Transcript AP Macro Unit 4 Notesx - Phoenix Union High School District

AP/ Honors Macroeconomics
Unit 4 Notes and Terms
Fiscal and Monetary Policy
1. Public Good- G or S provided by the government.
Examples:
Education, Military, Police, Fire, Jails, S.S., Welfare,
Agriculture Subsidies
2. Private Good- G or S provided by private
individuals or private companies.


Examples:
Shirt from Old Navy, Gas from ARCO, Car from
Sanderson Ford, Education from Brophy
2 Reasons for Public Goods
3. Non-exclusion rule- difficult to exclude(keep
out) individuals who are unwilling to pay.
Examples: Parks, Police/Military/Fire Protection, Roads,
Courts, Dams/ Flood Control
4. Shared Consumption rule- everyone
can share in the use of a G or S. One person using a G or
S does not lessen the benefit another person gets from it.
Examples: Education, Parks, Library, Street lights, system
of money, weights and measure.
Free Rider- someone who receives the benefits of a
good or service without having to contribute to its costs.
Examples:
 bumming a cigarette, copying homework,
borrowing yard tools
Dam example- 2 people (A & B) living in a flood
plain, both would benefit from a dam, only A wants to
pay for it, B does not.
6. Taxes- Required payments of money
to governments that are used to provide
public goods and services.
7. Types of taxes
A. Personal Income- on earnings
B. Corporate Income- on profit
C. Excise- tax on specific item (tobacco, alcohol, gas, tires,
marijuana
D. Tariffs- on imports
E. Inheritance- >$1 mil
F. Property- on land
G. Sales- on purchases
H. Luxury- excise tax on expensive jewelry, planes, boats, cars,
china, crystal
I. Social Security- on wages/salaries/tips
J. Licenses and Fees- Driver’s, hunting, business, toll road/bridge
8. Federal Spending
1. Defense
2. Social Security
Federal Taxes/ Revenue
1. Personal Income
2. Social Security
3. Net interest
4. Social Programs
3. Borrowing
4. Corporate Income
Government Purchases vs. Government Transfers
Percentage of U.S. Output
35
30
27%
25
Government
Transfer
Payments
31%
5%
12%
22%
19%
20
15
10
Government
Purchases
5
0
1960
2005
GLOBAL PERSPECTIVE
Total Tax Revenue – Selected Nations
Percent of Total Output-2004
10
Sweden
Denmark
Norway
Finland
France
Italy
United Kingdom
Germany
Canada
Australia
United States
Japan
South Korea
20
30
40
50
50.7
49.6
44.9
44.3
43.7
42.2
36.1
34.6
33.0
31.6
25.4
25.3
24.6
Source: Organization for Economic Cooperation and Development
Federal Expenditures-2005
Four Stand-Out Areas of Spending
0
10
20
30
Pensions &
Income Security
50
35%
National
Defense
20%
17%
Health
Interest on the
Public Debt
40
7%
Source: U. S. Office of Management and Budget
Income Tax Characteristics
• Progressive Tax Rates
•
Brackets of Income
• Marginal Tax Rate
• Average Tax Rate
Marginal Income Tax Rates (2009)
Taxable Income
10% for the first $8,350 earned,
15% between $8,250 to $33,950,
25% between $33,950 and $82,250,
28% between $82,250 to $171,550,
Progressive
Tax rates
with
brackets of
income and
marginal
rates.
33% between $171,550 and $372,950, and
35% above $372,950.
Average rates AFTER you take
tax deductions and tax credits
Federal Tax Revenues-2005
Basic Revenue Sources
0
10
20
Personal
Income Tax
50
37%
Corporate
Income Taxes
All
Other
40
43%
Payroll
Taxes
Excise
Taxes
30
13%
3%
4%
Source: U. S. Office of Management and Budget
State & Local Spending State & Local Taxes
1. Education
1. Sales
2. Health/ Welfare
2. Property
3. Public Safety
3. Excise
4. Transportation
4. Federal Grants
State Government Finances
• Primary Revenues
•
•
•
Sales & Excise Taxes - 48%
Personal Income Taxes - 34%
Corporate Income Taxes & License Fees – Most of
Balance
• Primary Expenditures
•
•
•
•
•
•
Education – 35%
Public Welfare – 28%
Health & Hospitals – 7%
Highways – 7%
Public Safety – 4%
Other – 19%
Local Government Finances
• Primary Revenues
•
•
Property Taxes – 73%
Sales & Excise Taxes – 17%
• Primary Expenditures
•
•
•
•
•
Education – 44%
Welfare, Health & Hospitals – 12%
Public Safety – 11%
Housing, Parks, & Sewers – 8%
Streets & Highways – 5%
U.S. is
actually a
“low tax”
country when
compared to
other
developed
countries.
Progressive tax- a tax that takes a larger
percentage of higher incomes than of lower
incomes.
Examples:
Income, Inheritance, Luxury, Property
Impact of Taxes on Income
% of
Income
50%
20%
10%
0
$1,000
$10,000
$100,000
Income ($)
Regressive tax- A tax that takes a larger
percentage of lower incomes than of higher
incomes.
Examples:
Sales, Licenses and Fees, Excise, Social Security
Impact of Taxes on Income
% of
Income
40%
20%
5%
0
$1,000
$10,000
$100,000
Income ($)
Proportional Tax- A tax that takes the same
percentage of income from all workers.
Examples:
Flat tax proposal for the income tax
Impact of Taxes on Income
% of
Income
20%
0
$1,000
$10,000
$100,000
Income ($)
13. Benefits Received Principle- The people who pay
the tax are the ones who directly receive the benefits.
 Examples: Licenses and Fees, Most Excise
Taxes, Social Security
14. Ability to Pay Principle- The amount of tax a
person pays is based on how much they can afford to
pay. Two types:
1. Based on Wealth- Value of your assets(what you own).
Examples: Property, Inheritance
2. Based on Income- How much money you earn now.
Examples: Personal Income, Luxury
Economic Statistics Rules of Thumb
aka “The Economic Sweet Spot”
Good  1-3% Inflation Bad
Bad  3-4% Growth (RGDP) Good
Good  4-6% Unemployment Bad
Economic Statistics- Expansionary Policy
3% CPI Increase/ Inflation Rate
-2% Growth in RGDP
10% Unemployment Rate
What is the problem with the economy?
Recession!
How do you know this?
Unemployment is at a very high rate, higher than it’s
normal range of 3-5%. The economy is also shrinking,
since the RGDP is negative.
Economic Statistics- Expansionary Policy
3% CPI Increase/ Inflation Rate
-2% Growth in RGDP
10% Unemployment Rate
What can the Congress and the President do to solve/
help this situation?
Increase the amount of income for people! This will put
more money into the economy and get it expanding again.
“Murphy's Law of Economic Policy”
''Economists have the least influence
on policy where they know the most
and are most agreed; they have the
most influence on policy where they
know the least and disagree most
vehemently.''
Economist Alan Blinder, former vice chair of the Federal Reserve
15. Fiscal Policy- Using Taxes and Government
Spending to achieve specific economic goals.
16. Expansionary Fiscal Policy- Efforts by Congress and
the President to stimulate the economy and get it
expanding. Used during a recession. Tries to increase
aggregate demand. 3 “Tools” of Fiscal Policy:
 1. Taxes- Decrease

2. Government Spending- Increase

3. Transfer Payments- Increase
AD/ AS Graph
PL
LRAS
SRAS0
AD/AS GraphExpansionary
Fiscal Policy
PL1
John Maynard
Keynes
PL0
AD0
FE
0
Y0
Y1
AD1
RGDP=Y
The economy is below FE at an output of Y0. Congress and the President can:
1. ↑ G
2. ↑ TP
3. ↓ T
Expansionary Fiscal Policy pushes AD from AD0 to AD1; PL ↑ from PL0 to PL1,
RGDP ↑ from Y0 to Y1. U ↓ because economy has risen to FE.
But…Demand-Pull Inflation!
Expansionary Fiscal Policy
Full $20 Billion
Increase in
Aggregate Demand
Price Level
$5 Billion
Additional
Spending
AS
Recessions
Decrease
Aggregate
Demand
P1
AD1
AD2
$490
$510
Real Domestic Output, GDP
Economic Statistics Rules of Thumb
aka “The Economic Sweet Spot”
Good  1-3% Inflation Bad
Bad  3-4% Growth (RGDP) Good
Good  4-6% Unemployment Bad
Economic Statistics- Contractionary Policy
15% CPI Increase/ Inflation Rate
5% Growth in RGDP
4% Unemployment Rate
What is the problem with the economy?
Inflation!
How do you know this?
CPI is going up at a very high rate. Higher than it’s
normal range of 2-3%.
Economic Statistics- Contractionary Policy
15% CPI Increase/ Inflation Rate
5% Growth in RGDP
4% Unemployment Rate
What can the Congress and the President do to solve/
help this situation?
Decrease the amount of income for people! This will
put less money into the economy and get it to slow
down or contract.
17. Contractionary Fiscal Policy- Efforts by Congress
and the President to constrict the economy and get it
contracting. Used during an expansion with high
inflation. Tries to decrease aggregate demand. 3
“Tools” of Fiscal Policy:

1. Taxes- Increase

2. Government Spending- Decrease

3. Transfer Payments- Decrease
AD/ AS Graph
PL
LRAS
SRAS0
PL0
PL1
AD/AS GraphContractionary/
Restrictive
Fiscal Policy
AD0
AD1
FE
0
Y1
Y0
RGDP=Y
The economy is above FE at an output of Y0. Congress and the President can:
1. ↓ G
2. ↓TP
3. ↑ T
Contractionary Fiscal Policy pushes AD from AD0 to AD1; PL ↓ from PL0 to
PL1, RGDP ↓ from Y0 to Y1. U ↑ because economy has decreased to FE.
Contractionary Fiscal Policy
Recessions
Decrease
Aggregate
Demand
$5 Billion
Initial Decrease
In Spending
Price Level
AS
Full $20 Billion
Decrease in
Aggregate Demand
P1
AD4
AD3
$510
$522
Real Domestic Output, GDP
18. Discretionary Stabilizers- Fiscal policy tools that
require Congress and the President to take some action.

Examplesincrease or
decrease taxes,
create or eliminate
a tax break, Spend
more on
infrastructure,
weapons,
education, NASA,
FBI, National
Parks
19. Automatic Stabilizers- Fiscal policy tools that do
not require Congress and the President to take some
action.
 Examples- Welfare, food stamps, AHCCS,
section 8 housing vouchers, other programs
based on income, unemployment compensation.
U.S. Income-Maintenance System

Entitlement Programs

Social Security

Earned-Income Tax Credit (EITC)




Medicare and Medicaid
Unemployment Compensation
Public Assistance “Welfare”
Supplemental Security Income (SSI)
Program
Temporary Assistance for Needy Families
(TANF)
Food-Stamp Program
Section 8 Housing Vouchers



2009 Stimulus Package
by category- Link to
larger graphic
Problems, Criticisms, and Complications
of Fiscal Policy

Problems of Timing




Political Considerations





Recognition Lag
Administrative Lag
Operational Lag
Political Business Cycle
Future Policy Reversals
Offsetting State and Local Finance
Crowding-Out Effect
Current Thinking on Fiscal Policy
O 11.2
2009 Stimulus
Package by year
in which money
is spent- Link to
larger graphic.
20. Barter- Trading of goods and services without the use of
money.
 Not very efficient! It lacks a “coincidence of wants”.
Trueques (barter markets) of Argentina
Baseball
cards!
Pogs!
Marbles!
Sources of Money’s Value

Commodity Money- The item used as money
has value of it’s own.

Ex: Silver, Gold, Gems, Salt, tobacco, furs, shells
Sources of Money’s Value

Representative Money- The item used as
money has value because it can be exchanged
for something valuable.

Gold and Silver Certificates
Sources of Money’s Value

Fiat Money- The item used as money has
value because the government says it is money
AND the citizens accept it is money.

Almost all coins and currency today
21. Functions of money
1. Medium of exchange Accepted in trade for G & S

2. Store of value Can be saved for use at a later
date
21. Functions of money3. Unit of Account/ Measure of value Easy to judge the worth of different
products

4. Standard of Deferred Payment
 Used as a standard benchmark for
specifying future payments for
current purchases, that is, buying now
and paying later.
22. Characteristics of money- Why do we
use certain items as money?




1. Divisibility Easy to break into smaller units
2. Portability Easy to carry or transport
3. Durability Lasts a long time
4. Stability in value Holds its value over time (no/
low inflation!)
23. M1- Measure of the supply of money in circulation.
Used by the Federal Reserve and others to measure the
growth of money in circulation. Includes the following:
1. Coins and Currency
2. Demand
Deposits/ Checking
Accounts
3. Traveler’s Checks
24. M2- Another measure of the supply of money.
Used for the same reason as M1. Many economists feel
it more accurately reflects the "readily available" supply
of money(the money that can relatively quickly be turned
into cash). M2 includes everything in M1 plus the
following major components :
 1. Savings Accounts
 2. Money Market Accounts (MMA’s)
 3. Certificates of Deposit (CD’s)
 4. Eurodollars (U.S. $ in Euro banks)
25. M3 = M2 + Large Time Deposits
Broadest definition of the money
supply
M1
M2
Currency +
54%
M1
Checkable Deposits +
46%
20%
February 2006
Small Time Deposits +
15%
Money Market Mutual
Funds Held By Individuals +
(MMMF)
11%
Savings Deposits
Including Money Market +
Deposit Accounts (MMDA)
54%
Totals
$1,375
Billion
$6,758
Billion
The Global Greenback

U.S. Currency Circulating Abroad






Russians $40 Billion
Argentineans $7 Billion
Polish $6 Billion
U.S. Profits from Dollars Leaving
Black Markets and Illegal Activities
Seeking Stable Purchasing Power



Soviet Union Collapse
Brazil Inflation Issues
Asian Market Exchanges
26.
The Monetary Equation of Exchange
MxV = P x Q
Money X Velocity = Price Level X Quantity
M = M1
Velocity = The number of times a dollar is spent
Price Level = The rate of inflation (GDP Price Deflator)
Quantity = Real GDP
Real GDP (Q) x Price Level (P) = Nominal GDP
27. Money Multiplier = 1/ Reserve Requirement X Initial Deposit
Example:
If the Fed has a Reserve Requirement of 20% this means 1 ÷ .2 = 5
5 is the money multiplier
$1000 initial deposit  $800 (80%) in excess reserves and $200 (20%) in
required reserves
$1000 x 5 = $5000 of money in circulation
$800 x 5 = $4000 new money created by the banking SYSTEM (not by 1 bank)
$1000 initial deposit + $4000 new money = $5000 in circulation
Refer to Money Creation Simulation for more examples
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100.00
Bank B
80.00
Bank C
64.00
Bank D
51.20
Bank E
40.96
Bank F
32.77
Bank G
26.21
Bank H
20.97
Bank I
16.78
Bank J
13.42
Bank K
10.74
Bank L
8.59
Bank M
6.87
Bank N
5.50
Other Banks 21.99
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
Monetary Multiplier or Checkable-Deposit
Multiplier
Monetary
Multiplier
=
or in Symbols…
Graphic
Example
1
Required Reserve Ratio
1
m =
New Reserves
$100
$80
Excess
Reserves
$400
Bank System Lending
Money Created
R
$20
Required
Reserves
$100
Initial
Deposit
The Monetary Multiplier

W 13.2
Reversibility
 Making Loans Creates Money
 Loan Repayment Destroys Money
 Multiple Step Money Expansion
 Multiple Step Destruction of Money
AP Macro Exam Tip
An injection of $100 of new money to the system when the
reserve requirement is 10% will change the money supply
by $1000. BUT the banking system increases the money
supply by $900 (the $100 difference being the action of
the depositor). Students have to be very careful to read the
question carefully and understand the two possible
answers for the change in the money supply.
A third possibility to the $100 of new deposits to the system is
"how much can this previously fully loaned out bank
immediately increase their loans?" Well now, I might not
have the wording that the College Board would use after a
two year period crafting the question, but a $100 deposit
with a reserve requirement of 10% allows the bank to
make a loan of $90.
28. The Federal Reserve(The Fed)- Central bank of the U.S.
Privately owned and financed by member banks in the U.S.
Very important and powerful. The Fed is given power by law to
conduct the following major functions:




1. Check clearing- Clears checks written under one
bank and then deposited in another bank.
2. Bank Regulation- Keeps banks honest and
depositors' money safe from banks misuse.
3. Providing Currency- Issues, but does not print, new
money when banks turn in old, worn out currency.
4. Regulating the money supply(using the 3 tools)Increase or decrease the money supply to fight inflation
and / or prevent the economy from entering a recession.
29. Structure of the Fed (Major parts)1. Regional Banks- 12 regional banks; AZ in the 12th district; San
Francisco HQ of 12th district; New York most important district.
Regional banks are in charge of the 1st 3 functions listed above.
29. Structure of the Fed (Major parts)2. Board of Governors- 7 members, appointed to 14
year terms by the President and confirmed by the
Senate. Oversee all operations of the Fed.
B of G Building
Chairman-Benjamin Bernanke, appointed in 2005 by G. W. Bush,
confirmed by Senate 1/31/2006
29. Structure of the Fed (Major parts)3. Federal Open Market Committee (FOMC)- 12 members (7
BofG's and 5 district bank presidents) Decides monetary
policy (see below).
7 members, appointed by
president, confirmed by
the Senate
12 regional bank presidents
All 7 of B of G
serve on FOMC
5 of the branch
presidents serve on
the FOMC too, 1 of
5 is always from NY
branch
Framework of the Federal Reserve
System and the Relationship to the Public
Board of Governors
Federal Open Market Committee
12 Federal Reserve Banks
Commercial Banks
Thrift Institutions
(Savings and Loan Associations,
Mutual Savings Banks,
Credit Unions)
The Public
(Households and
Businesses)
GLOBAL PERSPECTIVE
Central Banks, Selected Nations
Australia:
Canada:
Euro Zone:
Japan:
Mexico:
Russia
Sweden:
United Kingdom:
United States:
Reserve Bank of Australia (RBA)
Bank of Canada
Central Bank of Europe (CBE)
Bank of Japan (BOJ)
Banco de Mexico (Mex Bank)
Central Bank of Russia
Sveriges Riksbank
Bank of England
Federal Reserve System (the “Fed”)
(12 Regional Federal Reserve Banks)
Fed Salary Facts




Fed Chairman Makes $191,300
All other members make $172,200.
Salaries are not very high when
compared to what a private banker
could make
These numbers are as of January 2008.
30.
Monetary Policy- The control of the supply of money
by the Fed to achieve specific economic goals.
Changing the money supply will cause the aggregate
demand curve to shift!
31. The Three (3) Tools of Monetary Policy 1. Open Market Operations (OMO)- Sets the Federal Funds
Rate = IR Banks charge Banks

Buying and Selling Government Bonds (Securities)
 Fed Buys bonds Decrease in Fed Funds Rate
Increase in $ supply
 Fed Sells bonds Increase in Fed Funds Rate 
Decrease in $ supply
 Buy Bigger, Sell Smaller
Tools of Monetary Policy
Fed Buys $1,000 Bond from a
Commercial Bank
New Reserves
$1000
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
Tools of Monetary Policy
Fed Buys $1,000 Bond from the Public
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
Reserves
$1000
Initial
Checkable
Deposit
Total Increase in the Money Supply, ($5000)
Federal Funds Rate, Percent
Using Open Market Operations
To Set The Federal Funds Rate
4.5
Sf3
4.0
Sf1
3.5
Sf2
Df
Qf3
Qf1
Qf2
Quantity of Reserves
How the Fed’s
actions affect
all of the
participants in
the economy
2. Discount Rate (DR)- IR Fed charges Banks
Fed decreases DR Banks borrow more $
Banks lend out more $ Increase in $ Supply
Fed increases DR Banks borrow less $
Banks lend out less $ decrease in $ Supply
Many days, there is less than $100 million in discountwindow loans outstanding. That leapt to almost $46
billion after the Sept. 11, 2001, terrorist attacks on the
U.S. disrupted the money markets.
Link to change in FFR and DR rates
3.
Reserve Requirements (RR)-
Fed decreases RR Banks Lend out more $
Increase in $ Supply
Fed increases RR Banks Lend out less $
Decrease in $ Supply
Link to use of technology to reduce required
reserves
Money Market- The
market for short term
lending.
Nominal
Interest
Rate (i)
Money Market
i0
Money Market GraphMoney Demand Curve
i1
MD
0
QM0
QM1
Quantity of
Money (QM)
The nominal interest rate is the opportunity cost of
holding money.
As i ↓  ↑ Quantity of MD, ∆ QMD
As i ↑  ↓ Quantity of MD, ∆ QMD
Money Market Graph
The supply of money (MS)
is determined by the Fed so
it is a fixed amount
(perfectly inelastic)
Money Market
Nominal
Interest
Rate (i)
MS
i0
MD
0
QM0
Money demand (MD) slopes downward for 4 reasons:
Quantity of
Money
Transaction Demand- Need to keep money for daily purchases
Asset Demand- Need to hold money as an asset, for its liquidity and low risk
Speculative Demand- Change the amount of money you hold because you
think interest rates will change
Precautionary Demand- Need to keep $ to pay for emergencies
Demand for Money and the Money Market
(a)
Transactions
Demand for
Money, Dt
(b)
Asset
Demand for
Money, Da
(c)
Total
Demand for
Money, Dm
And Supply
Rate of Interest, I percent
10
Sm
7.5
=
+
5
5
2.5
0
Dt
50
100
Da
150
200
Amount of Money
Demanded
(Billions of Dollars)
50
100
150
200
Amount of Money
Demanded
(Billions of Dollars)
Dm
50
100
150
200
250
Amount of Money
Demanded and Supplied
(Billions of Dollars)
300
Interest Rates


G 14.1
Equilibrium Interest Rate
Interest Rates and Bond Prices
 Bond Prices Fall When Interest Rates
Rise
 Bond Prices Rise When Interest
Rates Fall
 Inverse Relationship Between
Interest Rates and Bond Prices
W 14.2
Money Market
Money Market Graph∆ MS (shift in MS)
An ↑ in MS from MS0 to
MS1 → ↓ i from i0 to i1;
↑ QM from QM0 to QM1
A ↓ in MS from MS0 to
MS2 → ↑ i from i0 to i2
↓ QM from QM0 to QM2
Nominal
Interest Rate
(i)
MS2
MS0
MS1
i2
i0
i1
MD
0
QM2
QM0
QM1
Quantity of
Money (QM)
Money Market Graph- ∆ MD (shift in MD)
An ↑ money demand from
MD0 to MD1 → ↑ i from i0
to i1
A ↓ money demand from
MD0 to MD2 → ↓ i from i0
to i2
Money Market
Nominal
Interest
Rate (i)
MS0
i1
i0
i2
MD1
MD2
0
What happens to Quantity of Money?
QM0
MD0
Quantity of
Money (QM)
Money Market Graph
Different elasticities of MD
Money Market
Nominal
Interest
Rate (i)
Country A has a relatively elastic MD.
Country B has a relatively inelastic MD.
MS0 MS1
i0
i1
MD- Country A
i2
MD- Country B
0
QM0 QM1
Quantity of
Money
Country A (Bolivia)- An ↑ in MS from MS0 to MS1will cause a relatively small ↓
in i from i0 to i1. Country A’s MD is relatively insensitive to ∆ in i. Countries with
less developed countries/ economies (LDC’s).
Country B (USA)- An ↑in MS from MS0 to MS1will cause a relatively large
↓ in i from i0 to i2. Country B’s MD is relatively sensitive to ∆ in i.
Countries with more developed countries/ economies (MDC’s).
Different Elasticities of Investment Demand
Money Market
Nominal
Interest
Rate (i)
MS0
Investment Demand
MS1
Nominal
Interest
Rate (i)
Country A
i0
i1
Country B
IDE
MD
0
QM0
QM1
Quantity of
Money
IDI
QI0 QII
QIE
Quantity of
Investment
The ↓ in i from i0 to i1 ↑ investment a little in the country A but a lot in
country B. A country would rather have an elastic investment D curve,
sensitive to changes in i. These would tend to be more developed countries/
economies (MDC’s).
Different Elasticities of Money Demand and Investment Demand
Money Market
Nominal
Interest
Rate (i)
MS0
Nominal
Interest
Rate (i)
MS1
Investment Demand
i0
IDE
i1
MDI
0
QM0
QM1
Quantity of
Money
QI0
QIE
Quantity of
Investment
A country would rather have an inelastic (insensitive) money demand curve
and an elastic (sensitive) investment demand curve. These would tend to be
more developed countries/ economies (MDC’s)
Economic Statistics Rules of Thumb
aka “The Economic Sweet Spot”
Good  1-3% Inflation Bad
Bad  3-4% Growth (RGDP) Good
Good  4-6% Unemployment Bad
Economic Statistics- Expansionary Policy
3% CPI Increase/ Inflation Rate
-2% Growth in RGDP
10% Unemployment Rate
What is the problem with the economy?
Recession!
How do you know this?
Unemployment is at a very high rate, higher than it’s
normal range of 4-6%. The economy is also shrinking,
since the RGDP is negative.
Economic Statistics- Expansionary Policy
3% Inflation
-2% Growth (RGDP)
10% Unemployment
What can the Federal Reserve do to solve/ help this
situation?
Increase the money supply! This will put more money
into the economy and get it expanding again.
32. Expansionary Monetary Policy (Easy money) Efforts by the Fed to stimulate the economy and get it
expanding. Used during a recession. Tries to increase
aggregate demand.
3 “Tools” of Monetary Policy:
 1. Open Market Operations (OMO) Fed Buys bonds/ Decreases Fed Funds Rate

2. Discount Rate (DR) Fed decreases DR

3.

Reserve Requirements (RR)Fed decreases RR
Expansionary Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
Fed Buys Bonds, Lowers Reserve
Ratio, or Lowers the Discount Rate
Excess Reserves Increase
Federal Funds Rate Falls
Money Supply Rises
Interest Rate Falls
Investment Spending Increases
Aggregate Demand Increases
Real GDP Rises
Expansionary Monetary Policy
Investment Demand Graph
Money Market Graph
Nominal
Interest
Rate (i)
MS0
Nominal
Interest
Rate (i)
MS1
i0
i1
MD
0
QM0
QM1
Quantity of
Money
Money Market- MS ↑ from MS0 to
MS1. This ↓ nominal interest rates (i)
from i0 to i1 and quantity ↑ from QM0
to QM1
ID
QI0
QI1
Quantity of
Investment
Investment Demand- ↓ i from i0 to i1
→ ↑ I from QI0 to QI1. ↑ I → ↑ AD.
AD/ AS Graph
PL
LRAS
SRAS0
AD/AS GraphExpansionary
Monetary Policy
PL1
PL0
AD0
FE
0
Y0
Y1
AD1
RGDP=Y
The economy is below FE at an output of Y0. The Fed can:
1. Buy Bonds, ↓ federal funds rate
2. ↓ Discount Rate
↑MS→ ↓IR → ↑C, I → ↑AD
3. ↓ Reserve Requirements
Expansionary Monetary Policy pushes AD from AD0 to AD1; PL ↑ from PL0 to
PL1, RGDP ↑ from Y0 to Y1. U ↓ because economy has risen to FE.
But…Demand-Pull Inflation!
Economic Statistics- Contractionary Policy
15% CPI Increase/ Inflation Rate
5% Growth in RGDP
4% Unemployment Rate
What is the problem with the economy?
Inflation!
How do you know this?
CPI is going up at a very high rate. Higher than it’s
normal range of 1-3%.
Economic Statistics- Contractionary Policy
15% CPI Increase/ Inflation Rate
5% Growth in RGDP
4% Unemployment Rate
What can the Federal Reserve do to solve/ help this
situation?
Decrease the money supply! This will put less money
into the economy and get it to slow down or contract.
33. Contractionary Monetary Policy (Tight money) - Efforts
by the Fed to constrict the economy and slow it down. Used
during an expansion with high inflation. Tries to decrease
aggregate demand.
3 “Tools” of Monetary Policy:
 1. Open Market Operations (OMO)
Fed Sells bonds/ Increases Fed Funds Rate

2. Discount Rate (DR) Fed increases DR

3.

Reserve Requirements (RR)Fed increases RR
Restrictive Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Inflation
Fed Sells Bonds, Increases Reserve
Ratio, or Increases the Discount Rate
Excess Reserves Decrease
Federal Funds Rate Rises
Money Supply Falls
Interest Rate Rises
Investment Spending Decreases
Aggregate Demand Decreases
Inflation Declines
Bank Panics of 1930-1933









Series of Bank Panics
Before Deposit Insurance
Mass Withdrawals From Fear
Move to Cash Reduced Money Supply Through
Reduction in Loans
Multiple Contraction Slowed Lending and the
Economy
1933 National Bank Holiday for One Week
Resulted in FDIC and 25% Drop in Money Supply
Contributed to the Great Depression
Regulation Protects the System Today
Contractionary Monetary Policy
Investment Demand Graph
Money Market Graph
Nominal
Interest
Rate (i)
MS1
Nominal
Interest
Rate (i)
MS0
i1
i0
MD
0
QM1
QM0
Quantity of
Money
Money Market- MS ↓ from MS0 to
MS1. This ↑ nominal interest rates (i)
from i0 to i1 and quantity ↓ from Q0 to
Q1
ID
QI1
QI0
Quantity of
Investment
Investment Demand- ↑ i from i0 to i1
→ ↓ I from QI0 to QI1.
AD/ AS Graph
PL
LRAS
SRAS0
PL0
PL1
AD0
AD1
FE
0
Y1
AD/AS GraphContractionary/
Restrictive
Monetary Policy
Y0
RGDP=Y
The economy is above FE at an output of Y0. The Fed can:
1. Sell Bonds, ↑ federal funds rate
2. ↑ Discount Rate
↓ MS→ ↑ IR → ↓ C, I → ↓ AD
3. ↑ Reserve Requirements
Contractionary Monetary Policy pushes AD from AD0 to AD1; PL ↓ from PL0 to
PL1, RGDP ↓ from Y0 to Y1. U ↑ because economy has decreased to FE.
Monetary Policy and Equilibrium GDP
(a)
The Market
For Money
Sm2
(c)
Equilibrium Real
GDP and the
Price Level
Sm3
AS
10
P3
Price Level
Rate of Interest, i (Percent)
Sm1
(b)
Investment
Demand
8
6
Dm
AD3
I=$25
P2
AD2
I=$20
ID
0
AD1
I=$15
$125
$150
$175
Amount of Money
Demanded and Supplied
(Billions of Dollars)
$15
$20
$25
Amount of Investment, I
(Billions of Dollars)
Q1
Qf Q3
Real Domestic Product, GDP
(Billions of Dollars)
Monetary Policy

Evaluation and Issues




Speed and Flexibility
Isolation From Political Pressure
Recent U.S. Monetary Policy
Problems and Complications



Recognition Lag
Administrative Lag
Operational Lag
AD-AS Theory of Price Level - Real Output and
Stabilization Policy
Input
Resources
With Prices
Productivity
Sources
LegalInstitutional
Environment
Consumption
(Cd)
Aggregate
Supply
Levels of
Output,
Employment,
Income, and
Prices
Aggregate
Demand
Investment
(Ig)
Net Export
Spending
(Xn)
Government
Spending
(G)
Loanable Funds Market
Real
Interest
Rate (r)
Loanable Funds MarketPrimarily, this is the market
where lenders make money
available to business
borrowers to expand their
investment in capital.
Loanable Funds Market
SLF
r0
DLF
0
QLF0
Quantity of
Loanable
Funds
Loanable Funds Market
Supply of Loanable FundsThe income people have
chosen to save or lend out
rather than use for
consumption. A ∆ savings
decisions will shift SLF.
Demand for Loanable FundsThe money households and
businesses want to borrow. A ∆
investment or consumption
decisions will shift DLF.
Real
Interest
Rate (r)
Loanable Funds Market
SLF
r0
DLF
0
QLF0
Quantity of
Loanable
Funds
Loanable Funds Market
Determinants of Supply of LF
1.Domestic Saving by Individuals
and Business
Real
Interest
Rate (r)
Loanable Funds Market
SLF
2.Government Budget Surpluses:
G<T
r0
3. International Savers/ Investors
Determinants of Demand of LF
1.Domestic Borrowers, both
individuals and business
2.Government Budget Deficit: G > T
3.International Borrowers
DLF
0
QLF0
Quantity
of
Loanable
Funds
34. Prime rate- The interest rate that the biggest banks charge
their biggest and best customers. When the Fed increases
Discount and/ or Federal Funds rate banks raise their Prime rate
which causes other rates(car, home loans, etc.) to increase. If
the Fed decreases its rates banks do the same with their prime
and other rates.
Fed ↑ Money Supply Banks borrow more  Banks lend/ create
more  ↓ Prime rate  ↓ rates for homes, cars, education  ↑ C,
I  ↑ AD.
35. Budget Deficit- When government spending exceeds
government revenue. When the government spends more than it
makes. To make up the deficit the government is forced to
borrow money. Currently 407 billion (FY2008). A yearly total.
Maybe $1.6 Trillion for 2009
Budget Deficit vs. Budget Surplus
A deficit exists when Government Spending is > Tax Revenue.
So: G > T
A surplus exists when Government Spending is < Tax Revenue.
So: G < T
A balanced budget exists when:
Government Spending = Tax Revenue.
So: G = T
Federal Deficits and Surpluses – 1990 - 2005
as a Percentage of Potential GDP
(1)
Year
(2)
Actual
Deficit (-) or
Surplus (+)
(3)
Standardized
Deficit (-) or
Surplus (+)
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
-3.9%
-4.4%
-4.5%
-3.8%
-2.9%
-2.2%
-1.4%
-0.3%
+0.8%
+1.4%
+2.5%
+1.3%
-1.5%
-3.4%
-3.5%
-2.6%
-2.2%
-2.5%
-2.9%
-2.9%
-2.1%
-2.0%
-1.2%
-1.0%
-0.4%
+0.1%
+1.1%
+1.1%
-1.1%
-2.7%
-2.4%
-1.8%
Source: Congressional Budget Office
Federal Budget Deficits and Surpluses
Actual and Projected, Fiscal 1992-2012
Actual
Projected
(as of March 2006)
Budget Deficit (-) or Surplus, Billions
$300
200
100
0
-100
-200
-300
-400
-500
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: Congressional Budget Office
36. National Debt- The sum of all past budget
deficits. Currently $10.6 trillion (November,
2008).
Who do we owe the debt to?
As of November 2007, Japan ($580 billion), China ($390 billon)
and the United Kingdom ($320 bilion) are the biggest foreign
holders of our Debt.
Debt Held by the Public as a Percent of
GDP 1980-2007
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Source: Congressional Budget Office, January 2008
118
Percent of Debt Held by the Public
Owned by Foreigners
(1980-2006)
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
1987
1990
1993
1996
1999
2002
2005
Source: United States Treasury Department
GLOBAL PERSPECTIVE
Publicly Held Debt:
International Comparisons
As a Percentage of GDP - 2005
0
Italy
Belgium
Japan
Germany
France
United States
Hungary
Netherlands
United Kingdom
Spain
Canada
Poland
20
40
60
80
100
101.3
86.3
80.9
58.8
46.5
45.7
39.6
39.3
39.1
28.7
26.4
17.0
Source: Organization for Economic Cooperation and Development
37. Discretionary Spending- Spending that is not required by
law.
Examples: ∆Taxes/ Tax deductions, Defense, NASA , Education
38. Entitlement Spending- Spending programs required by law
to be paid to anyone who meets criteria set by law.
Examples: Social Security, Welfare, Stud. Loans, Food Stamps
Growth of programs for baby boomers is a real concern for the
future- S.S., Medicare, Medicaid, Prescription Drug Benefit
39. Mandatory Spending = Entitlements + Net Interest on the
Debt. Both are required by law. Both growing dramatically
because of:
1. ↑ in the deficit  more debt
2. Aging Population  more spending
on Social Security, Medicare, and Medicaid
This then puts a squeeze on discretionary spending
such as defense, NASA, national parks, law
enforcement, education, etc.
40. Transfer payments- Payments made to
individuals/ households by the government.
Examples: S.S, Welfare, Stud. Loans, Food Stamps
Composition of Actual FY 2007 Federal
Government Revenues and Outlays
(Deficit: $163 Billion)
2,750
2,500
Billions of Dollars
2,250
Interest
238
Domestic*
493
Defense
549
26
138
1,500
1,250
Other
Entitlements
309
Medicare
& Medicaid
561
Other Taxes
370
Corporate
Taxes
870
Social
Insurance
Taxes
2,000
1,750
Estate & Gift Taxes
1,000
750
1163
500
250
Social
Security
Individual
Income
Taxes
581
0
Outlays: $2.73 trillion
Revenue: $2.57 trillion
*Includes all appropriated domestic spending such as education, transportation, homeland
security, housing assistance, and foreign aid. Source: CBO 2008.
Percentage of Population Aged 65 and Over
America’s Population is Aging
Population age 65 and Over
25%
20%
15%
10%
5%
0%
2007
2012
2017
2022
2027
Year
Source: Social Security and Medicare Trustees’ Report, April 2007
2032
2037
2042
2047
Americans are living longer
and having fewer children
Consequently, fewer workers are available
to support each Social Security recipient
1960: 5.1 to 1
Today: 3.3 to 1
2040: 2.1 to 1
Source: Social Security Administration, April 2007
130
Medicare Costs Soar in the Coming
Decades
12
10
8
6
4
2
0
2007
2010
2020
2030
2040
2050
2060
2070
2080
Calendar Year
General Revenues required to fund the program
Income from dedicated taxes, premiums, and state transfers
Source: Medicare Trustees’ Report, 2008
131
Mandatory spending is consuming a
growing share of the budget
1967
1987
26%
68%
44%
2007
42%
38%
53%
7%
14%
Mandatory
Net Interest
9%
Discretionary
Source: Congressional Budget Office, January 2008
NOTE: Numbers may not add up due to rounding.
Social Security, Medicare, & Medicaid as a
Percentage of the Federal Budget
All other Federal
Spending
Social Security,
Medicare and Medicaid
$1.6 Trillion
$1.1 Trillion
58%
42%
Source: Congressional Budget Office, January 2008.
Outlays of Select Mandatory Spending
Programs
(FY 2008 Projected)
$700
$600
$ Billions
$500
$400
$300
$200
$100
$0
Social
Medicare Medicaid Federal Unemploy- Earned
Security
Retirement ment
Income &
& Disability Comp. Child Tax
Credits
Food
Stamps
Family
Support
Child
Nutrition
Source: Congressional Budget Office, January 2008
Change in Composition of
Discretionary Spending
1967
1987
32%
36%
68%
64%
Defense
2007
47%
53%
Non-defense
Source: Congressional Budget Office, January 2008
135
Defense Discretionary Spending as a
Percentage of GDP
10.0
As a Percentage of GDP
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1965
1968
1971
1974
1977 1980
1983
1986
1989 1992
1995
1998
2001 2004
2007
Source: Congressional Budget Office, January 2008
136
Outlays of Select Discretionary
Non-Defense Programs
(FY 2008 Projected)
$90
$80
$70
$ Billions
$60
$50
$40
$30
$20
$10
$0
Education
Transportation
*includes ground, air, and water
Income
Security
Natural
Resources
& Env.
Veterans
Foreign Aid Homeland
Security
Science,
Space, &
Technology
Source: Congressional Budget Office, January 2008
137
Automatic Growth in the Big Three Entitlements Swamps
Growth of Appropriations
10 Year Growth in Social Security, Medicare and Medicaid
Increase Over 2007 Level of Funding
In Billions of Dollars
$1,250
$1,000
$750
$500
$250
$0
2008
2009
2010
2011
2012
2013
2014
2015
Year
2016
2017
2009-2018
Spending for Social Security, Medicare and Medicaid.
$5.9 trillion
Discretionary Spending
$1.9 trillion
Source: Congressional Budget Office, January 2008.
2018
Current fiscal policy is on an unsustainable path
Interest
All Other
Medicaid
Average tax revenue
Medicare
Social Security
Source: Government Accountability Office, March 2008
Social Security, Medicare, Medicaid and Interest
Consume All Federal Revenues in Less Than 20
Years
Percentage of Revenues
125%
100%
75%
50%
25%
0%
2003
2008
2013
Year
2018
Social Security, Medicare and Medicaid
Source: GAO. 2008.
2023
2028
Interest
Balanced Budget
There are good economic reasons (crowding out)
for a balanced budget.
A balanced budget exists when:
Government Spending is = Tax Revenue.
So: G = T
Balanced Budget
A deficit exists when Government Spending is > Tax Revenue.
So: G > T
So, to have a balanced budget the government
must:
↓ G or
↑ T or
↓ Transfer
payments
Crowding Out Illustrated
Federal Government engages in expansionary fiscal
policy to close the recessionary gap.
↑TP, ↓ T → ↑ DPI → ↑ C, I → ↑ AD
AD/AS Graph
PL
LRAS
SRAS0
↑ G → ↑ AD
PL ↑ from PL0 to PL1
RGDP ↑ from Y0 to Y1
PL1
PL0
AD0
FE
0
Y0
R Gap
Y1
AD1
RGDP=Y
U ↓ because the economy
has moved up to FE.
The recessionary gap is gone!
41. Crowding Out effect- Federal government spends
more than it makes (taxes) It must borrow the rest. The
rise in interest rates caused by increased borrowing by the
federal government.
Since the Gov is borrowing
more the D for loanable funds
↑ from DLF0 to DLF1 and real
interest rates increase from r0
to r1. Q of loanable funds ↑
from Q0 to Q1.
Loanable Funds Market
Real
Interest
Rate (r)
SLF
r1
r0
DLF1 (Private + Public Debt)
DLF0 (Private Debt)
0
QPrivate Q
0
Q1
Quantity of
Loanable Funds
Because of the ↑ in r the
Qd of loanable funds
available for private
borrowing ↓ from Q0 to
QPrivate.
Crowding Out effect- Loanable Funds and Investment Demand
Loanable Funds Market
Real
Interest
Rate (r)
SLF
Real
Interest
Rate (r)
Investment Demand
r1
r0
DLF1
DLF0
0
QLF0
QLF1
Quantity of
Loanable Funds
ID0
QI1
QI0
Quantity of
Investment
Demand
D for loanable funds has ↑ from The ↑ in real interest rates will
DLF0 to DLF1 and real interest cause the Q of Investment
rates have ↑ from r0 to r 1.
demand to ↓ from QI0 to QI1.
Crowding Out effect- Money Market and Investment Demand
Money Market
Nominal
Interest
Rate (i)
Nominal
Interest
Rate (i)
MS0
Investment Demand
i1
i0
MD1
ID
MD0
0
QM0
Quantity of
Money
MD has ↑ from MD0 to MD1
and nominal interest rates have
↑ from i0 to i1.
QI1
QI0
Quantity of
Investment
Demand
The ↑ in nominal interest rates
will cause the Q of Investment
Demand to ↓ from QI0 to QI1.
Effect of crowding out on the economy
Because of the↑ r → ↓ I
AD/ AS Graph
PL
LRAS
SRAS0
→ ↓ AD from AD1 to AD2
PL ↓ from PL1 to PL2
PL1
PL2
RGDP ↓ from Y1 to Y2
PL0
AD0
FE
0
Y0 Y2 Y1
AD2
AD1
RGDP=Y
Recessionary gap is
partially restored
U ↑ because you have
moved back below FE
The Investment Demand Curve
and the Crowding-Out Effect
A Large Public Debt to Finance Public Investment Will Cause…
16
If Public Spending
Spurs More Private
Investment Will
Increase to ID2
Real Interest Rate (Percent)
14
12
b
10
c
8
a
6
Interest Rate
Rise Will
4
Decrease
2 Investment
a to b
0
5
10
CrowdingOut Effect
ID2
ID1
15
20
25
30
35
Investment Demand (Billions of Dollars)
40
42. Crowding In effect- The decrease in interest rates caused by
decreased borrowing by the federal government. Federal
government spends less and raises taxes. It needs to borrow
less OR if Tax revenue > spending (A budget surplus) it does
not need to borrow at all.
Real
Interest
Rate (r)
Loanable Funds Market
SLF
r0
r1
Since the Gov is borrowing
less the D for loanable funds ↓
from DLF0 to DLF1 and real
interest rates decrease from r0
to r1.
DLF0
DLF1
0
Q1 Q0
Quantity of
Loanable Funds
↓ r means I ↑ so AD ↑ and
RGDP ↑.
Phillips Curve (Short run)
Phillips Curve
Inflation
Rate
Tradeoff between inflation
and unemployment
Fiscal policy- ↓ T, ↑ TP or G
↓ Unemployment from U0 to U1→
↑ Inflation from I0 to I1
PL
I1
I0
AD/ AS Graph
LRAS
SRAS0
SRPC
0
PL1
PL0
AD0
FE
0
Y0
Y1
R Gap
AD1
RGDP=Y
U1
U0
Unemployment
Rate
Same as ↑ in AD on AD/AS
graph
1930’s-1970’s:
Keynesian theory
reigns supreme
1970’s-2000’s:
Classical theory
rebounds with:
Monetarism
and
Rational
Expectations
Theory (RET)
but….
Crisis of 20082009: New
Keynesians
rebound
April 13 (Bloomberg) -- Federal Reserve Chairman Ben S.
Bernanke is siding with John Maynard Keynes against Milton
Friedman by flooding the financial system with money.
Bernanke’s gamble that the highest jobless rate in 25 years and the
most idle factory capacity on record will hold down inflation is
straight out of the late British economist Keynes. Should late
Nobel-prize-winner Friedman’s dictum that “inflation is always and
everywhere a monetary phenomenon” prove right, the $1 trillion or
more in liquidity Bernanke has pumped into the financial system by
expanding the Fed’s balance sheet may leave him to cope with
surging consumer prices.
So far, investors and economic data both back up the BernankeKeynes view. The market in Treasury Inflation-Protected Securities
as of April 6 indicated long-term inflation expectations of 2.5
percent, below the 2.8 percent average inflation rate of the past 10
years.
Helicopter Ben
Central Bank rate cuts
are occurring worldwide
October , 2008
Animated Phillips Curve
SRAS1
PL
LRAS1 LRAS0
SRAS0
PL1
PL0
AD
FE1
0
Y1
FE0
Y0
RGDP=Y
Supply Shock
An unexpected shock to the economic system such as a ↓ in availability of oil or
food supplies causes LRAS/SRAS to ↓, PL ↑, RGDP ↓, U Rate ↑. What’s the
problem?
High prices and high unemployment at the same time! The worst of all
economic worlds. This tends to then lead to an ↑ in inflationary expectations
which causes us to demand ↑wages which ↑costs of production but… → ?
More stagflation!
Phillips Curve (short run)
Inflation
Rate
Phillips Curve
Tradeoff between inflation
and Unemployment
↑ in SRPC from SRPC0 to SRPC1
caused by stagflation (↓ in LRAS/
SRAS)
SRPC1
Unemployment AND Inflation both ↑
SRPC0
SRPC2
0
↓ in SRPC from SRPC0 to SRPC2 caused by
↑ in technology or other LRAS
determinants (↑ in LRAS/ SRAS)
Unemployment AND Inflation both ↓
Unemployment
Rate
Phillips Curve
Phillips Curve (long run)
Inflation
Rate
LRPC
Phelps- Friedman hypothesis- There is a
“natural rate of unemployment
(NAIRU!) that the economy will always
return to.
C
B
Exp Fiscal Policy can ↓ U
temporarily, from A to B.
However, according to the theory
of NAIRU, this is a short-run
tradeoff b/c it will ↑ inflation
expectations, shifting SRPC0 to
SRPC1 and moving equilibrium
from B to C. ↓ in U below the
"Natural Rate" will be temporary,
and lead only to higher inflation in
the long run.
SRPC1
A
SRPC0
0
NAIRU
Unemployment
Rate
Movement along the SRPC (from A
to B) is caused by AD shift
A shift in the SRPC (SRPC0 to
SRPC1) is caused by AS shift
The Long-Run Vertical Phillips Curve
PCLR
Annual Rate of Inflation (Percent)
15
PC3
12
b3
PC2
9
a3
b2
PC1
6
a2
c3
a1
c2
b1
3
0
3
4
5
Unemployment Rate (Percent)
6
AD/ AS Graph
PL
SRAS1
LRAS
PL2
SRAS0
C
AD/AS GraphPhillips curve
equivalent
B
PL1
A
PL0
FE
0
Y0
AD0
Y1
AD1
RGDP=Y
Expansionary Fiscal/ Monetary Policy pushes AD from AD0 to AD1; PL ↑ from
PL0 to PL1, RGDP ↑ from Y0 to Y1.
Move from A to B → Demand-Pull Inflation! Real wages decrease!
Inflation causes resource prices to ↑ (nominal wages ↑ so real wages go back ↑),
which shifts SRAS from SRAS0 to SRAS1. The economy ↓ to LRE/ FE at Y0
but at a ↑ PL, PL2.
Move from B to C → Cost-Push Inflation!
Taxation and Aggregate Supply

Supply-Side Economics- attempts to ↑LRAS/SRAS
Δ Tax Incentives to encourage Work
Δ Tax Incentives to encourage Saving and Investing
to provide more $$$ for R & D, infrastructure, capital
projects
The Laffer Curve
100
Tax Rate (Percent)



n
Laffer Curve
m
m
l
Maximum
Tax Revenue
0
Tax Revenue (Dollars)
Taxation and Aggregate Supply

Criticisms of The Laffer Curve



Taxes, Incentives, and Time
Inflation and Higher Real Interest
Rates
Position on the Curve
From Short Run To Long Run
Demand-Pull Inflation in the
Extended AD-AS Model
AS2
Price Level
ASLR
AS1
b
P3
c
P2
a
P1
AD2
AD1
Qf
Real Domestic Output
From Short Run To Long Run
Cost-Push Inflation in the Extended AD-AS Model
If Government Counters Recession With Spending…
If Government Ignores Recession…
Price Level
ASLR
AS1
c
P3
P2
AS2
b
a
P1
AD2
AD1
Qf
Real Domestic Output
From Short Run To Long Run
Recession in the
Extended AD-AS Model
Price Level
ASLR
AS2
a
P1
P2
AS1
b
c
P3
AD1
AD2
Q1 Qf
Real Domestic Output
Intentionally Blank
AD/ AS Graph
SRAS0
PL
LRAS
PL0
SRAS1
A
AD/AS GraphPhillips curve
equivalent
B
PL1
C
PL2
AD0
FE
0
Y1
Y0
AD1
RGDP=Y
Contractionary Fiscal/Monetary Policy pushes AD from AD0 to AD1; PL ↓ from
PL0 to PL1, RGDP ↓ from Y0 to Y1.
Move from A to B. Real wages increase!
↓ PL causes resource prices to ↓ (nominal wages ↓ so real wages go back ↓),
which shifts SRAS from SRAS0 to SRAS1. The economy ↑ to LRE/ FE at Y0
but at a ↓ PL, PL2.
Move from B to C
Does the Economy Self-Correct?

O 17.3
New Classical View of SelfCorrection




Rational Expectations Theory
New Classical Economics
Speed of Adjustment
Unanticipated Price-Level Changes
 Price-Level

Surprises
Fully Anticipated Price-Level
Changes
G 17.1
Does the Economy Self-Correct?
New Classical View of Self-Correction
ASLR
AS2
Price Level
AS1
c
P3
b
P2
P1
a
AD2
AD1
Q1
Q2
Real Domestic Output
Does the Economy Self-Correct?
New Classical View of Self-Correction
ASLR
Price Level
AS1
AS3
P1
P4
f
a
d
P5
e
AD1
AD3
Q4 Q3 Q1
Real Domestic Output
Does the Economy Self-Correct?

Mainstream View of Self-Correction


Downward Wage Inflexibility
Efficiency Wage Theory
 Greater
Work Effort
 Lower Supervision Costs
 Reduced Job Turnover

Insider-Outsider Relationships

Insider-Outsider Theory
O 17.4
AD/ AS Graph
PL
SRAS1
LRAS
PL2
SRAS0
New Classical/ RET View
of ↑ in AD
C
B
PL1
RET= Rational
Expectations Theory
A
PL0
FE
0
Y0
AD0
Y1
AD1
RGDP=Y
New Classical View- Because of wage and price flexibility, Unanticipated ↑ in
AD  Demand-Pull Inflation from Pt. A to B 
Cost-Push Inflation from B to C, self-correction happens very fast b/c info is
very accessible so behavior changes fast!
Anticipated ↑ in AD leads from A to C immediately. AS is a vertical line at
LRAS. Since economy self-corrects then government should keep out!
AD/ AS Graph
RET=
Rational
Expectations
Theory
PL
SRAS1
LRAS
F
PL2
SRAS0
A
D
PL3
New Classical/
RET v.
Mainstream/
Keynesian View
B
PL1
A
PL0
FE
0
Y2
Y3
Y0
AD1
Y1
AD0
RGDP=Y
New Classical View- Because of wage and price flexibility, Demand-Pull Inflation
from Pt. A to B  Cost-Push Inflation from B to C, self-correction happens
very fast b/c info is very accessible so behavior changes fast!
Mainstream view- If prices are inflexible (“Sticky”) the PL stays at PL2 and
RGDP/output falls to Y2 ( Pt. F) OR
Mainstream view- If PL eventually ↓to PL3 RGDP/output still falls (to Y3) b/c
wage inflexibility prevents SRAS from ↓