Transcript Lecture7 - UCSB Economics

Introduction to Economics
Macroeconomics
The US Economy
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Questions About the News

What is the economic significance of the
following story in today’s business section
of the LA Times?
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Questions About Your Reading
What do we mean by specialization?
 What is comparative advantage?
 What is a factor market?
 What is circular flow?

Chapter 3
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Households as Sellers and
Buyers
 In
labor markets,
households sell their
labor to firms for
wages. About 75%
of income is earned
by households.
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The Circular Flow Diagram
• The circular flow
diagram is a
diagram showing
the flow of money
and goods
between markets.
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Questions about your reading

What are the functions of government?
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Government in a Market
Economy

The government has five general
responsibilities in a market-based economy:
• Providing goods and services.
• Redistributing income.
• Taxation.
• Regulation of business practices.
• Trade policy.
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Percentage of Government
Spending on Various Programs
Local Expenditures (1996)
Administration and
other 32%
Public welfare 5%
Highways 5%
Health and hospitals
9%
Police protection 5%
Education 42%
State Expenditures (1998)
Administration and
other 20%
Police and
corrections 4% Highways 8% Health and hospitals
8%
Public welfare 25%
Education 35%
Federal Expenditures (1999)
Net interest 13%
Social security
23%
Other 14%
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National defense
16%
International
affairs 1%
Income security
14%
Medicare 11%
Health 8%
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Tu A
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Ja y
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Tax Rates in Different Nations
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52
50
40
30
20
49.8
46.2 45.9 45.2
44.4 43.6
42.7 41.5
41
38.7 38.3 37.9 37.4 37.2
37
35.2 35.1 34.2 34.2
33.6 33.2
29.9 28.9 28.7
28.4
21.1
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10
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Questions About Your Reading

What is the law of demand?
Chapter 4
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The Individual Demand Curve
and the Law of Demand
 The
individual demand
curve shows the relationship
between the price of a good
and the quantity that a single
consumer is willing to buy,
or quantity demanded.
• The law of demand states
that the higher the price, the
smaller the quantity
demanded, ceteris paribus
(everything else held fixed).
Summary of Part I:
Personal Finance Advice
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Summary of Personal Finance
Spend
Learn
Earn
Choice
?%
Save
Life Span
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Choice: What to Build Equity In?
Housing
Save
Invest & Build Equity
Financial,
Including
cash reserve
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Who Wants to be a Millionaire?
Stocks @ 11% ( we hope)
One Time
Investment
3 M Treasury Bills @ 1.66%
Mattress @ 0%
Save 6% of Wealth
Per Year & Invest
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Stocks +  Savings : 17%
5 Y Treasury Bonds @ 3.14%
+  Savings: 9.14%
Mattress +  Savings: 6%
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Your Stocks
Market
Indices
corporate earnings(profits)
The Economy
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Index of Leading Economic Indicators
Gross Domestic Product
Unemployment Rate
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Outline: Lecture Seven

Two major types of policy
 fiscal
policy: spending and taxation
 monetary policy: the goals are low
unemployment and low inflation. What are the
tools?

Keynesian Models of the Economy
 two-legged
stool model
 three-legged stool model

Inflation
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Review: lecture 6

Keynesian “ Two - Legged Stool” Model
a
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weakness of the economy in the 1930’s
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National Economy Spending
The Stool and Two Legs
Total Spending
Consumers
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Businesses
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Expenditure Perspective
Consumption spending by households, C
 Investment spending by firms, I
 GDP = C + I

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The Consumption Function
consumption, C
autonomous
consumption, C0
C = C0 + mpc* Y
the slope of the consumption function,
the marginal compensity to consume,
mpc, is the increase in consumption
per $ increase in income
Income, Y
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Autonomous Investment
Investment, I
I
Income, Y
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Gross Domestic Product Equals Consumption Plus Investment
GDP = C + I
Consumption, C
Investment, I
GDP
GDP*
autonomous
consumption, C0
C = C0 + mpc* Y
I
C*
I*
Y*
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Income, Y
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Gross Domestic Product Equals Consumption Plus Investment
Consumption, C
Investment, I
GDP
GDP = C + I
autonomous
consumption, C0
Income, Y
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: Chapter Twenty

Conceptual Framework: Circular Flow
Firms
Income
Firms
Labor
Supply
Goods
Demand
Goods
Households
Households
Income Perspective
Expenditure Perspective
Y
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=
GDP
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Squares with Equal Sides and 45 degree Lines
Y=Y
Income, Y
Y1
450
Y1
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Income, Y
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Consumption, C
Investment, I
GDP
Income = expenditure
I.e. Y = GDP
GDP = C + I
Total
Expenditure
GDP Line
Aggregate
Expenditure
45
0
GDP = Y
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National
Income, Y
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Economy in 2001: a decline in I leads to a decline in GDP
Consumption, C
Investment, I
GDP
autonomous
consumption, C0
GDP = C + I
C = C0 + mpc* Y
I
1st
Income, Y
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Boom
Consumption, C
Investment, I
GDP
Income = expenditure
I.e. Y = GDP
GDP = C + I
Total
Expenditure
GDP Line
Aggregate
Expenditure
Unemployment
Rate Oct. 2000
= 3.9%
45
0
GDP = Y
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National
Income, Y
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Bust
Consumption, C
Investment, I
GDP
Income = expenditure
I.e. Y = GDP
GDP = C + I
Total
Expenditure
GDP Line
Aggregate
Expenditure
Unemployment
Rate Oct. 2000
= 3.9%
45
0
Unemployment Rate
Sept 2001 = 4.9 %
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GDP = Y
National
Income, Y
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Lecture 7

Keynesian “Three Legged Stool Model”
 federal
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government spending as a stabilizer
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National Economy Spending
The Stool and Three Legs
Total Spending
Consumers
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Businesses
Government
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Government, G
Consumption, C
Investment, I
GDP
Income = expenditure
I.e. Y = GDP
GDP = C + I +G
Aggregate
Expenditure
Total
Expenditure
GDP Line
45
0
GDP = Y
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National
Income, Y
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Bust
Consumption, C
Investment, I
GDP
Income = expenditure
I.e. Y = GDP
GDP = C + I +G
Total
Expenditure
GDP Line
Aggregate
Expenditure
Unemployment
Rate Oct. 2000
= 3.9%
45
0
Unemployment Rate
Sept 2001 = 4.9 %
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GDP = Y
National
Income, Y
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Unemployment Rate: unemployed/ (employed + unemployed)
Unemployment Rate: unemployed/ (labor force)
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In the Great Depression

We did not have the sea anchor (third stool
leg) of federal government spending to
stabilize the economy
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Gross Domestic Product Components
in 1929 . .
net exports
0%
investment
16%
government
9%
federal government was 1.6%, while
state & local government was 7.3%
consumption
75%
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Consumption + Investment + Government , 2001 II
government
17%
investment
16%
consumption
67%
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Keynesian Fiscal Policy Option
Government As a Fraction of GDP .
0.5
0.45
0.4
0.3
0.25
0.2
0.15
0.1
0.05
Year
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97
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
0
29
Fraction
0.35
Why was Expenditure Too Low
to Support Full Employment?
Consumption had dropped because of fear
 Investment had dropped because of fear

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Policy Option: Reassure the Public
“The only thing we have to fear is fear itself”
Franklin Delano Roosevelt
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Fiscal Policy Option in 2001

Use Federal Government Spending to Make
up for the Shortfall in Consumption and
Investment
 prime
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the pump
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Less than Full Employment Equilibrium
GDP = C+ I+G
Consumption, C
GDP = C + I
Investment, I
GDP
C = C0 + mpc* Y
I
45
0
GDP = Y
YFE
Income, Y
Full Employment Income
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Are we missing any policy options?
Keynesian model and using more
government spending during downturns is
called fiscal policy
 Federal Reserve conducts monetary policy

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Federal Reserve Policy Goals
Full employment
 stable prices (low inflation)

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Lecture 5
Inflation
Http://stats.bls.gov/eag/eag.us.htm
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What is the current rate of inflation? - Lab 4, Ch.21, Internet
Exercises, “Inflation in the US”, Bureau of Labor Statistics, 0.3%
for August, Year to date: 0.2+0.2+0.3+0.5+0.0+0.1+0.1+0.3=1.7%
Source:http://www.yardeni.com
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Inflation: % rate of increase of CPI
100*[CPI(August) - CPI(July)]/CPI(July)
 What is the Consumer Price Index?
 What is a price Index?

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Assigned reading

O’Sullivan and Sheffrin and Lab Four
 Ch.
21 “Unemployment and Inflation”
 What is the Consumer Price Index?
 What is its purpose?
 What effect could a higher inflation rate have
on the US economy?
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Consumer Price Index
Prices of a Market Basket of Goods and
Services
 Index of the Cost of Living

 but
it leaves out public goods like safety and
clean air which are hard to price
Based on a Monthly Survey of Prices by
the Bureau of Labor Statistics(BLS) and the
expenditure pattern (or mix of goods) of a
sample of households.
 Lab Four: Internet Exercises, “Inflation in
the
US, BLS and Consumer Price Info 53
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Phillips

Components of the CPI, Corresponds to Fig. 21.2
Household Services
9%
Rent
26%
Transportation
7%
Medical
5%
Other Services
7%
Durables
11%
Food & Beverages
18%
Apparel
6%
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Nondurables
11%
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Consumer Price Index: CPI
prepared by the Bureau of Labor Statistics,
BLS, US Dept. of Labor, USDOL
 1982-84=100
 weights for urban consumers, 10,000
families in the survey

 housing
= 42.6%
 transportation = 18.7%
 food & beverages = 17.8%
 apparel & upkeep = 6.5%
 other goods & services = 5.1%
 medical care = 4.8%
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 entertainment = 4.4%
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What Impact Could a Rising Inflation
Rate Have on US Economy?
Federal Reserve Bank of the US may raise
short term interest rates to combat inflation
 Raising interest rates could discourage
consumers from purchasing durable goods,
house, and cars
 Raising interest rates could discourage
business from borrowing to invest in new
equipment and expansion
 Prospect of higher interest rates affects
stock market
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
Economic Policy on a Knife Edge
If Federal Reserve raises interest rates to
slow down the risk of inflation, it slows
consumption and investment, which needs
to recover to end a recession
 A decrease in investment spending could
slow down the growth in worker
productivity, which has been permitting
rapid growth at low rates of inflation

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Impact of War on Prices
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Cost of Living Index, 1913=100, Massachusetts: Jan. 1910 - Dec. 1943
225
200
175
150
weights:
food: 37.6%
clothing: 12.8%
shelter: 21.8%
fuel & light: 5.0%
sundries: 22.8%
125
100
75
10
12 14
16
18 20
22
24 26
28
30 32
34
36 38
40
Year
cost of living index, Massachusetts
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Historical Cost of Living: Mass.

World War I & aftermath: inflation
 rapid
increases in 1917, 1918; peak in 1920
twenties: price stability
 early thirties: deflation
 World War II: inflation

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Consumer Price Index, http://www.globalexposure.com/
Last Ten Years/ 1948-
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Inflation Rate: CPI
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Summary-Vocabulary-Concepts
national income
 circular flow economy
 value added
 gross domestic
product
 consumption
 gross private domestic
investment
 government
expenditures
 net exports
 aggregate production
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function











nominal GDP
closed economy
John Maynard Keynes
aggregate expenditures
uncertainty
expectations
consumption function
autonomous
consumption
marginal propensity to
consume
equilibrium GDP
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Inflation
Historical Cost of Living
 Consumer Price Index
 GDP Deflator
 Real GDP and Growth of the Economy
 Rate of Inflation
 Impact of Inflation on You
 Social Impact of Inflation
 Inflation Forecast
 Cause of Inflation

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Rate of Inflation
 For
example, the annual rate:
[P(t)
- P(t-1)]/P(t-1) = P(t)/P(t-1)
 [CPI(1997)
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- CPI(1996)]/CPI(1996)
65
GDP Deflator
Nominal Value $ = Price * Quantity
Nominal GDP = GDP Deflator * Real GDP
 Nominal GDP/Real GDP = GDP Deflator
 Real GDP = Nominal GDP/GDP Deflator

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GDP Deflator, 1992=100 .
120
100
60
40
20
Year
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97
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
0
29
Index
80
GDP Deflator, 1992=100, Proportional Scale .
1000
Index
100
10
Year
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97
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
29
1
GDP Deflator: History
early thirties: deflation
 World War II: inflation
 Korean War: inflation
 fifties and sixties: price stability
 Vietnam War: inflation

 Lyndon

seventies: inflation
 OPEC:

Johnson: “guns and butter”
energy prices
nineties: price stability
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Is the economy growing less rapidly?

Growth in real GDP over time
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Real GDP Billions 96$, 1929-1999
12000
10000
GDP
8000
Real GDP Billions 96$
exponential trendline
6000
4000
y = 8E-29e0.0369x
R2 = 0.9767
2000
0
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
year
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