the reserve rate is set at 15%, how much of Merry’s deposit must the bank keep? How much can the bank loan out to Pippin Took?
The bank must keep=15%×100=$15
Loan (excess reserves)=$100-(100×0.15)=$85
b) What would be the maximum change to the money supply from a)? Where does the change come from and by what formula? Show reserve and loan amounts for the first 6 levels.
Maximum change to money supply=(1/0.15)×85=$566.67. The change comes from the excess reserves.
YOU DON’T SUBTRACT OUT THE INITIAL DEPOSIT HERE—IT IS NEW TO M1 FROM OUT OF THE COUNTRY. ALSO NEED TABLE SHOWING FIRST SIX LEVELS IN BANKING SYSTEM
c) Suppose Bilbo took $500 out of an old box he had buried at Bag End (Bilbo’s house in the shire) and put it in MENB. What would be the maximum change to the money supply if the reserve rate was now 20%?
RR=0.2
Total Reserves=$500
Excess reserves=$500-(0.2×500)=$400
Maximum change to money supply=(1/0.2)×400=$2000
d) What two assumptions are included in calculating the maximum change in the money supply in a)? Explain the difference between a) and c).
Assumptions
· Banks hold NO excess reserves
· Individuals DON’T hold money
We would expect the maximum change to money supply to be higher in c than in a because of a higher reserve rate in c. Although the reserve rate is higher in b, the total reserves are high enough to make the maximum change to money supply to be the highest.
THE MAIN DIFFERENCE IS A IS NEW TO MONEY SUPPLY, C IS NOT
‘Of course we understand,’ said Merry firmly. ‘That is why we have decided to come. We know the Ring is no laughing matter; but we are going to do our best to help you against the Enemy.’
Section 10
The Federal Council of Elrond (Fed) controls the banking system in Middle Earth. The Council is responsible for controlling the money supply and implementing monetary policy.
a) The Council wishes to expand the money supply. Describe precisely how this would work through open market operations and effects on reserves. NOTHING ELSE
The council can use open market operations to expand money supply. What the economy basically needs is for monetary policy to ease its current policy stance. The council needs to purchase bonds and securities from the people on behalf of the government. By purchasing bonds and securities, money will be ploughed back to individuals. In addition, the council needs to lower the reserve requirements to increase the supply of money. This will mean that banks will be required to keep less in required reserves, thereby increasing the excess reserves given out as loans. LOOK AT THE HANDOUT 17 WHERE IT TALKS ABOUT WHAT HAPPENS TO RESERVES WITH AN OM PURCHASE.
b) The Council wishes to decrease the money supply. Describe precisely how this would work through the required reserve ratio and effects on reserves.
If the council wishes to decrease money supply following an increase in inflation, it can choose to increase the required reserve ration. By doing this, required reserves will increase, and hence there will be less excess reserves. Bank will be compelled to reduce the proportion of loans they give to individuals and firms. The economy will experience a decrease in money supply.
c) The Council wishes to decrease the money supply. Describe precisely how this would work through the discount rate and effects on reserves.
If the council wishes to decrease money supply through the discount rate, it can achieve so by increasing the discount rate. This will mean that financial institutions will have to pay more in terms of interests for the money they borrow from the central bank. They will pass on this effect to individuals and firms by increasing their interest rates. In terms of reserves, the council should increase the reserves so that banks have less to give out in terms of loans. Overall, these policies will make the money supply to reduce. LOOK AT THE HANDOUT 17 WHERE IT TALKS ABOUT WHAT HAPPENS TO RESERVES WITH HIGHER DISCOUNT RATE
If the money supply in Middle Earth is $10,000, velocity of money is a constant 3, the price level is 2.0, and output is constant at 15,000,
d) What is aggregate demand? What is nominal GDP? How did you get your answer?
Aggregate demand is the same as the output, which 15,000
Nominal GDP=Money supply×Velocity
Nominal GDP=10,000×3
Nominal GDP=$30,000
or
Nominal GDP=Real output×Price level
Nominal GDP=15,000×2
Nominal GDP=$30,000
e) The Council increases the money supply by $1,000. What is the net effect of the increase in the money supply in this case? Graph the impact on the Middle Earth economy with a constant level of real GDP and velocity (simple AD/AS model). Use actual numbers.
I DID THIS IN CLASS. THERE IS NO SRAS ONLY 1 VERTICAL AS CURVE AT 15,OOO. REST IS OK.
When the money supply is increased, the Aggregate Demand curve shifts to the right from AD to AD1. However, this increase in aggregate demand is offset by a decrease in supply, which causes the short run aggregate supply curve to shift leftwards from SRAS to SRAS1. Although real GDP remains constant, the price level increases from 2 to 2.2.
LRAS
Price
SRAS
1
2.2
SRAS
2
AD
1
AD
$15,000
Real GDP (Output)
f) Explain exactly and draw how the change in e) affects the money market in the short run. What are the dynamics that make the nominal interest rate adjust in the long run? (don’t use numbers—answer in general terms)
MS
MS
1
Nominal interest rate
MD
Money Quantity
An increase in money supply causes a rightward shift of the money supply curve from MS to MS1. As a result the quantity of money will increase. Nominal interest rates adjust in the long-term due to changes in the expected inflation. YOU DON’T SHOW INTEREST RATES MOVING ON YOUR GRAPH. ALSO, YOU HAVE TO INCLUDE THE BOND MARKET DYNAMICS. LOOK IN HANDOUT 17
g) Now suppose that the Council implements a technological innovation with ATM’s in Middle Earth. Graph the change in the money market and explain how the change comes about. (don’t use numbers—answer in general terms)
MS
Nominal interest rate
MD
MD
1
Money Quantity
A technological innovation with ATM’s is likely to shift money demand to the left. This is because use of Automatic Teller Machines would allow individuals in Middle Earth to hold less cash.
YOU DON’T SHOW INTEREST RATES MOVING ON YOUR GRAPH. ALSO, YOU HAVE TO INCLUDE THE BOND MARKET DYNAMICS. LOOK IN HANDOUT 17
Section 11
Bilbo Baggins loved to have parties and give gifts. Since he came back from his adventures with Thorin Oakenshield and the dwarves with lots of gold, he could afford to import magical toys and other special presents from the foreign country of Dale where they are made. The Shire (where Bilbo lives) and Dale have different currencies.
a) Draw the foreign exchange market for the Shire dollar. Be sure to show the equilibrium exchange rate and quantity traded.
S
Exchange rate
Equilibrium exchange rate
D
Equilibrium Q
Quantity
b) Real income in the Shire increases. Draw what happens in the exchange rate market. What happens to the exchange rate and quantity traded? (Remember both sides of market can be affected)
If real income in the Shire increases, domestic prices are likely to increase, thereby increasing the interest rates. This will mean that the shire dollar will depreciate. The quantity traded will increase, thereby increasing the net exports.
IF REAL INCOME INCREASES, BUY MORE FROM OTHER COUNTRIES. NEED MORE FOREIGN CURRENCY SO BRING MORE DOLLARS TO MARKET AND INCREASE SUPPLY (NOT DEMAND)
Exchange rate
S
D2
D1
Q
c) The Shire’s interest rates fall compared to the rest of the world. Draw what happens in the exchange rate market. What happens to the exchange rate and quantity traded? (Remember both sides of market can be affected)
d)
A decrease in Shire’s interest rates will mean that it would be more attractive for Shire’s citizens to invest outside because of the relatively higher interest rates in foreign countries. As a result, the Shire dollar will depreciate relative to foreign currency. Foreign goods will be expensive to buy, thereby increasing the quantity traded and consequently, the net exports.
BOTH SIDES ARE AFFECTED. FOREIGN INVESTORS WILL BUY LESS SHIRE ASSETS SO DEMAND FOR CURRENCY DECREASES. ALSO AS SHIRE INVEST MORE IN FOREIGN, NEED MORE FOREIGN CURRENCY AND BRING MORE DOLLARS SO SUPPLY INCREASES.
Exchange rate
S
D2
D1
Q
e) The exchange rate for the Shire dollar is expected to rise in the future. Draw what happens in the exchange rate market. What happens to the exchange rate and quantity traded? (Remember both sides of market can be affected)
If the exchange rate is expected to rise in the future, domestic firms know too well that they will benefit because domestic currency will depreciate relative to the foreign currency. So if they expect the exchange rate to rise in the future, they will tend to defer their investments until that time. As a result, the Shire dollar will appreciate relative to the foreign currency. Imports will be cheap, thereby reducing net exports. Overall, the quantity traded will reduce.
SPECULATORS WILL BUY THE SHIRE CURRENCY NOW SO THEY CAN SELL LATER AT A HIGHER PRICE. DEMAND INCREASES. AT SAME TIME, IF SHIRE’S IS EXPECTED TO GO UP, OTHER CURRENCY IS EXPECTED TO GO DOWN. SHIRE WON’T BE BUYING FOREIGN CURRENCY NOW (WILL BE CHEAPER IN FUTURE) SO FEWER DOLLARS BROUGHT TO MARKET AND SUPPLY DECREASES.
Exchange rate
S
D1
D2
Q
Section 12
Denethor, son of Echthelion II, is Steward of Gondor in the absence of the rightful king.
He is a firm believer in Say’s Law and the laissez-faire approach to the economy of Gondor.
He is not as other men of this time, Pippin, and whatever be his descent from father to son, by some chance the blood of Westernesse runs nearly true in him; as it does in his other son, Faramir, and yet did not in Boromir whom he loved best. He has long sight. He can perceive, if he bends his will thither, much of what is passing in the minds of men, even of those that dwell far of. It is difficult to deceive him, and dangerous to try.
a)
a) Draw aggregate demand, aggregate short run supply and aggregate long run supply for Gondor’s economy in long run equilibrium. What is the unemployment level?
Price
Output
AD
SRAS
U
n
Un is the natural rate of unemployment. NEED PRICE LABELS, NOT LABEL Un BUT SHOULD BE Qn. NEED LRAS LABEL
b) Consumers in Minas Tirith believe there will be an acute shortage developing in the supply of rings and anticipate higher future price levels in the economy. Draw and explain what happens to aggregate demand in the Gondorian economy in the short run. Identify any change in determinant(s) and explain why and how the change occurs. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?
If consumers expect that there will be a shortage of rings and higher price levels in the economy, we can expect that they will spend more now due to the prevailing lower prices. As a result, aggregate demand will increase in the short run. In particular, the component of aggregate demand that will be influenced by this change is consumption by households. Individuals will increase their consumption of rings now. If aggregate demand increases, the price level will also increase. Also, unemployment will tend to decrease, while real GDP will increase. The economy will face an inflationary gap.
LOOK IN HANDOUT 21 FOR CORRECT GRAPH FOR INFLATIONARY GAP.
LRAS
Price
Output
SRAS
AD1
U
n
AD
c)
Draw and explain what happens to the Gondorian economy in the long run as a result of b). What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics in your explanation and graph.
In the long-run, however, the increase in aggregate demand will be offset by a decrease in aggregate supply. Therefore, as the aggregate demand curve shifts to the right, the short run aggregate supply curve will shift leftwards from SRAS1 to SRAS2. This shift will occur because workers will revise their price expectations and demand more wages. This will increase the cost of production for firms, hence shifting the short run supply curve to the left. While the price level will increase, unemployment and real GDP will remain unchanged.
LOOK IN HANDOUT FOR PROPER LABELS AND MOVEMENTS OF U AND Q. NEED PRICE LABELS
SRAS
2
LRAS
Price
SRAS
1
Output
AD1
U
n
AD
d) The Gondorian dollar appreciates. Draw and explain what happens to aggregate demand in the Gondorian economy in the short run. Identify any change in determinant(s) and explain why and how the change occurs. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?
If the Gondorian dollar appreciates, it will be cheaper to purchase foreign goods AND MORE EXPENSIVE TO BUY GONDOR GOODS.. EXPORTS DECREASE IMPORTS INCREASE, This will mean that net exports will reduce, thereby leading to a decrease in aggregate demand. The aggregate demand curve will shift leftwards from AD to AD1. As a result, the price level will reduce, while unemployment will increase. Real GDP will reduce. The economy will experience a recessionary gap.
LOOK IN HANDOUT FOR LABELS AND NOTATIONS.
Price
Output
SRAS
AD
AD
1
U
n
e)
b)
c)
f)
Draw and explain what happens to the Gondorian economy in the long run as a result of d). What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics in your explanation and graph.
In the long-run, as the AD curve shifts to the left, the short-run aggregate supply curve will shift to the right from SRAS to SRAS1. The price level will reduce, while unemployment and real GDP will remain unchanged. This is because the decrease in demand will be offset by an increase in supply.
LOOK IN HANDOUT FOR PROPER LABELS AND DYNAMICS NOTATIONS.
SRAS
LRAS
Price
SRAS
1
Output
AD
AD
1
U
n
g) A new discovery of mithril (a valuable metal resource) is located in the White Mountains of Gondor. Draw and explain what happens to the kingdom’s economy. What happens to the price level and real GDP in the long run?
Following a new discovery of mithril, aggregate demand is likely to increase, thereby causing the aggregate demand curve to shift to the right. Aggregate demand will increase the new resource will increase productive capacity. In the long-run, price level will increase, while real GDP will remain unchanged.
THIS MOVES PPF SO WILL MOVE LRAS AND SRAS. SEE HANDOUT
SRAS
2
LRAS
Price
SRAS
1
Output
U
n
AD
AD1
The Dwarves delved deep at that time, seeking beneath Barazinbar for mithril, the metal beyond price that was becoming yearly ever harder to win.
Section 13
The (returned) king, Aragorn the King Elessar, is a Keynesian advocate, as is his chief Steward, Faramir, younger son of Denethor.
Then Frodo came forward and took the crown from Faramir and bore it to Gandalf; and Aragorn knelt, and Gandalf set the White Crown upon his head, and said:
‘Now come the days of the King, and may they be blessed while the thrones of the Valar endure!’
a) Draw the total expenditures and total production model for the Gondor economy. Show the equilibrium level of real GDP being produced. What are the slopes of the TE and TP curves?
The TE and TP curves have a negative slope. THEY SLOPE UP TO RIGHT SO CERTAINLY NOT NEGATIVE. LOOK IN HANDOUT 22 FOR ALL LABELS FOR GRAPH AND LABLES FOR SLOPE.
TP and TE
TP=Real GDP
TE=G+C+I
E
Real GDP
b) Draw the Gondor economy in a recessionary gap, using the Keynesian total expenditures and total production model. What can you say about unemployment and real GDP?
During a recessionary gap, unemployment is high, while real GDP is low. In other words, real GDP is lower than the equilibrium GDP. LOOK IN HANDOUT. YOUR QN IS WRONG SIDE. ALSO NEED UNEMPLOYMENT ON GRAPH RELATIVE TO Un
TP and TE
TP=Real GDP
TE=G+C+I
E
Q
1
Q
e
Real GDP
c) Draw the Gondor economy in an inflationary gap, using the Keynesian total expenditures and total production model. What can you say about unemployment and real GDP?
TP and TE
TP=Real GDP
TE=G+C+I
E
Q
e
Q
1
Real GDP
During an inflationary gap, unemployment is low, while real GDP is high
LOOK IN HANDOUT. YOUR QN IS WRONG SIDE. ALSO NEED UNEMPLOYMENT ON GRAPH RELATIVE TO Un
The King has set the income tax rate at 20% for Gondorian citizens.
Personal Income
Consumption
Δ Personal Income
Δ Consumption
Savings
Δ Savings
$1,375
$1,000
$375
$1,625
$1,120
$250
$120
$505
$130
$1,875
$1,240
$250
$120
$635
$130
$2,125
$1,360
$250
$120
$765
$130
$2,375
$1,480
$250
$120
$895
$130
Faramir has provided the following information to King Elessar:
Personal Income
Consumption
$1375
$1000
$1625
$1120
$1875
$1240
$2125
$1360
$2375
$1480
d) What are the marginal propensity to consume (MPC) and the marginal propensity to save (MPS) in Gondor?
MPC= ΔConsumption/ΔPersonal Income DISPOSABLE INCOME
MPC=120/250
MPC=0.48
MPS= ΔSavings/ΔPersonal Income DISPOSABLE INCOME OR 1-MPC
MPS=130/250
MPS=0.52
e) What is the Gondorian economy’s multiplier?
Multiplier=1/(1-mpc)
Multiplier=1/(1-0.48)
Multiplier=1/0.52
Multiplier=1.923
We are truth-speakers, we men of Gondor. We boast seldom, and then perform, or die in the attempt. Not if I found it on the highway would I take it, I said. Even if I were such a man as to desire this thing, and even though I knew not clearly what this thing was when I spoke, still I should take those words as a vow, and be held by them.
f) The economy of Gondor is in an inflationary gap of $1,000. What type of fiscal policy can King Elessar undertake to bring the economy to back to the natural unemployment rate? By what method? Graph using the total expenditures and total production model and explain how the policy would work. Be numerically precise, using the information in d) and e). Include unemployment.
King Elassar should conduct contractionary fiscal policy. He can achieve this by increasing taxation and reducing government expenditures. This will shift the total expenditure curve to the left until it reaches a point where it intersects the total production curve. Since the multiplier is 1.923, this means that to close the inflationary gap, the King should reduce government expenditures by (1000/1.923), which is $520.02. HAVE TO REDO NUMBERS
TP
TP and
TE
TE
1
TE
Real GDP
Q
1
Q
e
Eventually, unemployment will increase and output will move back to its full potential level.
g) The economy of Gondor is in a recessionary gap of $500. Faramir suggests a different type and method of fiscal policy to King Elessar. Graph using the total expenditures and total production model and explain how the policy would work. Be numerically precise, using the information in d) and e). Include unemployment.
To close the recessionary gap, the fiscal policy undertake is expansionary. The King can either increase government expenditures or reduce taxes. Since the multiplier is 1.923, this means that the King can close the gap by increasing government expenditures by (500/1.923), which is $260.01. HAVE TO REDO NUMBERS. This policy will make the TE curve to shift rightwards from TE to TE1. Eventually, unemployment will reduce and output will move back to its full potential level.
TP
TP and
TE
TE
TE
1
Q
1
Q
e
Real GDP
h) Draw and explain the effect of a change in the price level, using the TE/TP model and the AD/AS model in combination.
LOOK AT HANDOUT 23 PAGE 5 BOTTOM 2 GRAPHS.
TP and
TE
TP
TE/SRAS
Price level
TE
1
/
SRAS
1
AD
AD1
Q
e
Real GDP
In our case, we consider the effect of a price increase. If the price level increases, the AD curve is likely to shift to the left. At the same time, the TE curve is also likely to shift to the left. The former would occur because high prices would scare of consumers. For the latter, high prices would reduce total expenditures, thereby shifting the TE curve to the left.
Section 14
Gandalf wishes the economy of Middle Earth to operate smoothly after he sails from the Grey Havens to the never-ending lands in the West. He gathers King Elessar of Gondor, King Eomer of Rohan, Thain Pippin Took of the Shire, King Thorin III Stonehelm of the Lonely Mountain, King Bard II of Dale, King Thranduil of Mirkwood, Gimli son of Gloin of Aglarond, Prince Faramir of Ithilien, Prince Imrahil of Dol Amroth, Treebeard of Fangorn Forest and other councilors and leaders of the various countries of Middle Earth to instruct them on fiscal policies designed to smooth out the business cycle.
Even as the first shadows were felt in Mirkwood there appeared in the west of Middle-earth the Istari, whom Men called the Wizards….[A]terwards it was said among the Elves that they were messengers sent by the Lords of the West to contest the power of Sauron, if he should rise again, and to move Elves and Men and all living things of good will to valiant deeds. In the likeness of Men they appeared, old but vigorous, and they changed little with the years, and aged but slowly, though great cares lay on them; great wisdom they had, and many powers of mind and hand.
a) Describe a budget deficit, a budget surplus and a balanced budget. Include relationship of tax revenues and government spending. What impact will each have on the market for loanable funds?
A budget deficit occurs when total expenditures exceed total revenues. A budget surplus, on the other hand, describes a situation where total revenues exceed total expenditures. Finally, a balanced budget is one where total expenditures are equal to total revenues. A budget deficit would imply that an economy would not be in a position to pay off its debts in case it is given a loan. A budget supply, on the other hand, would increase the probability of a country receiving loans.
b)
Describe and graph how an income tax affects potential GDP and aggregate supply. Indicate the income tax wedge. (2 graphs) How do taxes on expenditures affect the income tax wedge?
Price
AS
1
AS
D
GDP
Income Tax wedge
AS
1
AS
D
GDP
An increase in income tax reduces GDP and aggregate supply.
This is because an income tax translates to reduced expenditures, which reduces aggregate supply and GDP.
Taxes on expenditures, on the other hand, reduce the income tax wedge
c) Draw the Laffer curve. Show where the maximum tax revenues would be. From this point does an increase in tax rates increase or decrease tax revenues?
Tax Rate
Maximum tax revenues
Tax Revenue
From the maximum tax revenues point, any further increase in the tax rates reduces the tax revenues.
d) Describe the three multipliers for government fiscal policy and describe the differences in size of impact. How does each affect the economy?
The three fiscal multipliers are impact multiplier, peak multiplier and cumulative multiplier. The peak multiplier has the greatest impact, followed by the cumulative multiplier, then the impact multiplier. Each affects the economy depending on time frame.
e) Draw expansionary fiscal policy that is applied when the economy is in a recessionary gap using the AD/AS model. What are the two fiscal actions that the government could take to implement this policy?
Price
AS
AD
1
AD
Q
e
Q
1
GDP
The two fiscal actions that the government can undertake to close the recessionary gap are;
i) reduction of taxes
ii) increase of government expenditures.
f)
g) Draw contractionary fiscal policy that is applied when the economy is in an inflationary gap using the AD/ AS model? What are the two fiscal actions that the government could take to implement this policy?
Price
AS
AD
AD
1
Q
1
Q
e
GDP
The two fiscal actions that the government can undertake to close the inflationary gap are;
Increase of taxes
Decrease of government expenditures.
h) List and briefly describe the five lags that cause problems in implementing fiscal policy.
1. Data lags-relate to changes that policy makers are not cognizant of.
2. Wait-and-see lags-Relate to the tendency of policy makers to relax even when they have identified a problem in the economy
3. Legislative lags-relate to legal procedures that must be followed once a policy has been proposed.
4. Transmission lags-relate to the time a policy takes before in is effected.
5. Effectiveness lags-relate to the time a policy prescription takes before actual effect is felt on the economy.
Section 15
Thorin III Stonehelm, son of Dain, became King of the Lonely Mountain after his father’s fall in the War of the Ring. The dwarves of his kingdom were busy and prosperous producing the weapons, armor and jewelry for which they were famous and which the inhabitants of Middle Earth were demanding now that there was peace. But Thorin III Stonehelm began to notice that prices were rising in his kingdom and he went to consult with King Bard II of Dale (son of Brand) to see why this was happening.
T
he lands opened wide about him, filled with the waters of the river which broke up and wandered in a hundred winding courses, or halted in marshes and pools dotted with isles on every side; but still a strong water flowed on steadily through the mist. And far away, its dark head in a torn cloud, there loomed the Mountain! Its nearest neighbours to the North-East and the tumbled land that joined it to them could not be seen. All alone it rose and looked across the marshes to the forest. The Lonely Mountain!
a)
b) Draw (in the AD/AS model) and explain what happens to aggregate demand in the short run. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?
In the short-run, the aggregate demand increases, thereby causes a rightward shift of the demand curve from AD to AD1. At the same time, the price level increases, while the unemployment level decreases. Real GDP increases. The economy is facing an inflationary gap.
LRAS
Price
SRAS
p
1
p
e
AD
1
AD
Real GDP
Q
e
Q
1
c) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of a) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is this inflation? Explain why or why not. If so, what is it called?
In the long-run, the increase in aggregated demand will be offset by a decrease in aggregate supply. As the aggregate demand curve shifts to the right, the aggregate supply curve will shift to the left. This shift in the supply curve to the left will occur because laborers will demand higher wages upon realizing that prices have increased, yet their incomes have not increased. This will be costly to firms since they will incur higher business costs. This will result in a decrease in supply. Also, in the long-run, the price level will increase, while unemployment and real GDP will remain constant. The economy faces inflation because the price level increases considerably.
LRAS
Price
SRAS
1
SRAS
AD
1
Q
e
Real GDP
AD
d) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in the long run as a result of a) if the Council (Fed) immediately applies monetary policy and contracts the money supply rather than wait for the economy to self-correct like in b). What happens to the price level, unemployment and real GDP in the long run? What is the final difference in the result of the monetary policy and the results in b)?
If the Fed applies contractionary monetary policy, the AD curve will shift to the left. This will cause a decrease in the price level. At the same time, unemployment will increase, while real GDP will reduce. The difference that occurs when the council chooses to let the economy to self-correct itself and when it chooses to apply contractionary monetary policy is that in the former, unemployment and real GDP will remain unchanged, while in the latter, these will change.
Price
Output
SRAS
AD
AD
1
Q
e
Q
1
h)
d)
e) The Federal Council of Elrond (Fed) gets on a roll and increases the money supply each year for 3 years. Draw (in the AD/AS model) and explain the long-run effect of these increases on the economy of the Lonely Mountain. What happens to the price level, unemployment and real GDP in the short run and in the long run? What is the end result of these continued increases? Is there inflation? Explain why or why not. If so, what is it called?
In the long-run, a continued increase of money supply will be counterproductive because it will not be met by a proportionate increase in production. The price level is likely to increase significantly, both in the short-run and the long-run. Unemployment is likely to increase in the short-run, but will tend to remain constant in the long-run. As for real GDP, it will reduce in the short-run, but will remain unchanged in the long-run. As a result of the continued increase in money supply, the situation experienced is one where a lot of money is chasing few goods. This results in inflationary tendencies.
LRAS
Price
SRAS
AD
1
AD
Real GDP
Q
1
Q
e
The economy of the Lonely Mountain is dependent on iron for its armor and weapon manufacturing. A pack of Orcs fleeing the destruction before the gates of Barad-Dur make their way to the Iron Hills where the dwarves mine ore and force battle. The attack on the Dwarves’ mines causes a temporary supply shock to the economy of Middle Earth due to the reduction of raw materials.
f) Draw (in the AD/AS model) and explain the short-run effect of the supply shock on economy of the Lonely Mountain. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?
A supply shock is likely to cause a left-ward shift of the demand curve to the left. As a result, the price level will increase, while unemployment will increase. Real GDP will reduce. The economy will face a recessionary gap.
Price
SRAS
1
SRAS
LRAS
Q
e
Q
1
AD
Real GDP
Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of e) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is there inflation? Explain why or why not. If so, what is it called?
In the long-run, the decrease in supply will be offset by an increase in demand. Consequently, the price level will increase, while unemployment and real GDP will remain constant. The situation witnessed of sluggish economy and high inflation is called stagflation.
Price
LRAS
SRAS
1
SRAS
AD
1
Q
e
Q
1
AD
Real GDP
g) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in the long run as a result of e) if the attacks continually re-occur and the Council (Fed) applies expansionary monetary policy and increases the money supply one time rather than wait for the economy to self-correct like in f). What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is there inflation? Explain why or why not. If so, what is it called? What is the final difference in the result of the monetary policy and the results in f)?
If Fed applies expansionary monetary policy and increases money supply, the price level is likely to reduce, while unemployment will reduce. Real GDP will increase. The difference when the council chooses to let the economy to self-correct itself and when it chooses to apply expansionary monetary policy is that in the former, the economy will face a mild-recession, while in the latter, it will face inflation.
Price
SRAS
1
SRAS
Q
e
Q
1
AD
Real GDP
Section 16
After the War of the Rings, Legolas returns to Mirkwood, where his father rules the Woodland Elves. Due to new ideas gained in his wide travels, Legolas convinces King Thranduil to implement continuing expansionary monetary and fiscal policy to reduce unemployment in Mirkwood. (Actually, a reduction in the consumption of barrels of wine would work better.)
There was also a strange Elf, clad in green and brown, Legolas, a messenger from his father, Thranduil, the King of the Elves of Northern Mirkwood.
a)
b) Draw and explain the short-run Phillips curve for the economy of Mirkwood on which Legolas is basing his ideas. What is held constant along the short-run Phillips curve?
In the short-run Phillips curve expected inflation and actual inflation are held constant.
Inflation rate
Short-run Phillips curve
Unemployment rate
c) Draw the short-run and long-run Phillips curve for the Mirkwood economy. Explain what happens to the price level and unemployment in the long run?
In the long-run, the price level increases, while unemployment remains at its natural rate. This occurs because laborers revise their wages upon realizing that the price level has increased. Others even choose to renounce their job positions. This combination of some laborers renouncing their positions and others revising their expectation of inflation causes wages to increase and consequently, prices. This shift the supply curve to the left, taking the economy back to its full potential point.
Long-run Phillips curve
Inflation rate
Unemployment rate
Short-run Phillips curve
d)
Explain and show by graph the connection through unemployment and changes in the price level between the business cycle as shown by the AD/AS model and the long run Phillips curve (show 3 points on the graph).
Inflation Rate
3
2
1
U
n
U
1
Point 1: Shows an increase in output following a shift of the aggregate demand curve to the right.
Point 2: Shows the decrease in unemployment that is brought about by an increase in aggregate demand.
Point 3: Shows how the economy moves back to its full potential point when laborers revise their inflation expectations. This causes the short-run aggregate supply curve to shift to the left.
Unemployment Rate
e) Suppose job search time in Mirkwood suddenly becomes easier. Draw and explain what happens to the Phillips curve in Mirkwood.
Inflation Rate
2
1
U
n
U
1
If job search time in Mirkwood becomes easier, this means that the economy will move point 1 to 2. That is, the rate of unemployment will reduce.
Section 17
Elrond, Chairman of the Council, is a monetarist and believes that prices and wages are flexible so that the economy is self-regulating. But unlike Denethor, he feels that money is the key to the economy.
The face of Elrond was ageless, neither old nor young, though in it was written the memory of many things both glad and sorrowful. His hair was dark as the shadows of twilight, and upon it was set a circlet of silver; his eyes were grey as a clear evening, and in them was a light like the light of stars. Venerable he seemed as a king crowned with many winters, and yet hale as a tried warrior in the fulness of his strength. —
a) What are the monetary policy objectives and goals of the Federal Council of Elrond (Fed)? What tradeoff does the council face for its goals? Explain.
The main objective of monetary policy is to keep prices stable by changing money supply in the economy. In doing this, the Fed faces tradeoffs. Because of the tendency of the economy to self-correct itself following a recession or an inflation period, the Fed faces the tradeoff of allowing the economy to self-correct itself or implementing policy to correct the imbalance. Either way, there is a cost of each decision.
b)
c) Graph the implementation of expansionary monetary policy on the economy of Middle Earth when there is a recessionary gap (in both money market and AD/AS model). What happens to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed) could do to accomplish this policy.
AS
AD
1
AD
Q
e
Q
1
GDP
Following the implementation of expansionary monetary policy, the price level increases, while unemployment reduces. Real GDP increases.
The three actions that the Fed can undertake to close a recessionary gap are;
· Purchase of bonds and securities
· Decrease of interest rates
· Reduction of reserve requirements.
d)
Graph the implementation of contractionary monetary policy on the economy of Middle Earth when there is an inflationary gap (in both money market and AD/AS model). What happens to the price level, unemployment and real GDP? Specify 3 different actions the Council (Fed) could do to accomplish this policy.
Price
AS
AD
AD
1
GDP
Q
e
Q
1
Following the implementation of contractionary monetary policy, the price level will reduce, while unemployment will increase. Real GDP will reduce.
The three actions that the Fed can undertake to close an inflationary gap are;
· Sell of bonds and securities
· Increase of interest rates
· Increase of reserve requirements.
e)
f) Draw the effect on the federal funds rate if the Council (Fed) performs an open market purchase. Describe in detail or graphs the ripple effects of this action. Be sure to include the end result in each market and how those results affect the components of aggregate demand.
An open market purchase is likely to increase aggregate demand, thereby causing a shift of the aggregate demand curve to the right. In the money market, an open market purchase will lead to more money in the economy. The component of aggregate demand that will be affected is consumption. Individuals will consume more because the purchase will increase the money they hold
AS
AD
1
AD
Q
e
Q
1
GDP
g) Draw the effect on the federal funds rate if the Council (Fed) performs an open market sale. Describe in detail or graphs the ripple effects of this action. Be sure to include the end result in each market and how those results affect the components of aggregate demand.
An open market sale is likely to reduce aggregate demand, thereby causing a shift of the aggregate demand curve to the left. In the money market, an open market purchase will lead to less money in the economy. The component of aggregate demand that will be affected is consumption. Individuals will consume less because the sale will reduce the money they hold.
Price
AS
AD
AD
1
Real GDP
Q
e
Q
1
Then Círdan led them to the Havens, and there was a white ship lying, and upon the quay beside a great grey horse stood a figure robed all in white awaiting them. As he turned and came towards them Frodo saw that Gandalf now wore openly on his hand the Third Ring, Narya the Great, and the stone upon it was red as fire. Then those who were to go were glad, for they knew that Gandalf would also take ship with them….
Then Frodo kissed Merry and Pippin, and last of all Sam, and went aboard; and the sails were drawn up, and the wind blew, and slowly the ship slipped away down the long grey firth; and the light of the glass of Galadriel that Frodo bore glimmered and was lost. And the ship went out into the High Sea and passed on into the West, until at last on a night of rain Frodo smelled a sweet fragrance on the air and heard the sound of singing that came over the water. And then it seemed to him that as in his dream in the house of Bombadil, the grey rain-curtain turned all to silver glass and was rolled back, and he beheld white shores and beyond them a far green country under a swift sunrise.
Handout #17P
Money
The Root of All Reserves
Money is any good that is widely accepted in trade and for repayment of debt. People can use money for trade rather than having to barter. People accept money because they know other people will accept it. Money makes the economy more efficient, frees up resources and makes everyone better off. Money serves three functions:
· Medium of exchange—people can use money for trade rather than having to barter.
· Unit of account—provides a common measure for values.
· Store of value—can maintain its value over time to some satisfactory degree.
The money supply is measured in two ways.
· M1 is the narrow definition and includes only currency outside of banks, checkable deposits and traveler’s checks. These are totally liquid
asset
s. Liquid asset
are asset that are easily and cheaply turned into
cash
.
· M2 is the broader definition and includes M1 plus savings deposits, money market deposit accounts or non-institutional mutual funds, small denomination time deposits like CDs, These financial assets are just slightly less liquid than M1.
The Federal Reserve System (the Fed) is the central bank of the U.S. The Federal Reserve System has a number of functions, including:
· Controlling the money supply
· Providing paper money to the economy
· Providing check clearing services
· Holding banks reserves
· Supervising member banks
· Serving as the government’s banker
· Serving as the lender of last resort
· Handling the sales of US Treasury securities
These functions control the money supply through the nation’s banking system. It works through the required reserve ratio for banks. Banks only hold part of their deposits on hand as reserves. The required percentage banks must hold is set by the Fed.
In a simplified banking system with only one bank, suppose the bank receives a brand new $1000 bill as a deposit from customer 1. Though customer 1 could require his/her $1000 at any time, the bank is only required to hold part as reserves. Suppose the required reserve ratio set by the Fed is 10%. That means that the bank only has to hold onto $100 as require reserves out of the $1000 deposit and it can loan the rest out, charging interest on the loan, and earning income that way. So the bank loans out $900 to a borrower, customer 2, and he/she puts that $900 in his/her checking account at the bank. The bank has to keep $90 as required reserves and is free to loan out $810. So it does, to customer 3, who then deposits the $810 loan proceeds into his/her checking account. The bank has to keep $81 of this deposit as reserves, and has $729 to loan out to customer 4.
And so on
, and so on, and so on. . . . . .
Here’s the bank’s activities:
|
Total Reserves ( |
Required Reserves (10%) ( |
Loans ( |
New Deposits |
|
$1000.00 |
|||
|
$100.00 |
$900.00 |
||
|
$90.00 |
$810.00 |
||
|
$81.00 |
$729.00 |
||
|
$72.90 |
$656.10 |
||
|
$65.61 |
$590.49 |
||
|
$59.05 |
$531.44 |
||
|
$53.14 |
$478.30 |
||
|
$47.83 |
$430.47 |
||
|
$43.05 |
$387.42 |
||
|
$38.74 |
$348.68 |
||
|
$34.87 |
$313.81 |
||
| And so on |
By the time the process is all the way done, the money supply will have increased by $10,000 with $1000 from the initial new $1000 bill and $9000 from the banking system. The total change in the money supply can be calculated by the simple deposit multiplier which is
1 divided by the required reserve ratio (r). The multiplier would calculate the maximum total change in money supply as
∆M1 or M2
=
1 * ∆Bank reserves from original deposit of funds
r
In our example, this would be 1/.10 * $1000 or $10,000.
The process works in reverse to decrease the money supply—banks have to hold onto repaid loan funds to meet their reserves, rather than loan them out again. That shrinks the money supply through the simple deposit multiplier operating on the required reserve ratio, r.
When calculating the maximum change in the money supply, it matters whether the initial deposit into the banking system is new to the money supply or was already part of the money supply, just not in the banking system. If the money is new to the money supply, the maximum is calculated using the full multiplication: initial deposit in the bank * 1/r. However, if the deposit was already part of the money supply, you have to subtract it out at the end: (initial deposit * 1/r)-initial deposit.
Two things have to happen to reach the maximum change in the money supply. First, there can’t be any cash leakages. All the loans have to be re-deposited in the bank—if not, a smaller amount will be multiplied at every level afterward and the change in the money supply cannot reach the maximum. Second, the bank has to loan all its excess reserves. If the bank keeps part of the reserves it could otherwise loan, a smaller amount will be multiplied at every level afterward and the change in the money supply cannot reach the maximum.
The Fed can change the money supply through reserves in several ways:
· Open market operations—if the Fed purchases securities from banks, it deposits money to pay for the securities in the bank’s reserve account. This increase in reserves can then be loaned, and through the simple deposit multiplier, expand M1 or M2. If the Fed sells securities to a bank, it removes reserves from the bank’s reserve account which reduces reserves and in turn the amount that the bank can now loan. Open market purchases by the Fed expand the money supply and open market sales by the Fed contract the money supply.
· The required reserve ratio—the Fed can raise of lower the percentage of deposits that a bank is required to hold as reserves. If the Fed lowers the required reserve ratio, some of the bank’s required reserves will suddenly become excess reserves and the money supply will expand. If the Fed increases the required reserve ratio, banks will have to increase required reserves which means there will be less to loan out and the money supply will contract.
· The discount rate—this is the interest rate that the Fed charges to banks to borrow funds from the Fed. If the Fed lowers the discount rate, more banks will borrow funds from the Fed, which increases their reserves, and expands the money supply. If the Fed increases the discount rate, fewer banks will borrow funds from the Fed, and banks reserves will decrease, contracting the money supply.
The main point to remember—anything that increases reserves in the banking system will increase the money supply. Anything that reduces reserves will contract it.
Quantity Theory of Money
Changes in the money supply change the price level. This effect is analyzed through the equation of exchange. This equation states that
Money supply (M) * Velocity of money (V) = Price level (P) * Real GDP (Y) or (Q)
or MV = PQ
The velocity of money is simply the number of times annually that the money supply is spent on final goods and services in the economy. Suppose the economy has a money supply of $100 and during the year $700 of final goods and services was purchased. That means that each dollar of the money supply was spent an average of 7 times on final goods and services.
V = PQ or V = $700 so V = 7
M $100
MV measures total expenditures, also known as aggregate demand, and PQ measures nominal GDP. If MV measures total expenditures, then MV = C + I + G + NX.
The equation of exchange leads to the simple quantity theory of money. If you assume that velocity and real GDP are constant (in the short-run), then changes in the money supply will make a proportional change in the price level, or $∆M = %∆P. Or, increases in the money supply lead to inflation.
The equation of exchange results in the statement
P = MV
Q
If real GDP is assumed to change also, then you have three influences on the price level
· Inflationary influences—increases in money supply, increases in velocity (numerator) or decrease in real GDP (denominator)
· Deflationary influences—decreases in money supply, decreases in velocity (numerator) or increase in real GDP (denominator)
Looking at growth rates, the equation of exchange is:
(Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate). You can rearrange this equation by subtracting the (Real GDP growth rate) from both sides,
That gives you:
(Inflation rate) = (Money growth rate) + (Growth rate of velocity) ( (Real GDP growth rate).
If velocity is assumed to remain constant, then in the long run the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP. In periods of hyperinflation, or rapidly increasing price levels in excess of 50% per month, velocity will not remain constant but will be rapidly increasing also.
The Market for Money
There is a market for money, which is different from the market for loanable funds.
People like to hold some of their wealth in the form of money, creating a demand for money.
The quantity of money that people plan to hold depends on:
· The Price Level: The higher the price level, the more money people will want to hold.
· The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of real money demanded.
· Real GDP: An increase in real GDP increases the quantity of money people plan to hold.
· Financial Innovation: Any financial innovation that enables people to more easily access their financial accounts, like ATMs and debit cards, or increases the opportunity cost of holding money (interest paid on checking accounts) affects the demand for money.
The demand curve for money shows the relationship between the quantity of real money demanded and the interest rate, which is the cost for holding money. By holding money, people are foregoing the opportunity to make income through interest earnings. When interest rates are high, you are giving up the chance to earn more income, so you become less willing to hold your wealth in cash or non-interest earning deposit accounts. The negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping.
The supply of money is fixed at whatever level the Fed has set it at. The supply curve will be a vertical line at that quantity.
If the Fed increases the money supply by:
a) open market purchase, or
b) decreasing the required reserve ratio, or
c) decreasing the discount rate,
the money supply curve will move out to the right because all of these methods will increase bank excess reserves that can be loaned. At the current nominal interest rate, this causes a surplus of money and people will buy more of everything, including bonds. The demand for bonds will increase which drives the price of bonds up. When bond prices increase, real interest rates decrease (PBONDS and ireal always move in opposite directions). Since nominal interest rate = real interest rate + expected inflation, nominal interest rates decrease also down to inom1.
If the Fed decreases the money supply by:
a) open market sale, or
b) increasing the required reserve ratio, or
c) increasing the discount rate,
the money supply curve will move in to the left because all of these methods will decrease bank excess reserves that can be loaned. At the current nominal interest rate, this causes a shortage of money and people will sell bonds to turn their bonds into money. The supply of bonds will increase which drives the price of bonds down. When bond prices decrease, real interest rates increase (PBONDS and Ireal always move in opposite directions). Since nominal interest rate = real interest rate + expected inflation, nominal interest rates increase also up to inom1.
A change in real GDP or financial innovation changes the demand for money and shifts the money demand curve. An increase in real GDP increases the demand for money and shifts the money demand curve to the right, ultimately increasing the short-run nominal interest rate.
A new financial innovation or a decrease in real GDP will decrease the demand for money and shifts the demand for money curve leftward, ultimately decreasing the short-run nominal interest rate.
In the long run, the real interest rate is determined by supply and demand in the loanable funds market. Since the nominal interest rate equals the real interest rate plus the expected inflation rate, the nominal interest rate cannot adjust to balance the demand and supply in the market for money. Instead the price level adjusts to create that balance. When the Fed changes the quantity of money, the price level changes (in the long run) by a percentage equal to the percentage change in the quantity of money (remember the equation of exchange). So the % change in M will equal the % change in P in the long run.
When the price level changes, the expected rate of inflation will change too. That will in turn change the nominal interest rate. The change in the nominal interest rate changes the opportunity cost or price of holding money, so the quantity demanded of money will increase or decrease, shown as a movement along the demand curve for money.
Quantity of Real Money
inom
MS (M1 or M2, set by the Fed)
MD
Nominal Interest Rate
Quantity of Real Money
inom
MS1
MD
Nominal Interest Rate
inom1
AFTER ireal (
MS
MONEY SURPLUS
Buy bonds (DBONDS
(PBONDS ((ireal ((inom
(Money Supply
Quantity of Real Money
inom
MS1
MD
Nominal Interest Rate
inom1
AFTER ireal (
MS
MONEY SHORTAGE
Sell bonds (SBONDS
(PBONDS ((ireal ((inom
(Money Supply
Quantity of Real Money
inom1
MS
MD1
Nominal Interest Rate
( Real GDP(
(Money Demand
MD
inom
MONEY SHORTAGE
Sell bonds (SBONDS
(PBONDS ((ireal ((inom
Quantity of Real Money
inom
MS
MD
Nominal Interest Rate
(Financial Innovation or (Real GDP(
(Money Demand
MD1
inom1
MONEY SURPLUS
Buy bonds (DBONDS
(PBONDS ((ireal ((inom
Page 10 of 10
#17P
2/28/13
Handout MACRO #18P
Exchange Rates
Just Between Friends
Foreign currency is the money of other countries, in any form and is exchanged in the foreign exchange market, like any other good. The price of one nation’s currency in terms of another currency is the nominal exchange rate.
Movements in one currency against another currency are referred to as either appreciation or depreciation. Appreciation means that the value of one currency rises against another currency and depreciation means that the value of one currency drops against another. Appreciation of the dollar means that more of a foreign currency is need to buy it while depreciation means less of a foreign currency is needed to buy it. Another way to think of it is that when the dollar appreciates it buys more foreign currency, and when the dollar depreciates, it buys less foreign currency. Automatically, when one currency appreciates, the other depreciates.
Your purchasing power is really affected by fluctuations in currency rates. Let’s say you go to Italy and you want to buy some shoes. You take
$400
with you to spend. Shoes cost
€100
(euros).
Exchange Rate
Other Way Exchange Rate
Price in Dollars
Price in Euros
Effect on You
Original
$1 = €1/2
€1 = $2
$200
You can buy 2 pairs of shoes
Dollar Appreciates (Worth More)
$1 = €1
(Buys more euros)
€1 = $1
(Buys fewer dollars)
$100
€100
$100 cheaper so you can buy 4 pairs of shoes
Dollar Depreciates (Worth Less)
$1 = €1/4
(Buys fewer euros)
€1 = $4
(Buys more dollars)
€100
$200 more expensive so you can only buy 1 pair of shoes
As the dollar appreciates, foreign goods become cheaper, and if the dollar depreciates, foreign goods become more expensive. When the dollar appreciates, foreigners cut back on their purchases of American goods, and exports will decrease and imports will increase as Americans purchase more of the now cheaper foreign goods. If the dollar depreciates, exports will increase and imports decrease, as American and foreign consumers turn away from the relatively higher priced foreign goods toward the now bargain American goods.
In the foreign exchange market, supply and demand determine the price of currency or the nominal exchange rate. But in this market, when you have one currency, let’s say dollars, and you want to exchange them for euros, you are at the same time supplying dollars and demanding euros. So factors that affect the demand for a countries currency will also affect the supply of the currency.
The quantity demanded of a currency will depend on its exchange rate. If the exchange rate rises, less quantity will be demanded and if the exchange rate falls, more will be demanded. This is represented by movements along the demand curve for currency.
SHAPE \* MERGEFORMAT
The quantity demanded of currency will be determined by two things – the exports effect and the expected profit effect. The exports effects shows how when the exchange rate is low, US exports are cheaper than foreign goods. With cheaper US exports, foreigners want to buy more US goods which are priced in dollars. So in order to pay for the increased quantity of US goods, a higher quantity of dollar currency is demanded. Conversely, if the exchange rate rises, US exports are more expensive, foreigners want to buy less US goods, and so they don’t require as many US dollars to pay for them.
The expected profits effect comes from the speculative buying and selling of currencies by currency traders. Traders wish to buy a currency when the exchange rate is low so they can sell the currency when the rate rises in the future and make a profit. Thus the quantity demanded of a currency will be higher when the exchange rate is low. Conversely, when the exchange rate is high, if traders bought the currency now, they would more likely make a loss, so the quantity demanded is low.
Changes in the demand for currency will depend on:
· World demand for US exports. An increase in world demand for US exports (for reasons other than the exchange rate like changes in foreign real national income) means foreigners will need more US dollars to pay for the higher exports. The demand curve for US dollars will shift out and to the right and the equilibrium exchange rate will increase.
SHAPE \* MERGEFORMAT
A decrease in world demand for US exports will work just the opposite and shift the demand for US dollars in to the left.
SHAPE \* MERGEFORMAT
· The differential between US interest rates and foreign interest rates. Since the market for loanable funds is a world market, when US real interest rates are higher than the world interest rate, investors will want to invest in financial assets in the US which are priced in dollars. The demand curve will shift out to the right, resulting in a higher exchange rate. Obviously, if the interest rate differential between the US and the world is negative, meaning that interest rates are lower in the US, the demand for US dollars to buy US financial assets will decrease and the demand curve will shift left.
· The expected U.S. exchange rate. If the exchange rate for the US dollar is expected to increase, traders could expect to make a profit by buying US dollars today and selling them in the future for a higher price. So the demand for US dollars today would increase. If the exchange rate was expected to fall in the future, the demand for dollars today would decrease. Note that an increase in the US exchange rate would mean a fall in the foreign currency exchange rate.
The quantity supplied of currency will also be determined by two things – the imports effect and the expected profit effect. The imports effects shows how when the exchange rate is high, US goods are more expensive than foreign goods. With cheaper foreign imports, American consumers want to buy more foreign goods which are priced in foreign currencies. A higher quantity of US dollar currency is offered to buy foreign currencies to pay for the increased imports. Conversely, if the exchange rate drops, US exports are cheaper, US consumers want to buy less imports, and so they don’t require as many US dollars to pay for foreign currency.
The expected profits effect works just the opposite as for demand. Traders wish to sell a currency when the exchange rate is high to reap a profit. Thus the quantity supplied of a currency will be higher when the exchange rate is high. Conversely, when the exchange rate is low, traders are more likely make a loss, so the quantity supplied is smaller.
Changes in the supply of currency will depend on:
· US demand for foreign imports. An increase in US demand for foreign imports (for reasons other than the exchange rate like changes in US real national income) will increase the supply of US currency as US consumers will offer more US dollars to pay for the higher imports. The supply curve for US dollars will shift out and to the right and the equilibrium exchange rate will fall.
SHAPE \* MERGEFORMAT
A decrease in US demand for foreign imports will work just the opposite and shift the supply of US dollars in to the left.
SHAPE \* MERGEFORMAT
· The differential between US interest rates and foreign interest rates. In the opposite direction from demand, when US real interest rates are higher than the world interest rate, US investors will want to invest in fewer foreign financial assets. US investors will not need to offer as many dollars to buy foreign assets, so the supply curve will shift in to the left, resulting in a higher exchange rate. Obviously, if the interest rate differential between the US and the world is negative, meaning that interest rates are lower in the US, the supply of US dollars to buy more profitable foreign financial assets will increase and the supply curve will shift right.
· The expected foreign exchange rate. If the exchange rate for foreign currency is expected to increase, US traders could expect to make a profit by buying foreign currencies today and selling them in the future for a higher price. So the supply of US dollars today would increase to pay for the purchase of foreign currency. If the foreign currency exchange rate was expected to fall in the future, the supply of dollars today would decrease as traders backed off their speculative purchasing. Note that an increase in the foreign currency exchange rate would mean a fall in the US exchange rate.
Because in this market, demanding one currency is at the same time supplying another currency
, the final impact on exchange rates will depend on both demand and supply changes in response to a factor change.
xre
Quantity of US currency
Exchange Rate
S
Qe
D
Qe1
xre
Quantity of US currency
Exchange Rate
S
Qe
D
D1
xre1
xre
Quantity of US currency
Exchange Rate
S
Qe
D
D1
xre1
Qe1
xre1
Quantity of US currency
Exchange Rate
S
Qe
D
S1
xre1
Qe1
Qe
xre1
Quantity of US currency
Exchange Rate
S
D
S1
xre1
Qe1
Page 1 of 6
#18P
3/4/13
Handout MACRO #19P
Aggregate Supply and Aggregate Demand
Good Things in a Bigger Package
Aggregate Demand
Aggregate demand is the total quantity demanded of real GDP at all price levels. The aggregate demand curve (AD) looks just like a market demand curve, sloping downward to the right, showing an inverse relationship between the price level and the quantity demanded of real GDP. Remember, real GDP = Consumption [C] + Investment [I] + Government [G] + (Exports – Imports) [NX].
The AD curve slopes downward showing the inverse relationship between price level and quantity demanded of real GDP for three reasons:
1)
The real balance effect
—when the price level falls, the purchasing power of consumers increases and they can buy more goods and services with the same amount of money. C will increase. When the price level rises, the purchasing power of consumers decreases and they can buy fewer goods and services with the same amount of money. C will decrease.
2)
The interest rate effect
—when the price level falls, consumers can save more without reducing the goods and services they purchase. When consumers save more, interest rates go down.
Simplistically, there is a supply and demand for loanable funds in an economy. The supply of loanable funds comes from savers and the demand for loanable funds comes from borrowers for investment (I). The equilibrium price of loanable funds is the interest rate—savers receive interest and borrowers pay interest.
When interest rates go down, the quantity demanded of real GDP by consumers and businesses goes up because the cost of borrowing is cheaper and they can buy more goods and services. C & I will increase. When interest rates go up, the quantity demanded of real GDP by consumers and businesses goes down because the cost of borrowing is higher and they can buy fewer goods and services. C & I will decrease.
3)
The international trade effect
—when the price level in the U.S. economy drops, U.S. goods are relatively cheaper than goods in other countries, ceteris paribus. Consumers in other countries will buy more U.S. goods and fewer foreign goods than before, so exports will increase and thus NX will increase. U.S. consumers will also buy more U.S. goods and fewer foreign goods than before, so imports will decrease and thus NX will increase.
When the price level in the U.S. economy rises, U.S. goods are relatively more expensive than goods in other countries, ceteris paribus. Consumers in other countries will buy fewer U.S. goods and more foreign goods than before, so exports will decrease and thus NX will decrease. U.S. consumers will also buy fewer U.S. goods and more foreign goods than before, so imports will increase and thus NX will decrease.
Factors Influencing Aggregate Demand
As with market demand, there are various factors or determinants that can change aggregate demand. These factors work through the components C, I, G and NX. Some factors can influence more than one component.
1)
Consumption Factors
a) Wealth—changes in wealth will change consumption. If wealth, which is simply the value of all monetary and non-monetary assets, increases then consumption will increase. When consumption increases, aggregate demand increases. The AD curve shifts outward to the right. A decrease in wealth will decrease consumption and thus aggregate demand. The AD curve will shift inward to the left.
b) Expectations of future prices and income—just like with the market demand curve, if individuals expect future prices to be higher, they will buy more now. Consumption will increase and thus aggregate demand will increase. The AD curve will shift outward to the right. If individuals expect future prices to be lower, they will wait to buy and consume less now. Consumption will decrease and thus aggregate demand will decrease. The AD curve will shift inward to the left.
If individuals expect their future income to be higher, they will increase consumption, which will in turn increase aggregate demand. The AD curve will shift outward to the right. If individuals expect their future income to be lower, they will decrease consumption, which will in turn increase aggregate demand. The AD curve will shift inward to the left.
c) Interest rate—if the interest rate falls, individuals will increase consumption, especially on consumer durables like cars and appliances. Aggregate demand will then increase and the AD curve will shift outward to the right. If the interest rate rises, individuals will decrease consumption and aggregate demand will also decrease. The AD curve will shift inward to the left.
d) Income Taxes—when income taxes go down, consumers’ disposable income goes up and consumption will increase as will aggregate demand. The AD curve will shift outward to the right. When income taxes go up, consumers’ disposable income goes down and consumption will decrease. Aggregate demand will also decrease and the AD curve will shift inward to the left.
2)
Investment Factors
a) Interest rate—if the interest rate falls, businesses will increase investment because the costs of investment projects are lower. Aggregate demand will then increase and the AD curve will shift outward to the right. If the interest rate rises, fewer investment projects will be undertaken and both investment and aggregate demand will decrease. The AD curve will shift inward to the left.
b) Expectations of future sales—if businesses expect future sales to be higher, they will gear up now to produce more. More investment projects will be undertaken and investment will increase. Aggregate demand will increase and the AD curve will shift outward to the right. If businesses expect future sales to be lower, they hold off on investment and thus aggregate demand will decrease. The AD curve will shift inward to the left.
c) Business Taxes—when business taxes go down, business profits go up and investment will increase as will aggregate demand. The AD curve will shift outward to the right. When business taxes go up, profitability goes down and investment will decrease. Aggregate demand will also decrease and the AD curve will shift inward to the left.
3)
Net Exports Factors
a) Foreign real national income—if income rises in other countries, foreigners will buy more U.S. goods and services. Exports will increase, so net exports will increase and so will aggregate demand. The AD curve will shift outward to the right. If income falls in other countries, foreigners cut back on purchases of U.S. goods and services. Exports will decrease, so net exports will decrease and so will aggregate demand. The AD curve will shift inward to the left.
b) Exchange rate—if the exchange rate of U.S. currency for other countries’ currency falls or depreciates, requiring less foreign currency for each $1, U.S. goods become relatively cheaper than before. Foreigners can buy more U.S. goods and services with the same amount of foreign currency. Conversely, foreign goods are now more expensive to Americans, as it will take more dollars to buy the same priced good. Exports will increase while imports will decrease. Net exports will rise, and thus aggregate demand increases. The AD curve will shift outward to the right.
If the exchange rate of U.S. currency for other countries’ currency rises or appreciates, requiring more foreign currency for each $1, U.S. goods become relatively more expensive than before. Foreigners can buy fewer U.S. goods and services with the same amount of foreign currency. Conversely, foreign goods are now less expensive to Americans, as it will take fewer dollars to buy the same priced good. Exports will decrease while imports will increase. Net exports will fall, and thus aggregate demand decreases. The AD curve will shift inward to the left.
Aggregate Supply
Aggregate supply is the total quantity supplied of real GDP at all price levels. Aggregate supply includes both short-run aggregate supply and long-run aggregate supply. The short run is a period of indeterminate length where supply cannot fully adjust to changes, due to some fixed factors such as technology or capital stock. The long run is a length of time where all necessary adjustments can be made in response to changes in the economy. The economy has two supply curves—an aggregate short-run supply curve and an aggregate long-run supply curve.
The aggregate short-run supply curve (SRAS) looks just like a market supply curve, sloping upward to the right, showing a positive relationship between the price level and the quantity supplied of real GDP. Costs of the factors of production are the primary determinant of supply, with labor costs being the largest component of costs for producers in the aggregate. Therefore, changes in wage rates will have a major effect on supply in the economy, but the effects are different depending on whether the change was in nominal (money) wage rates or real wage rates.
Nominal wages are real wage rates expressed at the current price level (in other words, in current dollars). The real wage rate is the equilibrium wage set by supply and demand in the labor market, at the base year price level (in other words, with inflation removed). You can calculate the real wage rate by dividing real wages by the price level. So a drop in the price level causes real wages to increase and an increase in the price level will cause real wages to fall, ceteris paribus.
When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the SRAS curve. The SRAS curve slopes upward showing the positive relationship between price level and quantity supplied of real GDP. This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, The lower real wage rate in turn increases the quantity of labor firms employ which increases the real GDP that firms produce.
Producers increase output or real GDP in the short run for three main reasons:
1)
Sticky Wages
—due to inflexibility in wages from long-term contracts and other factors, when the price level falls, firms might still be locked into a nominal wage rate. That would mean that their real wages have risen and they will cut back output and hire fewer workers. With sticky wages, a drop in the price level will result in a decrease in the quantity supplied of real GDP. An increase in the price level will cause an increase in real GDP supplied because real wages will fall when nominal wages are inflexible.
2)
Sticky Prices
—not all prices will adjust quickly. For some industries, there are costs to adjusting prices. When the price level drops, some firms will choose not to lower their prices immediately because of the cost and because they are not sure if the price level decrease is permanent or temporary. While they hold off on lowering their prices, they will not be able to sell the same level of output as before, so these firms will reduce the quantity supplied. A decrease in the price level results in a decrease in quantity supplied of real GDP, while a price level increase results in an increase in quantity supplied of real GDP.
3)
Misperceptions
—if producers and workers can’t tell if changes in prices and wages are real or nominal, they will not know how to react when the price level changes. Producers may see higher prices as a signal to increase output when actually the higher prices are a result of an increase in the overall price level. Producers may increase output when in reality they should keep it constant, or even decrease production. In the same way, workers can’t tell if higher wages are the result of an overall price increase or if real wages have risen. Due to the confusion, when price levels increase, output will increase, until things become clearer. When price levels fall, output will fall until producers and workers can tell which type of price change has occurred—real or nominal.
Factors Influencing Short Run Aggregate Supply
As with market supply, there are various factors or determinants that can change aggregate supply. Basically, anything that increases costs to producers will decrease supply and anything that reduces costs to producers will increase it.
1)
Money Wage Rates
—changes in money wage rates have a major impact on the costs of producers, and thus are a major influence on short run aggregate supply. If money wages decrease, supply will increase and the SRAS will shift outward to the right. If money wages increase, supply will decrease and the SRAS will shift inward to the left.
2)
Prices of Non-labor Inputs
—changes in other inputs to the production process have an impact on the costs of producers. If prices of non-labor inputs decrease, supply will increase and the SRAS will shift outward to the right. If prices of non-labor inputs increase, supply will decrease and the SRAS will shift inward to the left.
3)
Supply Shocks
—there can be adverse or beneficial natural or other supply shocks to the economy. Any supply shock that decreases costs will increase supply and the SRAS will shift outward to the right. Any supply shock that increases costs will decrease supply and the SRAS will shift inward to the left.
Short-run aggregate supply changes and the SRAS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the SAS curve leftward.
Short Run Equilibrium
Aggregate demand and short run aggregate supply interact to establish an equilibrium price level and quantity of real GDP, just like in a market.
Any change in aggregate demand or short run aggregate supply will change the short run equilibrium, just like in the market.
Long Run Aggregate Supply
In the long run, aggregate supply is simply the level of potential GDP — real GDP produced at full employment or when the unemployment rate is at its natural level. Only frictional and structural unemployment is occurring and there is no cyclical unemployment. The long run aggregate supply (LRAS) is a vertical line at the level of GDP associated with potential GDP, also known as natural real GDP (QN). LRAS represents the output the economy produces when all adjustments have taken place and there are no more inflexibilities or misperceptions.
When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along the LRAS curve. In the long run, the money wage rate and other resource prices change in proportion to the price level. So moving along the LRAS curve both the price level and the money wage rate change by the same percentage.
LRAS illustrates the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP and shows that potential GDP does not depend on the specific price level. Potential GDP increases when the full employment quantity of labor increases, labor productivity increases, the quantity of capital increases, or technology advances. When potential GDP increases, both long-run and short-run aggregate supply increase, and the LRAS and SRAS curves both shift to the right. A decrease in potential GDP would shift both LRAS and SRAS to the left.
Changes in the price level have no effect on potential GDP so the LRAS does not shift when the price level changes. Price level changes move along the LRAS while changes in potential GDP move the whole LRAS curve.
And Then Unemployment
Changes in aggregate demand or aggregate supply also change the unemployment rate. If real GDP rises, from an increase in AD or SRAS, more workers are needed to produce the higher output. Thus the unemployment rate will drop. If there is a decrease in AD or SRAS, workers will be laid off, and the unemployment rate will rise.
ie
Equilibrium interest rate
Interest Rate (i)
S
Qe
Equilibrium quantity exchanged in the market
D
Loanable Funds
Pe
Short run equilibrium price level
Price Level
SRAS
Qe
Short run equilibrium real GDP
AD
Real GDP
Short run equilibrium
Price Level
LRAS
Potential GDP (QN)
U=UN
Page 2 of 8
#19P
3/19/13
Handout MACRO – #20P
Three States of the Economy
Too Hot, Too Cold, Just Right
In the short run, aggregate supply slopes upward to the right showing the positive relationship between price level and quantity supplied of real GDP. In the long run, aggregate supply is simply the level of potential real GDP produced at full employment or when the unemployment rate is at its natural level.
The economy can be in any of three states: a recessionary gap, an inflationary gap, or in long-run equilibrium.
· A recessionary gap occurs when, at its short run equilibrium, the economy is producing less than the natural real GDP.
In a recessionary gap, the quantity of real GDP being produced is below the full employment level of output, which means that unemployment is higher than its natural rate. There is a surplus of labor in the labor market.
· An inflationary gap occurs when, at its short run equilibrium, the economy is producing more than the natural real GDP.
In an inflationary gap, the quantity of real GDP being produced is above the full employment level of output, which means that unemployment is lower than its natural rate. There is a shortage in the labor market.
· Long run equilibrium occurs when, at its short run equilibrium, the economy is producing the same level of output as the natural real GDP.
In long run equilibrium, the quantity of real GDP being produced is the same as the full employment level of output (potential GDP), which means that unemployment is at its natural rate. The labor market is also in equilibrium.
Price Level
LRAS
QN
Natural Real GDP at full employment
(Potential GDP)
AD
Real GDP
Long run equilibrium
SRAS
Pe
Price Level
LRAS
Qe
AD
Real GDP
Short run equilibrium
SRAS
< QN
U>UN
Pe
Real Wage
Labor Demand (Businesses)
At QN
Labor Hours
Labor Supply (Households)
Surplus of Labor
We1
We
Too High Now
Labor Demand1 (Businesses)
At Qe QL1
Less than
QN Full Employment
U QLe
At
QN Full Employment
U=UN
LRAS Price Level Qe AD Real GDP Short run equilibrium SRAS QN <
U We1 Labor Demand1 (Businesses) At Qe>QN
QL1 Greater than
QN Full Employment Price Level LRAS Qe AD Real GDP Short & long run equilibrium
SRAS QN =
U=UN Pe Real Wage Labor Demand (Businesses) Labor Hours Labor Supply (Households) QLe We Page 4 of 4 #20P 3/20/13
Handout MACRO #21 P
Classical View of the Economy
Build It and They Will Come
Classicists believe the economy will fix itself, based on Say’s Law. That law states that supply creates its own demand and production will create sufficient demand to purchase all goods and services produced. The supplying of goods is simultaneously the demanding of other goods. Aggregate supply (AS) will always equal aggregate demand (AD). Why would someone produce more than they would consume? In order to trade it for something else they want being produced by someone else. This is how the production of a good creates a demand for other goods.
According to the classicists, Say’s Law works in both a barter and money economy. In a money economy, producers receive money for the goods they produce. But they don’t have to spend all the money they receive on other goods—they can save it: savings equals disposable income minus consumption. That would seem to mess up Say’s Law—supply of goods might not create sufficient demand for all goods and services produced because part of the money stream would leave the consumption stream. The classicists’ answer to the Say’s Law dilemma is to assume flexible interest rates. If there is a decrease in consumption (C) with a corresponding increase in savings, the supply of loanable funds will increase. That, of course, drops the interest rate. With a lower interest rate, borrowers increase the quantity of loanable funds demanded for investment. So in our GDP equation, C + I + G + NX = GDP, the classicists state that through lower interest rates, when C goes down, I goes up. Or when C goes up, higher interest rates will cause I to go down. Everything will still stay in balance with SRAS still equaling AD. Classicists also assume that prices and wages are fully flexible and can adjust to changes in the economy.
The Self-Regulating Economy Under these assumptions, the economy is self regulating. In other words, if things get out of whack, the economy will naturally move back to equilibrium, on its own.
Suppose aggregate demand decreases. There is now a recessionary gap, output is lower than natural real GDP and there is a surplus in the labor market. The surplus causes both real and money wages to fall.
As wages fall, reducing costs, the SRAS curve moves out, increasing output closer to the natural real GDP level. The price level decreases and the quantity demanded of real GDP increases. The same process will continue until output equals natural real GDP.
Suppose there is an increase in aggregate demand. There is now an inflationary gap, output is higher than natural real GDP and there is a shortage in the labor market. The shortage causes real and money wages to rise.
As wages rise, increasing costs, the SRAS curve moves in, decreasing output closer to the natural real GDP level. The price level increases and the quantity demanded of real GDP decreases. The same process will continue until output equals natural real GDP.
In both cases, the economy moves back to the long run equilibrium level of output at the natural real GDP level. However, the price level will be different. In the case of the recessionary gap, the price level will be lower after all adjustments in the long run. In the case of the inflationary gap, the price level will end up higher in the long run.
Inflationary Gaps
So, in a self correcting economy, when there is an initial change in aggregate demand, the AD curve will shift right or left. In the case of an increase in aggregate demand, we see an inflationary gap.
In the short run, QE > QN , U < UN and P has increased. Now that the economy is in an inflationary gap, the economy begins to correct itself in the long run through the labor market. Because U < UN, there is a shortage in the labor market which exerts upward pressure on wages. As wages rise, so do costs for producers so there is a decrease in SRAS and it moves left. The process continues until the economy is back at full employment level of real GDP.
The economy ultimately ends up at long run equilibrium at the natural rate of unemployment, full employment level of real GDP, but at a higher price level (inflation).
Recessionary Gaps
In the case of a decrease in aggregate demand, we see a recessionary gap.
In the short run, QE < QN , U > UN and P has decreased. Now that the economy is in a recessionary gap, the economy begins to correct itself in the long run through the labor market. Because U > UN, there is a surplus in the labor market which exerts downward pressure on wages. As wages fall, so do costs for producers so there is an increase in SRAS and it moves right. The process continues until the economy is back at full employment level of real GDP.
Fiscal Policy Choices Fiscal policy, or what actions the government should take when the economy is not at full employment, for the classicists is fairly simple: do nothing to interfere with the natural economic processes. This public policy of non-interference is known as lassez-faire. If the economy will regulate itself, any interference by the government will just get in the way. Classicists rely on the invisible hand.
Long Run Aggregate Supply Long-run aggregate supply is associated with the institutional PPF and potential GDP. The physical PPF shows possible output in the economy given the physical restraints of finite resources and the current state of technology. The institutional PPF shows the possible output including any institutional constraints. An institutional constraint is anything that prevents the economy from achieving the maximum real GDP that is physically possible, such as laws like minimum wage or the normal structure of the economy. For example, a major cause of the difference between the physical and the institutional PPF is job search time for frictional and structural unemployment. This is normal to the economy and means that 100% of all labor resources will never be employed—the norm is for the economy to operate at its natural unemployment rate. So the institutional PPF will always be less than the PPF. Anything that increases the PPF and institutional PPF, such as economic growth or an increase in resources and/or technology, will increase both short-run aggregate supply and long-run aggregate supply. Both SRAS and LRAS curves will shift right, reflecting the fact that the economy now has a higher level of potential GDP and can produce a higher level of real GDP in both the short run and the long run. When SRAS and LRAS shift, a new long-run equilibrium is established for the economy. QN increases and the price level drops. ie
Loanable Funds
Interest Rate (i)
S
Qe
D
S1
ie1
Qe1
Real Wage
Labor Demand (Businesses)
At QN
Labor Hours
Labor Supply (Households)
Surplus of Labor
We1
We
Too High Now
Labor Demand1 (Businesses)
At Qe QL1
Less than
QN Full Employment
U QLe
At
QN Full Employment
U=UN
Price Level
LRAS
Qe1 AD2
Real GDP
Short run equilibrium
SRAS1
QN
P1
P2
AD1
SRAS2
Real Wage Labor Demand (Businesses) Labor Hours Labor Supply (Households) Shortage of Labor
We1 Labor Demand1 (Businesses) At Qe>QN
QL1 Greater than
QN Full Employment Price Level LRAS Qe AD2 Real GDP Short run equilibrium SRAS1
QN
P1 P2 AD1 SRAS2 Price Level Qe AD1 Real GDP Short run equilibrium SRAS
QN P1 P AD
Short Run:
(AD ( (P (QE>QN (U Inflationary Gap
LRAS Long run equilibrium
Price Level Qe AD1 Real GDP Short run equilibrium SRAS QN P1 P2 SRAS1 Long Run:
Labor shortage ( (Wages ( (Costs ( (SRAS to QN ( (P (QE=QN (U=UN
Long Run Equilibrium
LRAS Price Level LRAS Qe AD Real GDP Short run equilibrium SRAS QN P P1 AD1 Short Run: (AD ( (P (QE Recessionary Gap
Long run equilibrium Price Level LRAS Qe SRAS1 Real GDP Short run equilibrium SRAS QN P2 P1 AD1 Long Run: Labor surplus ( (Wages ( (Costs ( (SRAS to QN ( (P (QE=QN (U=UN
Long Run Equilibrium Institutional PPF U=UN
Physical
PPF
QN Price Level LRAS Real GDP SRAS QN P AD Institutional PPF U=UN QN QN1
Price Level LRAS Real GDP SRAS QN P AD LRAS1
SRAS1 QN1 P1 Page 7 of 7 #21P 3/20/13
Handout #22P
Keynesian View of the Economy
Takes a Licking But Won’t Keep Ticking
John Maynard Keynes challenged the beliefs of the classicists. Based on the evidence of the Great Depression, he felt that the economy was basically unstable, for a number of reasons. 1) Interest rates do not balance savings and investment—Keynes felt that changes in the interest rate would not necessarily cause changes in saving to be exactly offset by an equal change in investment. In this case, aggregate demand will not automatically equal aggregate supply, a necessary assumption for the classicists. Total Expenditures (TE) = C + I + G + NX. If savings increase, C will fall, ceteris paribus. If lower interest rates from the increased savings do not cause I to rise by the same amount that C dropped, total expenditures will end up lower than before. If output equaled TE at the start, then now aggregate supply is greater than aggregate demand. Keynes believed that savings would not necessarily change if interest rates changed—he felt that savings levels were more responsive to changes in income. Keynes also felt that investment was responsive to interest rates but there were other factors such as expected profits, technology changes and innovations, with even larger impacts on changing investment levels. So if interest rates dropped but profits from a possible investment project were expected to be low, there might not be any increase in investment, even with lower interest rates.
2) Wage rates are inflexible downward—Keynes felt that surpluses in the labor market would not lead to lower wages. He felt that wages were inflexible downward. Without falling wages, the price level would not fall, and no increase in real GDP demanded would be forthcoming. In other words, the economy could not fix itself and can be stuck in an recessionary gap. 3) Prices are not always flexible downward —Keynes felt that anti-competitive forces in the economy could prevent prices from falling. Again, if the price level could not fall sufficiently, no increase in real GDP demanded would be forthcoming and again, the economy could not fix itself.
Keynesian or Income-Expenditure (TE-TP) Model of the Economy The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and services. As a result in this model, the price level is fixed Total Expenditures (TE) = C + I + G + NX. Of these components, the consumption function is the most important. Keynes developed a consumption function to analyze how consumption responds to changes. The consumption function is: Autonomous consumption (C0) is a constant level of consumption, representing a basic level of consumption that does not depend on disposable income. Autonomous consumption changes from factors other than disposable income. The marginal propensity to consume is a number between zero and one, representing the portion of each additional dollar of disposable income that is spent on consumption. It is the ratio of ∆ in consumption to ∆ in disposable income, or ∆C/∆Yd. And, since disposable income is either spent or saved, 1-MPC is the MPS, or marginal propensity to save. It can be calculated as the ratio of ∆ in saving to ∆ in disposable income. Working through the consumption function, consumption can be increased by increasing any of its components: C0, MPC, or Yd. However, increasing C0 will increase only the level of consumption, while increasing MPC or Yd will also change the level of saving. There is also the average propensity to consume (APC) which shows the portion of total (not additional!) disposable income spent on consumption. It is the ratio of total consumption to total disposable income, or C/Yd. And again, since disposable income is either spent or saved, 1-APC is the APS, or average propensity to save, or S/∆Yd. The simple Keynesian model uses the consumption function to create a total expenditure function and curve, based only on domestic spending, excluding the foreign sector (though your book includes imports in its discussion). The simple model also assumes a constant level of I and G. TE = C0 + (MPC)(Yd) + I + G
Graphically, the TE curve is upward sloping to the right. *Aggregate planned expenditures (AE) in your book The total production curve in the Keynesian model is a 45o line which represents all the points where TE or AE = Real GDP.
The Three States of the Economy
Using the Keynesian model, in this closed economy:
· total expenditures (TE) can be equal to total production (TP) · total expenditures (TE) can be less than total production (TP)
· total expenditures (TE) can be greater than total production (TP)
In the last two states (disequilibrium), the economy would move toward the first state (equilibrium). Business inventories would be the mechanism for the economy’s adjustment. Producers hold some level of business inventory that is optimal. In the state of the economy where TE < TP, firms will notice that their inventories are growing. Since they wish to keep the optimal level of inventory on hand, they will cut back total production. As TP falls, it will become closer to the level of TE. This process will continue until TP = TE, where firms will reach their optimal inventory and maintain TP at that level. No incentive to change will remain, ceteris paribus. In the state of the economy where TE > TP, firms will notice that their inventories are falling. Since they wish to keep the optimal level of inventory on hand, they will increase total production. As TP rises, it will become closer to the level of TE and again, this process will continue until TP = TE, where firms will reach their optimal inventory and maintain TP at that level. No incentive to change will remain, ceteris paribus.
The TE/TP model will only show short run equilibrium unless the level of full employment output is known (include all labels if asked to draw the TE/TP model).
Note that there is nothing to relate the equilibrium point of TP=TE to the full-employment real GDP level. In this framework, the economy could easily be in a recessionary gap, at an output less than full employment output, with no automatic force operating to push output higher. Unless you know where QN is, do not draw it on the graph of the TE/TP model. If the economy is in a recessionary gap, Qe is less than Qn – that would show on the TE/TP model graph with the vertical line for Qn drawn to the right of the intersection of TP and TE, like in the graph below. That shows that Qe is less than Qn and which mean that unemployment was greater than Un. If the economy is in an inflationary gap, Qe is greater than Qn – that would show on the TE/TP model graph with the vertical line for Qn drawn to the left of the intersection of TP and TE, like in the graph below. That shows that Qe is greater than Qn which would mean that unemployment was less than Un. If the economy is in long run equilibrium, Qe is equal to Qn – that would show on the TE/TP model graph with all the lines meeting at the same point. The vertical line for Qn is drawn at the intersection of TP and TE, like in the graph below (include all labels). There is an underlying assumption in the Keynesian model that there are idle resources available at each expenditure round. If there were no idle resources to bring into production, real GDP could not increase. In that case, the autonomous spending increase would only increase prices.
Because the Keynesian model assumes prices are constant until full employment output is reached (changes are real, not nominal below QN) and idle resources exist at each expenditure level, any change in aggregate spending changes output only. In the AD/AS model, with the assumption of constant prices and idle resources, Keynes’ theory shows an increase in aggregate demand before full employment output is reached (meaning there are idle resources) increases QE but not price.
the economy is already at full employment level of output, an increase in aggregate demand will only increase prices, not output.
Disposable Income
Consumption
C
Slope=MPC<1
C0
C0
Real GDP
Total Expenditures (TE)*
TE*
Slope=MPC<1
G
I
C0 Real GDP Total Expenditures (TE)
Slope= 1
TP (TE=Real GDP)
45o
Real GDP TE, TP
$
TE
TP QE
TE=TP
Real GDP TE, TP
$ TE TP QE $TE=$TP
TE=TP $TE > $TP
$TE < $TP
Falling inventories, increase output
Rising inventories, decrease output
Real GDP TE, TP TE=C+I+G
TP
C0+I+G
TE=TP QE Slope=MPC
45o Real GDP TE, TP TE TP QE <
TE=TP QN
U>UN
Real GDP TE, TP TE TP QE TE=TP QN <
U Real GDP TE, TP TP TE QN = QE
U=UN
TE=TP AS
Price Level
QE QN Natural Real GDP at full employment
AD
Real GDP AD1
QE1
PE
AS Price Level QN AD Real GDP AD1 PE1
PE Page 10 of 10 #22P MAC 3/26/13
Handout#23P
Multiplier
And So On, And So On, And So On . . . .
The multiplier is a key concept in the Keynesian view of the economy. The multiplier shows how a change in spending works its way through to changing real GDP.
There are two kinds of spending—autonomous which is independent of income or real GDP, and induced spending which is related to changes in income or real GDP. Looking at the consumption function, C0 is an autonomous element and (MPC)(YD) is an induced element, because it changes with income. Autonomous consumption, investment or government spending changes with real GDP held constant. After autonomous spending changes, what then happens to real GDP? The multiplier shows that a change in autonomous spending results in an even larger change in real GDP. The multiplier (m) is 1 divided by (1-MPC) or 1-MPC
It can also be thought of as ∆ Real GDP or Y/∆Autonomous Spending..
The multiplier is used to predict the change in real GDP.
∆Real GDP = m * ∆Autonomous Spending
It works like this. Suppose the MPC is .75. Suppose there is a $100 increase in government spending (autonomous). Income or real GDP will increase by $100. The $100 increase in income will cause an increase in induced consumption of $75 (MPC of .75 times ∆YD of $100). The $75 increase in consumption is an increase in income of $75. That increase in income causes an increase in induced consumption of $56.25 (MPC of .75 times ∆YD of $75). The $56.25 increase in consumption is an increase in income of $56.25. That increase in income causes an increase in induced consumption of $42.19 (MPC of .75 times ∆YD of $56.25). And so on, and so on and so on.
The net result will be a total increase in real GDP of $400 [(1/(1-.75)) * $100]. The multiplier is 4 in this case. Graphically, you can see the larger increase in real GDP compared to the increase in autonomous spending. First, let’s look at the multiplier in the TE/TP model. The TE curve shifts up by the change in autonomous spending. When that happens, the equilibrium moves from A to B. Real GDP increases by an amount equal to the multiplier times the change in autonomous spending, from Q1 to Q2. If you use the numeric example above with an MPC of .75, RGDP at $2000, and an increase in G of $100, it would look like If you know how much you need real GDP to increase in the case of a recessionary gap, you can calculate how much the change in G or taxes needs to be to get the economy back to the full employment level of output. The change in G, which is autonomous spending, would come from dividing the necessary change in real GDP by the multiplier. In the above example with an MPC of .75, if you knew that the shortfall of real GDP was $600, you could divide $600 by the multiplier of 4 and know that you had to increase government spending by $150. The multiplier of 4 times the $150 increase in autonomous G would ultimately increase real GDP by the $600 you need to get back to full employment level of output. The government could also try to increase TE by lowering taxes to increase consumption which would be considered induced consumption since Yd is changed. However, this change is not autonomous like a change in government spending—it affects induced spending instead by changing disposable income. In this case, it is important to take into account the MPC. So now you would take the change you need (shortfall/multiplier) and divide by the MPC to see how you need to change taxes. This will always be a larger amount than the change in government spending. In our example, you would divide the needed change of $150 by .75 and that tells you that you would need to lower taxes by $200. The lower taxes would increase disposable income by $200 and consumers would spend .75 of that to get the necessary $150 increase in induced spending. The multiplier works exactly the same when the economy is in an inflationary gap. Let’s say that the MPC is .8 and the economy is in an inflationary gap of $1000. You would divide $1000 by the multiplier of 5 and know that you had to lower government spending by $200. Or, you could increase taxes by $200 divided by .8, or $250, to decrease C by $200 you need. Two important things to note about the multiplier in reality, not theory. First, the change in real GDP takes time to work its way through. It doesn’t happen immediately. Second, remember the underlying assumption that there are idle resources available at each expenditure round. With no idle resources to bring into production, real GDP could not increase.
Keynes’ TE/TP model focuses on the short run. When firms find their inventories changing in an unexpected fashion, they change their production not their prices. But eventually they also change prices. To study the determination of the price level and real GD, we have to use the AS-AD model. The AD curve is related to the TE curve. The TE/TP model and the multiplier tell us how far the AD curve shifts when autonomous expenditure changes. The TE curve shows how aggregate expenditure depends on real GDP (through the effects of disposable income), other things remaining the same. The AD curve shows how equilibrium aggregate expenditure depends on the price level, other things remaining the same. A change in the price level changes autonomous expenditure, which shifts the TE curve, generates a new level of equilibrium expenditure, and creates a new point on the AD curve. A change in autonomous expenditure at a given price level shifts the TE curve, generates a new level of equilibrium expenditure, and shifts the AD curve by an amount equal to the change in autonomous expenditure multiplied by the multiplier. Suppose the price level increases from P1 to P2. The real balance, interest rate and international trade effects show that a rise in the price level decreases consumption expenditure. On the simple TE/TP model (left), autonomous expenditures such as C0, I and G will decrease and cause the TE curve to shift down, and real GDP decreases from Q1 to Q2. Changes in expenditures will shift both the TE curve and the AD curve. Suppose the economy is at full employment level of output and G increases from G1 to G2. On the simple TE/TP model, the TE curve will shift up by the amount of the increase in G, and real GDP increases from QN to Q1 as the change in G is multiplied. On the AD/AS model, the change in G shifts the AD curve out by the increase in G and then the AD moves further out to Q1 as the multiplier takes effect, at a constant price level PE. But the price level will begin to rise as a response to the increase in AD, moving to P1 and with the rise in price level, the quantity demanded of real GDP will drop to Q2 in an inflationary gap. The multiplier is smaller once price level effects are taken into account. The more that the price level changes (the steeper the SRAS curve), the smaller the multiplier in the short run. With the rise in the price level and corresponding decrease in quantity demand of real GDP, TE will decrease, shifting lower in the TE/TP model. In the long run, as the economy moves back to full employment level of output in the AD/AS model, increasing the price level again, the TE curve will move down to its original point. In the long run, the multiplier is zero. A
B
Change in autonomous spending such as G or I
Real GDP
TE, TP
$
TE 2
TP Q2
Q1
TE1
Change in real GDP
�
greater than change in spending
� (G $100
Real GDP TE, TP
$ TE2
TP
$2400
$2000
TE1 (G $150
Real GDP TE, TP TE2 TP QN=$2600
QE=$2000
TE1 $600
(C $150
BY (T $200
Real GDP TE, TP TE2 TP QN=$2600 QE=$2000 TE1 $600 (G $200
Or
(C $200
BY (T $250
Real GDP TE, TP TE1 TP QN=$2000
QE=$3000
TE2 $1000
Real GDP TP TE2 TE1 TE/TP Model
Q11
Q2 C01 at P1
C02 at P2
TE, TP Real GDP AD1
AD/AS Model
Q2 Q1 P1 P2 Price Level
TE
Real GDP TP TE1 TE/TP Model QN1
Q1 G2
G1
TE, TP Constant PE
Real GDP AD
Q1 QN
Constant PE When prices adjust P1
Price Level AD1 multiplied
SRAS
LRAS
ΔG
Q2 AD/AS Model Real GDP TP TE1 TE TE/TP Model QN1 Q1 G2 G1 TE, TP Constant PE TE2 Q2 Page 5 of 5 #23P MAC 3/26/13
Handout #24 P
Fiscal Policy
Mr. Fix-It
So now let’s look at government’s tinkering with the economy. Fiscal policy is when the government uses its spending or taxes to deliberately smooth out the macroeconomic fluctuations of the business cycle or achieve other economic goals such as stable price, low unemployment, and economic growth. · Expansionary fiscal policy tries to raise aggregate demand (AD) or total expenditures (TE). An increase in government spending (G) would increase AD/TE. A decrease in taxes would raise disposable income which would increase consumption (C), which in turn would increase AD/TE. This type of fiscal policy would be used for a recessionary gap. · Contractionary fiscal policy tries to decrease raise aggregate demand (AD) or total expenditures (TE) by reducing government spending (G) or raising taxes which lowers disposable income and decreases consumption (C), which in turn would increase AD/TE. This type of fiscal policy would be used for an inflationary gap.
There two other ways to look at government fiscal policy. The first is automatic fiscal policy. This happens when government spending automatically contracts without any action having to be undertaken by anyone. The best example of this is when a recession starts to kick in, workers lose their jobs. The workers go to the unemployment office and file unemployment claims for benefits. The increase in benefits automatically increases government spending which is precisely the expansionary fiscal policy that you would want to apply. The second is discretionary fiscal policy which requires someone in government to do something to initiate and implement policy action. In general, this means Congress has to act because they control government expenditures through the budget and taxes. There are three states of the government budget: surplus, deficit and balanced. A government surplus exists when government tax revenues and other income exceeds government expenditures. There is an excess of funds left over and government enters the loanable funds market as a lender. A budget deficit occurs when government spending outstrips the money it receives, and there is a shortage of funds. Government will operate as a borrower in the loanable funds market to cover its budget shortfall. When the budget is balanced, money in will equal money out for the government. In recent times, the US government had operated “in the red” by running deficits. Continual deficits have added to the growing public debt or what the government owes its creditors, now exceeding $16.7 trillion. This situation creates a generational imbalance where the current generation is enjoying lower taxes and benefits while passing off the obligation to fully cover those benefits to future generations. There are two categories of budget deficits, structural and cyclical. Structured deficits are planned to be deficits. This happens when Congress deliberately passes a budget where expenditures exceed revenues. This type of deficit would occur even if the economy were operating at full employment. A cyclical deficit is the part of the deficit that occurs when the economy takes a downturn in economic activity, adding more to the total. So the total deficit equals the structural plus the cyclical deficit. There are three government multipliers that operate on fiscal policy changes.
· The expenditure multiplier is the multiplication effect of a change in government spending on goods and services (G) on aggregate demand or total expenditures. When G increases, real GDP (Y) increases, which in turn increases consumption (C) as the spending works its way through the economy. If the expenditure multiplier is 5, then a $100 increase in G, will raise AD/TE by $500. · The autonomous tax multiplier is the multiplication effect of a change in taxes on aggregate demand or total expenditures. A decrease in taxes will raises disposable income (YD) which in turn raises consumption (C) and thus AD/TE. However, this fiscal policy multiplier will have a smaller effect on AD/TE than the expenditure multiplier because of the marginal propensity to consume (MPC). Since the change in YD will be multiplied by the MPC which is less than 1, AD/TE will not increase by the whole amount of the tax decrease. If the MPC is .8, the tax multiplier will be 5 calculated by [1/(1-MPC)]. So if taxes are lowered by $100, YD will increase by $100 and C will increase by .8*$100, or $80. Then AD/TE will rise by $80*5 or $400. Note this is less than the $500 increase in AD/TE that the expenditure multiplier produced on $100 change in government spending. · The balanced budget multiplier is the multiplication effect on aggregate demand or total expenditures from a simultaneous equal change in government spending and taxes that does not crease a surplus or deficit. It will have a small positive or negative effect because the expenditure multiplier has a larger impact than the offsetting tax multiplier. If fiscal policy increased both G and taxes by $100, the increase in G would result in +$500 in AD/TE while the increase in taxes would yield -$450. So the net effect would be +$50.
Expansionary fiscal policy applied to a recessionary gap in the AD/AS model would look like the graph below. First, the initial fiscal policy would increase aggregate demand, shifting the AD curve to the right. As the multiplier effects build, the AD curve shifts all the way out to return the economy to full employment. Contractionary fiscal policy applied to an inflationary gap in the AD/AS model would work the other way. First, the initial fiscal policy would decrease aggregate demand, shifting the AD curve to the left. As the multiplier effects build, the AD curve shifts all the way in to return the economy to full employment. If you know the amount of the gap of real GDP that is needed to bring the economy to full employment, you can calculate the size of the fiscal policy you need to implement. The dollar amount will be different if changing government spending is the method used or if tax changes are used.
In the TP/TP model, expansionary fiscal policy applied to a recessionary gap in the economy would look like the graph below. If the economy is in a recessionary gap, Qe is less than Qn and the TE line should shift up to the point where TP=TE=QN. Let’s say that the gap in Real GDP is $5000. Using the MPC of .8 and multiplier of 5, we can calculate the change in G that is need to bring the economy back to full employment by dividing the gap, $5000 by the multiplier 5. That means we need to increase government spending by $1000 so when it is multiplied by 5 , we will get the $5000 we need to close the gap. In the TP/TP model, contractionary fiscal policy applied to an inflationary gap in the economy would look like the graph below. If the economy is in an inflationary gap, Qe is greater than Qn and the TE line should shift down to the point where TP=TE=QN. Let’s say that the gap in Real GDP is again $5000. Using the MPC of .8 and multiplier of 5, we can calculate the change in taxes that is need to bring the economy back to full employment by dividing the gap, $5000 by the multiplier 5 and then dividing the result by the MPC. The tax increase would thus need to be $1250, as compared to the $1000 ΔG above, A increase in taxes of $1250 would give a decrease in consumption of .8*$1250 or $1000 which is what we need to close the $5000 gap with a multiplier of 5
There are real world problems with implementing fiscal policy, besides the fact that precise knowledge of what should be done is not achievable. There are five “lag” problems that really get in the way of effectively correcting the economy’s movements
· The data lag: Policymakers are not aware of changes in the economy as soon as they happen because the data is not yet available. Data statistics take time to accumulate and develop to measure what is happening in the economy.
· The wait-and-see lag: After the data indicates a change in the economy, policymakers will usually wait to see if the change is temporary or ongoing. Data can bounce up and down from month to month.
· The legislative lag: Once policymakers decide that there has been a change in the economy, a decision has to be reached on whether or not to implement fiscal policy. If policy is to be implemented, a particular plan of fiscal policy has to be proposed (President or Congress), politically debated, amended, and passed by Congress. This can take many months.
· The transmission lag: After the fiscal policy is passed, it has to move through the bureaucratic process to be implemented. This might include bids, design, contracts etc. and could take quick a long time—maybe years.
· The effectiveness lag: After the fiscal policy is actually implemented, it takes time to work its way through the economy.
The net effect of these lags is that by the time the fiscal policy actually takes effect, the economic problem 1) may no longer exist, 2) may not exist to the degree it did, or 3) may have changed altogether to another problem. So the fiscal policy may actually cause a new problem such as over-correction.
One other issue with fiscal policy is crowding-out. Crowding-out occurs when an action by the government, quite often taken to implement fiscal policy, causes an opposite movement in the private sector. For example, when government spending (G) increases, any budget deficit will also increase, and the government enters the loanable funds market as a borrower. Real interest rates are driven up to a higher level because of the increase in the demand for loanable funds. The increase in the real interest rate in turn, decreases both consumption and investment which offsets the expansionary effects on real GDP from the increase in government spending. Another example would be if government spends more on building public libraries, private sector spending on books could decrease, causing consumption to fall. There can be no crowding-out, partial crowding-out, or complete crowding-out. With no crowding-out, fiscal policy has its full impact on real GDP. Partial crowding-out causes fiscal policy to have a smaller impact on real GDP because of the offset by the private sector. Complete crowding out results in no change in real GDP when fiscal policy is implemented by the government. For a recessionary gap, you can see the three different effects of crowding-out below.
In an inflationary gap, just the opposite occurs.
Fiscal policy can have effects on the supply side of the economy as well as on aggregate demand. Imposing a tax on income—labor, interest, and capital—has an effect on the economy in several ways. First, a tax on labor income reduces the supply of labor. That reduction in the supply of labor causes potential GDP to decrease and reduces output in the short-run and long-run. The before-tax wages rise but the after-tax wages fall—referred to as the income tax wedge. Since employers are paying the higher before-tax wages, they employ less labor and since workers are only receiving the lower after-tax wage, less labor is supplied. A decrease in potential real GDP along the production function will shift the LRAS and the SRAS into the left causing a decrease in QN and an increase in the price level.
SHAPE \* MERGEFORMAT Taxes on consumption add to the tax wedge. Taxes on consumption raise the prices worker have to pay for goods and services which is equivalent to a drop in the real wage rate. The higher are the taxes on goods and services, the lower is the after-tax wage rate, and the lower the incentive to supply labor. Taxes on interest income and capital earnings also affect the incentive to save and invest. A tax on interest income decreases the supply of loanable funds. The leftward shift in the supply of loanable funds increases the before-tax real interest rate but also creates a tax wedge so that the after-tax real interest rate falls. Investors would pay a higher interest rate on funds borrowed and savers would earn a small amount on funds saved. Because of the tax wedge effects of taxes on employment and saving, a higher tax rate does not always result in higher tax revenues. Tax revenues are calculated by the tax rate times the tax base or earnings. But if a higher tax rate causes reduced labor hours, the tax base could actually decrease more than the increase in the tax rate and tax revenues would go down rather than up. The Laffer curve shows this relationship between tax rates and tax revenues. AD 1
(Expansionary fiscal policy)
AD 2
(After multiplier)
Real GDP
Price Level
LRAS
Qn
A D
Qe
P P1
P2
SRAS
AD1
(Contractionary fiscal policy)
AD2
(After multiplier) Real GDP Price Level LRAS Qn AD Qe P P1 P2 SRAS Real GDP TE, TP
$
TE
TP QE
$1000
(G
QN
$5000
TE1
A
B
Real GDP TE, TP
$ TE TP QE $1000 (C
From (tax $1250
QN $5000 TE1 B A Economy starts here
Govt trying to go here
AD1 (Expansionary Fiscal Policy
3
2 1 Real GDP Price Level LRAS Qn AD SRAS SRAS1
During lags, economy moves here on its own
Ends up here after economy self-corrected
4
AD2 (Smaller impact of fiscal policy with partial crowding out)
AD1 (Full impact of fiscal policy with no crowding out)
Real GDP Price Level LRAS Q1
no crowding out
AD Q3
total crowding out
out
P P1 P2 SRAS AD3
(No impact of fiscal policy with complete crowding out)
1 no private offset
2 some private offset
total private offset 3
Q2
partial crowding out
AD2 AD1 Real GDP Price Level LRAS Q1 AD Q3 P P1 P2 SRAS AD3 1 no private offset some private offset 2
total private offset 3 Q2 Higher Before-Tax Wages
Labor Hours
Real Wage Rate
LS
QL
LD
LS1
Lower Employment QL1
Lower After-Tax Wages
Income Tax Wedge
We
Real GDP Labor Hours
PF
QL Potential GDP
QL1 Lower Potential GDP1
Pe
Q
Price Level
QN D P1 QN1
SRAS SRAS1 LRAS LRAS1
Tax Revenues
Tax Rate
Maximum Tax Revenues
0%
100%
( Tax Rate ( ( Revenues
( Tax Rate ( ( Revenues Page 12 of 12 #24P MAC 3/26/13
Handout #25 P
Inflation
Up, Up and Maybe Away
Inflation is an ongoing process in which there is a broad increase in the price level and money is losing its purchasing value. Changes in the money supply cause changes in the price level. Changes in the price level can be one-time or a persistent rise in the rate at which the price level increases.
Demand-Pull Inflation A one-time demand induced price increase comes from a outward shift in aggregate demand, such as an increase in the money supply or a component of GDP—C, I, G or NX. The one-time demand induced increase will lead to an increase in aggregate demand and the economy will be in an inflationary gap—the price level will be higher, real GDP will be higher than Qn and unemployment will be lower than Un. Since the economy is self-regulating, the shortage in the labor market with U < Un will lead to wages being bid up. Higher wages lead to increased costs to producers, which in turn leads to a decrease in SRAS back to Qn. Basically, a demand-induced change leads the self-regulating economy back the full employment level of real GDP, at a higher price level.
Demand-pull inflation rises from continual outward shifts in aggregate demand which are caused by continuous increases in the money supply. Continual increases in the money supply will lead to continual increases in aggregate demand and the economy will be in repeated inflationary gaps—in repeated cycles, the price level will be higher, real GDP will be higher than Qn and unemployment will be lower than Un. Since the economy is self-regulating, the shortage in the labor market with U < Un will lead to wages being bid up. Higher wages lead to increased costs to producers, which in turn leads to a decrease in SRAS back to Qn. Basically, continuous increases in the money supply leads the self-regulating economy back the full employment level of real GDP, at higher and higher price levels—a demand-pull inflation spiral.
Cost-Push Inflation A one-time supply induced price increase comes from an inward shift in aggregate supply, such as an oil price shock.
The one-time supply shock will lead to a decrease in short-run aggregate supply and the price level will be higher, real GDP will be lower than Qn and unemployment will be higher than Un. Since the economy is self-regulating, the surplus in the labor market with U > Un will lead to wages being bid down. Lower wages lead to lower costs to producers, which in turn leads to an increase in SRAS back to Qn. Basically, a one-time supply-induced change leads the self-regulating economy right back to the full employment level of real GDP, at the original price level.
Inflation that results from an initial increase in costs is called cost-push inflation. The two main sources of increases in costs are an increase in wage rates or an increase in the prices of raw materials. Inflation occurs only if, in response to the higher price level, the force that initially decreased aggregate supply recurs so that aggregate supply continues to decrease and, at the same time, the Fed continues to increase the money supply and in turn aggregate demand—a cost-push inflation spiral.
Expected Inflation
Expectations play a large role in economic decisions. Expectations are formed in basically two ways: adaptive expectations and rational expectations. Adaptive expectations are made based on what has happened in the past. History is projected into the future. If inflation has been at 3% per year, you will expect inflation to be 3% this year and make your decisions accordingly. Rational expectations are based on adaptive expectations but include any additional knowledge available to you. Your decision is based on all relevant knowledge. If the Fed announces that it is targeting an inflation rate of 2%, you would change your forecast to a lower rate of inflation, even if the rate has been 3% for several years. When inflation is correctly anticipated, the money wage rate changes to keep up with the anticipated inflation; money wage rates are real wage rates plus expected inflation rates. So when the AD curve shifts rightward, increasing the price level, the money wage rate increases and the SRAS curve shifts leftward simultaneously If the increase in the price level is fully anticipated, then the money wage rate rises by the same percentage so that the real wage rate remains constant. There are no deviations from full employment. The magnitude of the shift in AD equals that in SRAS so that actual GDP remains equal to potential GDP and the economy moves up along the LRAS curve with no change in GDP—just a higher price level as expected. If inflation is not perfectly anticipated, the money wage rate changes but by a different percentage than the price level. As a result, the real wage rate changes and there are deviations from full employment. (Real wage rate = money wage rate/price level. If the price level increases more than expected inflation, the denominator increases more than the numerator and real wage decreases, causing firms to hire more labor and increase output. If price level increases less than expected inflation, denominator increases less than numerator and real wage increases, causing firms to hire less labor and decreasing output.) So if inflation is not correctly anticipated, there will be a movement along the SRAS and output will change. If inflation is correctly anticipated, there will not be any change in output along the SRAS. If aggregate demand grows faster than anticipated, the price level is higher than expected, real GDP exceeds potential GDP, and the economy behaves as if it were in a demand-pull inflation. If aggregate demand grows slower than anticipated, real GDP is less than potential GDP and the economy behaves as if it were in a cost-push inflation. Real GDP
Price Level
$
LRAS
Qn
AD
AD 1
SRAS
Q1
P P1
P 2
SRAS1
Price Level LRAS AD AD1
(Money supply increases)
SRAS P P1 P2
SRAS1 (demand-pull)
AD2
(Money supply increases) SRAS2
(demand-pull) P5
P4
P3
SRAS3
(demand-pull) AD3
(Money supply increases) P6
Real GDP Qn Q1 Price Level LRAS AD SRAS Real GDP Qn Q1 P P1 SRAS1 1 2 SRAS3 (cost-push)
AD Real GDP Price Level LRAS Qn AD1 SRAS Q1 P P1 P2 SRAS1 AD2 SRAS2 P5 P4 P3 AD3 P6 Real GDP Price Level LRAS Qn AD AD1 SRAS P P1 SRAS1 ADActual
Real GDP Price Level LRAS Qn AD SRAS Q1 P P1 PEXPECTED
ADExpected
EXPECTED INFLATION LOWER THAN ACTUAL INFLATION SO LOWER ( IN MONEY WAGES (SMALLER ( SRAS
SRAS1 SRAS1 EXPECTED INFLATION HIGHER THAN ACTUAL INFLATION SO BIGGER ( IN MONEY WAGES (LARGER ( SRAS
ADActual Real GDP Price Level LRAS Qn AD SRAS Q1 P P1 PEXPECTED ADExpected Page 6 of 6 #26P 4/9/13 MACRO PART 2 Handout Guide (See Handouts for Help) SECTION 9 a)-d) HO17 P2,3 SECTION 10 a)-c) HO17 P3 d) HO17 P4 e) I did in class f) HO17 P7 g) HO17 P10 SECTION 11 a) HO18 P2 b) HO18 P5 top c) HO18 ↓D↑S d) HO18 ↑D↓S SECTION 12 a) HO20 P4 top b) HO21 P4 bottom c) HO21 P5 top d) HO21 P5 bottom e) HO21 P6 top f) HO21 P7 bottom right SECTION 13 a) HO22 P6 b) HO22 P7 top c) HO22 P7 bottom d) HO23 I showed how in class e) HO23 P1 f) HO23 P4 bottom g) HO23 P3 or P4 top depending on what you did in f) h) HO23 P5 bottom 2 graphs SECTION 14 a) HO24 P1,2 b) HO24 P10 2 graphs c) HO24 P12 d) HO24 P2 e) HO24 P3 f) HO24 P4 g) HO24 P6 SECTION 15 a) HO21 P4 bottom b) HO21 P5 top c) HO27 P8 d) HO25 P2 e) HO25 P3 only move to the left, not back f) HO21 P3 g) HO27 P11 SECTION 16 a) HO26 P1 b) HO26 P2 c) HO26 P3 2 graphs d) HO26 P4 other direction (decrease) SECTION 17 a) HO27 P3 top 2 paragraphs b) HO27 P9 top and P11. Also look at HO17 for 3 methods. c) HO27 P6 and P8. Also look at HO17 for 3 methods. d) HO27 P5 bottom graph. Ripple pages 8 bottom thru 11 e) HO27 P5 top graph. Ripple pages 6 thru 8
U
At QN
At
QN Full Employment
U=UN
At QN
U
and so total expenditures or aggregate demand determines real GDP.
C = C0 + (MPC)(Yd). Or, in English, consumption equals autonomous consumption plus the marginal propensity to consume times disposable income. The MPC time Yd is called induced consumption because it depends on disposable income.
Total expenditures (TE) equal to total production (TP)
Total expenditures (TE) not equal to total production (TP)
$
$
$
$
Natural Real GDP at full employment
1
$
$
$
$
$
2
$
(Smaller impact of fiscal policy with partial crowding out)
(Full impact of fiscal policy with no crowding out)
no crowding out
total crowding out
out
(No impact of fiscal policy with complete crowding out)
partial crowding out
$
$
$
(Money supply increases)
(cost-push)
(Money supply increases)
(cost-push)
(Money supply increases)
$
$
$
