Transcript Imports

Circular Flow Model
Gross Domestic Product
Valuation of economy
 Value of production, not simply production
 Final Goods
 Second hand goods not included
 Transfers not included
GDP
GDP = AD (Aggregate Demand)
GDP = C + I + G + (X-M)
 C = Personal Consumption
 I = Capital Investments
 G = Government Expenditures
 No transfer payments
 X-M = Net Exports = eXports - iMports
GDP vs GNP
Gross Domestic Product
 What is produced within a
country’s borders, regardless of
who produces it.
 Mercedes built in America count
towards American GDP
 Fords built in Germany count
towards German GDP
Gross National Product
 What is produced by the citizens
of a country, regardless of where
they produce it.
 Mercedes built in America count
towards German GNP
 Fords built in Germany count
towards American GNP
Real vs Nominal GDP
Nominal
 Value of current production in current prices
Real
 Value of current production in base year prices
GDPReal = (GDPNom)(Price Index)
%∆GDPReal = %∆GDPNom - %Δ Index
CPI
Consumer Price Index
 Measure inflation
 Base year
 Market Basket
What is the difference between the
CPI and the GDP deflator?
 Both are price indices but they have different
market baskets. The CPI includes consumer
goods whereas the GDP deflator contains all
items that are produced domestically.
Causes of Inflation
2 types
 Demand-pull inflation
 Aggregate demand > productive capacity
 Causes include increases in money supply or credit.
 Cost-push
 Prices increased by producers to cover higher costs of
production.
 Supply shocks such as changes in oil prices, crop failures & natural
disasters.
5 Major Effects of Inflation
Decreased purchasing power
Decreased value of real wages
Increased interest rates
Decreased savings & investing
Increased production costs
Unemployment
Unemployed – must be looking for work to be part
of labor force.
Unemployment rate is % of labor force that is
unemployed.
Types of unemployment include:
 Frictional
 Seasonal
 Structural
 Cyclical
Full employment is economy at full steam. Since
there is always frictional & structural
unemployment, the Natural unemployment rate is
the unemployment rate for full employment.
Consumption Function
Consumption Function
C = a + b (DI)
a = autonomous spending
spending when income = 0
B = consumption rate
Consumption
DI
CF
Savings
Dissavings
Disposable Income
Marginal Propensity to Consume & Save
MPC = ΔC/ΔDI
MPC= Consumption rate in
consumption function
MPS = ΔS/ΔDI
MPC + MPS = 1
 C=Consumption, S=Savings, DI=Disposable Income
Multiplier
Multiplier
 = 1 / MPS
 = 1 / (1-MPC)
Examples
 MPC = .9, Multiplier = 1/.1 = 10
 MPC = .8, Multipler = 1/.2 = 5
 MPC = .5, Multiplier = 1/.5 = 2
NB Taxes have a smaller multiplier than
direct government spending
AD – AS Model
Price
Level
LRAS
Long-run Aggregate
Supply (LRAS)
SRAS
Short-run Aggregate
Supply (SRAS)
P
Aggregate Demand (AD)
= C+I+G+(X-M)
AD
YO
GDPR
AD – AS Model - Inflation
Price
Level
LRAS
SRAS
GDP beyond L-R
Equilibrium at Y1 & P
Inflationary Gap
Higher rates drive
down interest sensitive
expenditures (AD )
P
P2
AD Shift causes Y to go
 to L-R YO, & P 
AD2
YO
Y1
AD
GDPR
Economy producing
Beyond L-R capacity
AD – AS Model - Inflation
Price
Level
SRAS
LRAS
GDP below L-R
Equilibrium at P & Y1
SRAS2
Recessionary Gap
Lack of demand drives
down nominal wages
( SRAS  )
P
P2
SRAS2 shift results
in P  & Y 
AD
Y1
YO
GDPR
Economy producing
under L-R capacity
Shifts in AD
Changes in expectations
 Expectations  – AD 
Changes in wealth
 Wealth  , - AD 
Amount of physical capital
 Existing Capital  – AD 
Fiscal policy
 Government spending  – AD 
Monetary policy
 Money supply  – AD 
Shifts in SRAS
Commodity prices
 Example is oil
 Prices  - AS 
Nominal wages
 Wages  - AS 
Productivity
 Productivity  - AS 
AD AS Model
Shifts of AD
Demand shock
Negative
 “Great Depression”
 ADN, EN, PN, YN
Ag. Pr.
Level
SRAS
EP
PP
PE
ESR
PN
ADP
EN
ADN
Positive
 WWII
 ADP, EP, PP, YP
YN
YE
YP
AD
Real GDP
AD AS Model
Positive Demand Shock
 AD shifts to AD2
 E1 up to E2
 P1 up to P2
 YP up to Y2
 Inflationary Gap
Ag. Pr.
Level
P3
SRAS2
SRAS
LRAS
E3
P2
P1
E2
E1
AD2
Inflation causes L-R
increase in wages
AD
 SRAS shifts to SRAS2
 E2 shifts to E3
 P2 up again to P3
 Y2 down to YP
YP
Y2
Real GDP
AD AS Model
Shifts of SRAS
Supply shock
Negative
 Oil Crisis
 SRASN, EN, PN, YN
SRASN
Ag. Pr.
Level
SRAS
SRASP
PN
EN
PE
ESR
PP
EP
AD
Positive
 Internet
 SRASP, EP, PP, YP
YN
YE
YP
Real GDP
Continuum – Government Policies
Restrictive
Low Growth
Low Inflation
Expansionary
High Growth
High Inflation
Fiscal Policy
Expansionary
 Stimulates economy
 Decrease taxes and/or increase spending
 Increases disposable incomes/demand
 Inflationary & leads to debt
Restrictive
Expansionary
Restrictive
 Reduces Disposable income/demand.
 Lack of cash reduces investments.
 Reduction in government spending/programs
Monetary Policy
Easy Money
 Increases growth (good)
 Increases inflation (bad)
Tight Money
Easy Money
Tight Money
 Decreases growth (bad)
 Decreases inflation (good)
How the Fed Can Change MS

Fed Tools
1.
2.
3.
4.
Open Market Operations
Fed Funds Rate & Discount Rate
Reserve Requirements for Banks
Moral suasion
Money
Supply
up
Interest
Rates
down
Exchange
rates
down
Expansionary Policy
Investments
up
AD
up
GDPR
up
GDPN
up
Exports
up
Imports
down
Price
Level
up
Inflation
up
Unemploy
-ment
down
Phillips Curve
Inflation
LRPC
S-R trade-off between
Inflation & unemployment
Trade-off does not
Occur in the L-R
Shifts in SRPC the result
of Δ expected inflation
%2
SRPC2
%
SRPC
NRU/
NAIRU
Unemployment
Money Supply
Interest
Rate, i
i = nominal
interest rates
MS
Δ in MS controlled
by the Fed Reserve
i
M*V=P*Q
MS*Velocity or multiplier
= Price Level * Output
MD
M
GDPR
Interest
rate
Money Supply & Interest Rates
Money supply
MS2
Price Level
Increased MS
leads to r 
Lower r leads to C
& I  meaning AD 
AD shifts right,
leading to Price
Level  & GDPR 
SRAS
P2
P1
r1
AD2
r2
MD1
Mde1 Mde2 Quantity
of money
AD1
Y1 Y2 GDPR
r = real
interest rates
Loanable Funds
Interest
Rate, r
SM
NB - With interest rates
i includes inflation
while r is for real
r
DM
YO
GDPR
Terms
Crowding out
 Government competes with or eliminates private
enterprise.
 Providing a service otherwise supplied by a company
 Competing in the marketplace for loans to finance debt.
Rational Expectations Theory
 Businesses & consumers react to expected changes
in monetary & fiscal policy, thereby negating their
impact.
Automatic Stabilizers
 adjust automatically, without government deliberation,
to offset economic conditions
Crowding Out Effect – Change in Demand
Interest Rate, r
∆ in Demand:
government debt
creates additional
demand for funds.
S1
r2
r1
Rightward shift of
demand curve results
in r  & Q .
D2
D1
Q1 Q2
Quantity of
Loanable Funds
Crowding Out Effect – Change in Supply
S2
Interest Rate, r
∆ in Supply:
Government is
Most credit worthy
Borrower, so Fed
Debt removes supply
S1
r2
r1
Leftward shift of
Supply curves results
In r  & Q 
D1
Q2
Q1
Quantity of
Loanable Funds
Automatic Stabilizers
$
Deficit – Economy in recession, causes
taxes to drop below govt. expenditures
Taxes
Surplus – Economy booms,
causes taxes to increase
above govt spending
Govt
Automatic adjustments to
economic conditions by
increasing deficit during
recessions & increasing surplus
in boom periods (income taxes)
GDPR
Macroeconomic Theories
Classical
 Changes in MS only affect nominal rates, not real
 Automatic stabilizers will correct market fluctuations
 No government action
Keynesian
 Fiscal policy as a tool to correct cyclical fluctuations
 Govt spending up to offset recessions
Monetarists
 Govt often wrong or late, only make matters worse
 MS to grow at rate of GDP growth (no fiscal remedies)
Foreign Trade
 Revisit Comparative & Absolute advantages from
Micro PP
Balance of Payments
 Current Account – Transactions w/o liabilities
 Capital Account – Transactions w/ liabilities
Exchange Rate Changes
 Consumer tastes
 Relative incomes
 Relative inflation
 Speculation
 Money supply/ relative interest rates
Exchange Rates
Demand for $ increases as
other currencies trade for $
$/€
€/$
S
S2
Demand Curve shifts to D2
causing $  & Q 
Looking at exchange rate from
other side – euros/dollar
High demand for $ means
people want to trade euros in
& this leads to excess supply
$2
€
$
€2
D
Qe
Q2
D2 Supply curve shifts to S2,
causing €  & Q 
Q
International Trade & Taxes
Dollars/
Euro
SDom
Example: US Oil Market
Equilibrium at $100 & 10M
Barrels.
Effects of tariff include
P $10, Q  1M barrels,
& Imports  2M barrels
$100
$90
$80
World price is $80. Effect on
US market is Demand at $80
Is 12M while Supply is 8M.
Difference of 4M is imports.
Imports
D
Q
Protective tariff of
$10/Barrel added
8 9 10 11 12
Deadweight Loss (DWL)
Graph Relationships
I
Money Market
MS
i
Investment Demand
MS
i
i
i
i
MD
M
M
Contraction of MS
leads to higher i,
which reduces I,
causing GDP to fall
Graph reversed so
GDP is falling
M
Y
Y
GDPR
I
I
I
I
I
I
Graph Review – MS 
I/R
Money Supply
MS
I/R
Loanable Funds
Fed increases
MS i 
MS
i
S
S
r
r
i
MD
M
M
D
Q
I/R
q q
Investment Demand
 r leads
to  I
 MS leads to
shift right in S in
r
loanable funds
r
r&q
Q
I/D
I
I
Q
Inflation
 I =  AD
P/L = X  & M 
AD =
 AD =  P & Y
Supply of $ 
Phillips CurveInflation  & Exchange Rates
ER  & q P/L ADAS Model
A/B
LRPC Unemployment 
S
AS
S
ER
ER
%
P
P
AD
SRPC
%
D
U/R NRU
Unemployment
q q
Q
AD
YY
Real GDP