ECON 105
INTRODUCTION TO MACROECONOMICS
on this page:
~ money
~ monetary & banking policy
Barter economy - exchange of goods for other goods. There is a "want of coincidence" rather than "double coincidence".
Bank money - deposits in a bank or other financial institution. 9/10ths of all transactions. Currency - easily carried and stored, private individuals cannot create it so it's scarce.
M1- transactions money - items that are actually used for transactions. Consists of: coins, paper currency (fiat money - has no value, legal tender - must be accepted for debts), and checking accounts (funds that you can write checks on".
M2 - broad money - asset money or near-money: M1 + savings accounts in banks and similar accounts. ex: deposits in a savings account, a money market mutual fund etc. They cannot be used as means of exchange for all purposes, thus they are not transactions money.
Interest rate - amounts of interest paid per unit of time expressed as a percentage of the amount borrowed. The cost of borrowing money, measured in dollars per year per dollar borrowed. Amortization - repayment of principal (the amount borrowed).
Nominal interest rate - yield in dollars per year per dollar invested. Real interest rate - corrected for inflation, calculated as nominal interest rate minus rate of inflation.
Maturity - the length of time until loans must be paid off; Risk - safest are securities of the US government; Liquidity - liquid if can be converted into cash easily with little loss in value, illiquid if no well-established market exists.
Money's functions: medium of exchange, unit of account (unit by which we measure the value of things), store of value (allows value to be held over time).
Opportunity cost of holding money - sacrifice in interest that must occur by holding money rather than a riskier, less liquid asset or investment.
As our incomes rise, the dollar value of the goods we buy goes up, and we need more money for transactions, raising our demand for money. Transactions demand for money: other things equal, as interest rises, the quantity of money demanded declines.
Financial intermediaries- institutions like commercial banks that take deposits or funds from one group and lend these funds to other groups. They transfer funds from lenders to borrowers. In doing this, they create financial assets (like checking and savings accounts). The most important asset is bank money (checking accounts) which is primarily provided by commercial banks.
Balance sheet - statement of a firm's financial position at a points in time. Lists assets (items that a firm owns) and liabilities (that firm owes). The difference between the assets and liabilities is net worth. Reserves - item which appears on asset side, cash on hand or funds deposited by the bank with the central bank.
Rserve requirements - banks must set aside 10% of their checking deposits in reserves. This allows the Fed to control the money supply. Multiple expansion of bank deposits.
Money-Supply multiplier - ratio of the new money created to the change in reserves. For every additional dollar in reserves provided to the banking system, banks eventually create $10 of additional deposits or bank money. Defined as : change of money/ change of reserves = 1/ required reserve ratio.
Leakage - if somewhere along the chain an individual receives a check and does not leave it in a checking account. Possible excess reserves - if banks kept rather than lent the new reserves. If one of these two happens, the deposit creation departs from the 1/10 ratio.
Investments: money, savings accounts (have fixed dollar principal value and interest rates determined by short-term market interest rates), government securities (bills and bonds of government, assure repayment), equities (ownership rights to companies, yield dividends), pension funds (ownership in the assets held by companies or pension plans).
Rate of return - dollar gain from a security, measured as a percentage of the price at the beginning of the period. Capital gain or loss - increase or decrease in the value of the asset. Risk - variability of the returns on an investment.
Speculative bubble - when prices rise because people think they are going to rise in the future. Sometimes lead to economic panics.
Stock-price indexes - weighted averages of the prices of a basket of company stocks.
Efficient market theory - you can't outguess the market. It is not possible to make profits by looking at old information or patterns of past price changes. Dartboard theory of selection.
Random walk - because stock prices move in response to erratic events, they themselves move erratically.
When investing: know the investments, diversify the investments, consider common-stock index funds (minimal management and brokerage fees), match investments to risk preference.
Qualifications of the Efficient Market view: efficient market is a stable, self-monitoring state. Fw people with special flair and skills will permanently earn higher returns on their skills. Applies to individual stocks but not necessarily the entire stock market.
Federal Reserve system: 12 regional Federal Reserve Banks. Board of governors - seven members nominated by president and confirmed by Senate to serve overlapping terms of 14 years. FOMC - has 12 voting members: the 7 governors plys five of the presidents of regional Federal Reserve Banks. Chairman of the Board of Governors: Allan Greenspan. Mission of Fed: to control the money supply and credit conditions.
3 instruments of monetary policy:
1. open-market operations: Fed sells or buys government securities to lower or raise bank reserves. If in recession - Fed buys securities and loosens monetary policy, if inflation - Fed sells securities and tightens monetary policy.
2. discount-rate policy - setting the interest rate, called the discount rate, at which commercial bansk can borrow reserves from a regional Fed Bank.
3. reserve requirements - setting and changing the legal reserve ratio requirement on deposits with banks and other financial institutions. If raised, can lead to high interest rates, credit rationing, declines in investment, massive reduction in GDP and employment. Changes made sparingly because they cause too abrupt a change.
Transactions account - serves as means of payment, nontransactions account - holds funds for the future.
Sterilization - actions by a central bank to insulate the domestic money supply from international reserve flows.
Floating exchange rate - a country's foreign exchange rate is entirely determined by market forces if supply and demand (such as the US and Japan). Fixed exchange rates - countries set and defend exchange rates (Germany and France).
If Fed wanted to decrease inflation: Reserve down à money down à interest rates up à investment & consumption down à AD down à real GDP down, inflation down.
Demand for money - depends on the need to undertake transactions. Supply for money - determined by the private banking system and the nation's central bank. The intersection of the supply and demand schedules determines the market interest rate.
A tighter monetary policy shifts the SS curve to the left, raising market interest rates. An increase in the nation's output or price level shifts the DD curve to the right and increases interest rates.
Shot term rates - 3-month Treasury bills, Federal Funds rate. Long term rates - 10-year and 20-year government and corporate bonds and mortgages.
At a higher interest rate, there would be excessive money balances. People would get rid of their excessive money holdings by buying bonds, thereby lowering market interest rates towards the equilibrium. vv.
Money up --> interest rates down --> I, C, X up --> AD up --> GDP up and Potential output up.
As wages and prices adjust, the AS curve tends to be near-vertical in the long run. Monetary expansion will raise prices and nominal GDP without real affect on real GDP. (money is neutral).
AD - determined by exogenous or autonomous factors (investment and net exports and government policies). Governments take responsibility for moderating the swings of the business cycle.
Economic growth = expansion of a country's potential GDP or national output. It occurs when a nation's PPF shifts outward. Close concept - growth rate of output per person, which determines the country's standard of living.
4 wheels of growth: human resources (labor supply, education, discipline, motivation), natural resources (land, minerals, fuels, environmental quality), capital formation (machines, factories, roads), technology (science, engineering, management, entrepreneurship).
APF - Aggregate Production Function: Q = AF x (K, L, R).
Productivity - ratio of output to a weighted average of inputs. Social overhead capital: investments taken by government, large-scale projects that precede trade and commerce. Governments make sure that the social overhead of infrastructure investments are effectively undertaken.
Techonological change - changes in the processes of production or introduction of new products or services.
Adam Smith "Golden Age": since there is no capital, national output doubles as population doubles. A doubling of population = PPF shifts by factor of 2. But this cannot last forever, since as population growth continues, all the land will be occupied, Thus the increasing land/labor ratio leads to declining marginal product of labor and to declining real wage rates.
Malthus "Dismal Science": Whenever wages are above the subsistence level, population expands; below the subsistence level, high mortality and population decline. So only at subsistence wages can there be a stable equilibrium of population. Malthus overlooked that technological innovation and capital investment could overcome the law of diminishing returns.
Economic growth with resource and environmental constraints can increase GDP. With technological change, we can shift to more output and a cleaner environment. Without technological change, we have higher output but deteriorating environment.
Neoclassical model of economic growth - economy in which a single homogenous output is produces by two types of input, capital and labor. Q = F (K,L).
Capital deepening occurs when the stock of capital grows more rapidly than the labor force. In the absence of technological change, capital deepening will produce a growth of output per worked, or the marginal product of labor, and of wages, and will also lead to diminishing returns on capital and a consequent decline in the rate of return on capital.
Without technological change - incomes and wages end up stagnating. Economic growth consists only of accumulating capital, and then the standard of living will stop rising.
Technological change - advances in processes of production and introduction of new and improved goods. In addition to considering capital deepening, must consider technological change.
Labor-saving inventions: increase profits relative to wages; Capital-saving inventions: raise wages relative to profits. Between them, the neutral inventions, which have no effect.
Trends in development: capital stock has grown more rapidly than population and employment, resulting in capital deepening; strong upward trend in real wage rates; share or wages and salaries in national income has edged up slightly but virtually constant over last 2 decades; no strong upward or downward trends during business cycles; the capital-output ratio has declined since 1990; the national savings rate has declined sharply in the US; the national product has grown at an average rate of 3% a year.
Fundamental equation of growth accounting: %Q growth = ¾ (% L growth) + ¼ (% K growth) + T.C.
Total factor of productivity - growth of output minus the growth of the weighted sum of all inputs.
Productivity slowdown - spend money on improving health and safety, no output increases; increase in energy prices, deterioration in labor quality; nature of R&D.
Developing country - low per capita income. poor health and short life expectancy, low levels of literacy, malnutrition. Low income, lower-middle income, upper-middle income, and high-income.
Human Development Index - 4 indexes: per capita real GDP, life expectancy at birth, school enrollment, and adult literacy. Idea that economic growth should enrich people's health and education as well as purses.
Demographic transition - when a population stabilizes low birth rates and low death rates.
Vicious cycle of poverty: Low incomes à Low saving and investment à Low pace of capital accumulation à Low productivity à Low incomes etc.
Backwardness hypothesis - poorer countries have important advantages that already industrialized countries don't. Can draw upon capital, skills and technology of more developed countries.
Convergence = when countries or regions that have initially low incomes tend to grow more rapidly than countries with high incomes.
State vs. Market - extensive reliance on market provides most effective way of managing an economy and promoting rapid economic growth. Important elements: outward orientation in trade policy, low tariffs and few trade restrictions, promotion of small businesses, fostering of competition. Taxes predictable and inflation low.
Growth and openness: open economy - characterizes by low trade barriers, open financial markets and trade markets. Like the East Asian NIC's. Closed economy - like Latin American countries, doesn't work.
High investment rates ensure that economies benefit from latest technology and can build up necessary infrastructure; Low inflation and high investment rates, investment in human and physical capital; Keeping exchange rates undervalued to promote exports; Government set-up of races among domestic firms to stimulate the competition.
Short run - interaction of aggregate supply and demand determine business cycle fluctuations, inflation, unemployment, recessions, and booms.
Long run - growth of potential output working through aggregate supply.
AS curve: shows level of national output that will be produced at each possible price level, other things being equal. Short run AS curve - upward sloping. Long run AS curve - vertical.
Outward shift - increase in potential output that came from growth in the labor force and capital as well as improvements in technology. Upward shift - increases in the cost of production, as wages, import prices, and other production costs rose.
Potential GDP - highest sustainable level of national output. Measured as the output that would be produced at the lowest sustainable unemployment rate (LSUR).
Input costs - as production costs rise, businesses are willing to supply a given level of output only at a higher price.
Keynesian approach - AS curve is flat in short run. Changes in aggregate demand have a significant and lasting effect on output. Classical approach - strength of self-correcting forces that operate through the price mechanism, AS curve is steep or even vertical, changes in demand have little lasting effect on output.
Reason why short and long term AS is different: Some elements of business cost are inflexible or sticky in the short run. As a result of this, businesses can profit from higher levels of aggregate demand by producing more output.
The AS will differ from potential output in short run because of inflexible elements of costs. In short run, firms will respond to higher demand by raising both production and prices. In long run, as costs respond to the higher level of prices, the respond to increase demand takes the form of higher output. So, in the long run, the AS curve is vertical because all costs adjust given sufficient time.
Employed - who have jobs and do work. Unemployed - actively looking for work, or waiting to return to work. Labor force - all employed and unemployed. Not in labor force - those not looking for work.
Unemployment rate - number of unemployed divided by total labor force.
Okun's Law: for ever 2% that GDP falls relative to potential GDP, the unemployment rate rises about 1% a point. (link between output and labor market. association between short-run movements in real GDP and changes in unemployment).
Frictional unemployment - workers are between jobs and moving in and out of the labor force; structural unemployment - workers who are in regions that ire in a persistent slump, cyclical unemployment - workers laid off when overall economy suffers a downturn.
Theory of sticky wages and involuntary unemployment - slow adjustment of wages produces surpluses and shortages in individual labor markets. Labor markets are nonclearing markets in the short run. They eventually respond to market conditions as wages of high-demand occupations move up relative to those of low-demand occupations. In the long run, these pockets of unemployment disappear.
Inflation - when general level pf prices is rising. Calculated by using price indexes - weighted averages of the prices of thousands of individual products.
The CPI measures the cost of a market basket of consumer goods and services relative to the cost of that bundle during a particle base year. The GDP deflator is the price of GDP.
Rate of inflation: price level (year t) - price level (year t-1) / price level (year t-1) x 100.
Real wages: the wage rate divided by consumer indexes.
Inflation can be - low (people trust money), galloping, and hyperinflation.
Effects of inflation (during periods of inflation all prices and wages to not move at the same rate so relative prices occur): 1. a redistribution of income and wealth among different groups; 2. distortions in the relative prices and outputs of different goods, or sometimes in the output and employment of the economy as a whole.
Unanticipated inflation redistributes wealth from creditors to debtors, helping borrowers and hurting lendors. An unanticipated decline in inflation has opposite effect. But mostly it randomly distributes wealth among population with little significant impact on any single group.
Menu costs of inflation - idea that when prices are changed, firms must spend real resources to reprint their menus etc.
Fed takes forceful steps to stop inflation - by reducing money growth, raising interest rates, and thereby restraining the growth of real output and raising unemployment.
Inertial inflation - the rate of inflation that is expected and built into contracts and informal arrangements. Occurs when AS and AD curves are moving steadily upward at the same rate.
Demand-pull inflation - when AD rises more rapidly than the economy's productive potential, pulling prices up to equilibrate aggregate supply and demand. So, demand dollars are competing for the limited supply of commodities and bid up their prices.
Cost-push inflation - inflation resulting from rising costs during periods of high unemployment and slack resource utilization.
Rate of inflation = rage of wage growth - rate of productivity growth.
Phillips Curve: short run - inverse relationship between inflation and unemployment. An increase in AD which lowers the employment rate below the sustainable rate will tend to increase the inflation rate. A demand decrease will tend to lower inflation.
Long run - there is a minimum unemployment rate that is consistent with steady inflation (LSUR) - a period of low unemployment and increasing inflation will lead people to expect higher inflation and will tend to shift up the short-run Phillips curve.
LSUR - rate at which upward and downward forces on price and wage inflation are in balance. At the LSUR inflation is stable.
INCOME POLICIES: government actions that attempt to moderate inflation by direct steps: Wage-price controls - ineffective since people evade them. Market strategy - relies on discipline of markets to restrain prices and wage increases. Tax-based income policies - uses fiscal carrots and sticks. Profit-sharing policies - giver workers a share of the profits rather than a straight wage.
Cruel Dilemma: There is a lowest sustainable rate of unemployment which our economies can only produce at the risk of spiraling inflation. The sustainable rate is often thought to be efficiently high. Central flaw of modern capitalism - high unemployment.
Say's Law of Markets
- overproduction is impossible by its very nature. Whatever factories can
produce, workers can afford to buy. Supply creates its own demand as prices move
to balance demand with AS.
Classical view - changes in AD affect the price level but have no lasting
impact upon output and employment. Price and wage flexibility ensures that real
level of spending is sufficient to maintain full employment. Macroeconomic
policy has no role to play in stabilizing the economy.
Keynesian revolution - inflexibility of prices and wages, so output and unemployment rate are determined by the interaction of supply and demand forces. The Keynesian AS is upward sloping, and monetary and fiscal policies affect both prices and real output. No automatic self-correcting system, so economy can experience long periods of depression or inflation.
Monetary and fiscal policies can substitute for flexible wages and prices, stimulating the economy during recessions and slowing aggregate demand during booms to forestall inflationary tendencies.
Monetarism - money supply is the determinant of short-run movements in both real and nominal GDP.
It relies on the analysis of trends in the velocity of money to understand the impact of money on the economy.
Velocity of circulation of money (V) = ratio of dollar GDP flow to stock of M. V= GDP/M = PQ/M
Quantity theory of prices: P=kM k = V/Q. P almost strictly proportional to M.
3 major propositions: 1. the growth of money supply is the major systematic determinant of nominal GDP growth, 2. prices and wages are relatively flexible, 3. the private economy is stable.
New Classical Macrocosmic: people's expectations are formed efficiently and rationally, and prices and wages are flexible. (critic: prices and wages are inflexible in the short run).
Policy Ineffectiveness Theorem: With rational exceptions and flexible prices and wages, anticipated government policy cannot affect real output or unemployment.
Lucas Critique: people may change their behavior when policy changes. Economic behavior can change when policymakers rely too heavily on past regularities.
Misperceptions theories: the cyclical movements of unemployment greatest challenge.
Real-business cycle theory: explains business cycles as shifts in AS, without any reference to monetary or other demand-side forces.
Supply-Side Economics: emphasis on economic incentives, advocacy of large tax cuts, downplaying the importance of changes in aggregate demand etc. Did not work in improving US economy.