Lecture 5: Basics of Macroeconomics II
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
April 16, 2010
Chapter 28
Unemployment & Its Natural Rate
U.S. Unemployment, 1960-2007
12
percentage of labor force
Unemployment rate
10
8
6
4
Natural rate of
unemployment
2
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Unemployment Insurance Claims
and Unemployment Rate
(%)
11
('000)
700
10
600
9
500
8
7
400
6
300
5
4
MAR JUN
2007
SEP
DEC
MAR JUN
2008
SEP
Un em pl oy m en t Ra t e (Left )
DEC
MAR JUN
2009
SEP
DEC
MAR
2010
U.I. Cl a im s (Ri gh t )
200
Unemployment Rate: U.S. vs. Georgia
(%)
12
10
8
6
4
2
1991
1994
1997
2000
2003
2006
2009
Identifying Unemployment
 Natural Rate of Unemployment
– The natural rate of unemployment is unemployment
that does not go away on its own even in the long run.
– It is the amount of unemployment that the economy
normally experiences.
 Cyclical Unemployment
– Cyclical unemployment refers to the year-to-year
fluctuations in unemployment around its natural rate.
– It is associated with short-term ups and downs of the
business cycle.
How Is Unemployment
Measured?
 Based on the answers to the survey questions, the
Bureau of Labor Statistics (BLS) places each adult
into one of three categories:
– Employed
– Unemployed
– Not in the labor force
 Labor Force
– The labor force is the total number of workers, including
both the employed and the unemployed.
– The BLS defines the labor force as the sum of the
employed and the unemployed.
Breakdown Of The Population In 2007
Employed
(146.0 million)
Adult
Population
(231.8 million)
Unemployed (7.1 million)
Not in labor force
(76.0 million)
Labor Force
(153.1 million)
Unemployment - What is it?
The unemployment rate is calculated as the
percentage of the labor force that is
unemployed.
Number unemployed
Unemployment rate =
 100
Labor force
Labor Force Participation Rate
Labor force participation rate
Labor force

 100
Adult population
Example
 In 2001, 135.1 million people were employed and
6.7 million people were unemployed.
– Labor Force = 135.1 + 6.7 = 141.8 million
– Unemployment Rate
= (6.7 / 141.8) X 100
= 4.7 percent
– Labor Force Participation Rate =
(141.8 / 211.9) X 100 = 66.9 percent
Figure 3 Labor Force Participation
Rates for Men and Women Since 1950
Labor-Force
Rate (in percent)
90
80
Men
70
60
50
Women
40
30
20
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
The Labor-Market Experiences of Various
Demographic Groups (2007)
Demographic Group
Adults (ages 20 and older)
White, male
White, female
Black, male
Black, female
Teenagers (ages 16–19)
White, male
White, female
Black, male
Black, female
Unemployment
Rate
Labor-force Participation
Rate
3.7%
3.6
7.9
6.7
76.3%
60.1
71.2
64.0
15.7
12.1
33.8
25.3
44.3
44.6
29.4
31.2
This table shows the unemployment rate and the labor-force participation
rate of various groups in the U.S. population for 2007
Copyright©2004 South-Western
Questions About Unemployment
 Does the Unemployment Rate Measure What We
Want It To?
 How Long Are the Unemployed without Work?
 Why Are There Always Some People
Unemployed?
Article: Why do Americans Work More Than Europeans?
WSJ; by: Edward Prescott
 Americans aged 15-64, on a per-person basis, work
50% more than French. The French, for example,
prefer leisure more than do Americans or on the other
side of the coin, that Americans like to work more. This
is silliness !!
 Germans and Americans spend the same amount time
working, but the proportion of taxable market time vs.
nontaxable home work time is different
 But marginal tax rates explain virtually all of this
difference. Labor supply is not fixed. People be they
European or American, respond to taxed on their
income.
– Spanish labor supply increased by 12% in 1988
when taxes were cut
Chapter 29
The Monetary System
Money–What is it and what does it do?
Money is the set of assets in an economy that people regularly
use to buy goods and services from one another
 Medium of Exchange –what sellers accept from buyers as
payment for goods and services. Eliminates inefficiencies of
barter.
 Unit of Account – When there is one unit of account, like the
($) in the United States, you don't have to think in relative
terms when valuing goods and services.
 Store of Value – people have the option to hold money over
time as one way of storing their assets. Money is an important
store of value, because it is the most liquid asset in the
economy
Types of Money
 Commodity Money money that takes the form of a
commodity with intrinsic value.
 Fiat Money money without intrinsic value that is
used as money because of government decree
How to Measure Money
Money Stock: The quantity of money circulating in the
economy
Q: Suppose you want to know the size of the U.S.
money stock. What should you count as money?
A: Currency and demand deposits, and a few other
items (detailed below) but not credit cards.
Currency - the paper bills and coins in the hands of the
public
Demand Deposits - balances in bank accounts that
depositors can access on demand by writing a check
(or by using a debit card)
Two Measures of the Money Stock for the U.S.
Economy (2007)
Billions
of Dollars
M2
$7,447
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($6,083 billion)
M1
$1,363
0
• Demand deposits
• Traveler’s checks
• Other checkable deposits
($605 billion)
• Currency
($759 billion)
• Everything in M1
($1,364 billion)
Continued…
Q: How is the U.S. money stock measured and reported?
A: Two most important measures – M1 and M2
M1 = Currency, Traveler's checks, Demand Deposits and Other
Checkable Deposits
Here is a breakdown of M1 for 1996:
Item$ (Billions) % of total
Currency
Traveler's Checks
Demand Deposits
Other Checkable Deposits
$1076.8
395.7
8.6
400.7
271.8
100.0%
36.7
0.8
37.2
25.3
M2 = Everything in M1 plus Savings deposits, Small Time
Deposits, Money Market Mutual Funds and a few minor
categories. M2 for 1996 was $3657.4 billion.
Banks & Money Supply
Q: How do banks operate?
A: Banks accept deposits from people. That money is in an
account until the depositor makes a withdrawal or writes a
check on their account.
Q: Do banks keep all of your money in their vault?
A: No. Our banking system is called fractional reserve
banking. Bankers understand that it is not necessary to
keep 100 percent of a depositors money on hand at all
times. As a result, bankers take some of your money and
loan it out to other people.
Continued..
Fractional reserve banking - a banking
system in which banks hold only a fraction
of deposits as reserves
Reserve ratio - the fraction of deposits that
banks hold as reserves. Minimum reserve
ratios are set by the Fed.
Money Creation with
Fractional-Reserve Banking
When a bank makes a loan from its
reserves, the money supply increases.
The money supply is affected by the amount
deposited in banks and the amount that
banks loan.
– Deposits into a bank are recorded as both assets
and liabilities.
– The fraction of total deposits that a bank has to
keep as reserves is called the reserve ratio.
– Loans become an asset to the bank.
Money Creation with FractionalReserve Banking
This T-Account shows a bank that…
– accepts deposits,
– keeps a portion
as reserves,
– and lends out
the rest.
– It assumes a
reserve ratio
of 10%.
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
Money Creation with
Fractional-Reserve Banking
When one bank loans money, that money is
generally deposited into another bank.
This creates more deposits and more
reserves to be lent out.
When a bank makes a loan from its
reserves, the money supply increases.
The Money Multiplier
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Money Supply = $190.00!
Total Liabilities
$90.00
The Money Multiplier
Suppose that the Fed requires banks to keep 10 percent of their
demand deposits on reserve.
Q: What happens when somebody brings in $100 and deposits it
in a bank?
A: The bank is required to keep $10 (10 percent) on reserve.
Q: What does the bank do with the remaining $90?
A: The bank will turn around and lend it to somebody else,
earning interest income for the bank.
Q: What did that $90 loan do to the size of the money supply?
A: The money supply increased by $90 when the loan was made.
Why? When the bank made the $90 loan, $90 in currency
reentered the money supply
Continued…
 Now suppose that the person who received the $90 loan
deposits that money into their checking account.
 Q: What does the bank have to do with the $90?
 A: Keep 10 percent on reserve (10 percent of $90 = $9).

 Q: What does the second bank do with the remaining $81?
 A: They can lend that out to somebody else
Money Multiplier
Q: How far does this process of money creation go?
A: The process of bank money creation continues until there are no more
excess reserves to be lent out.
Money multiplier - the amount of money the banking system generates with
each dollar of reserves. The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
With a reserve requirement, R = 10% or 1/10,
The multiplier is 5. Therefore, the original $100 deposit will eventually
turn into $1000 of deposits.
Q: The banking system can create money, but can it also create real wealth?
A: No. Each loan has two parts. Recall that the first $90 loan generated $90 in
new money. At the same time, that $90 loan also created a new $90
liability for the person borrowing the money. The banking system cannot
create real wealth.
The Federal Reserve System
The Federal Reserve (Fed) serves as the
nation’s central bank.
– It is designed to oversee the banking system.
– It regulates the quantity of money in the
economy.
The primary elements in the Federal
Reserve System:
1) The Board of Governors
2) The Regional Federal Reserve Banks
3) The Federal Open Market Committee
The Federal Reserve System
Copyright©2003 Southwestern/Thomson Learning
The Fed’s Organization
The Federal Open Market Committee
(FOMC)
– Serves as the main policy-making organ
of the Federal Reserve System.
– Meets approximately every six weeks to
review the economy.
The Fed’s Tools of Monetary Control
 The Fed has three tools in its monetary toolbox:
–
–
–
–
–
Open-market operations
Changing the reserve requirement
Changing the discount rate
NEW ALPHABET SOUP OF CREDIT PROGRAMS
BUYING T-BONDS & MBS/DEBT
The Fed’s Tools of Monetary Control
Open-Market Operations
– The Fed conducts open-market operations when it
buys government bonds from or sells government
bonds to the public:
– When the Fed buys bonds, the money supply is
increased. Here is why: The Fed pays for the bonds it
buys with money that was not currently a part of the
money supply, hence, when the Fed buys bonds it
simply increases the total amount of money in
circulation.
– When the Fed sells bonds, the money supply is
decreased. Here is why: The Fed sells bonds in the
market and receives cash in return for the bonds it
sells. Once the Fed receives the cash, this cash is
taken out of circulation – therefore, the size of the
money supply is decreased.
The Fed’s Tools of Monetary Control
Reserve Requirements
– The Fed also influences the money supply with
reserve requirements.
– Reserve requirements are regulations on the
minimum amount of reserves that banks must
hold against deposits.
Problems in Controlling the
Money Supply
The Fed must wrestle with two problems
that arise due to fractional-reserve banking.
– The Fed does not control the amount of money
that households choose to hold as deposits in
banks.
– The Fed does not control the amount of money
that bankers choose to lend.
Credit Crunch
Update
Total Commercial Paper Outstanding
($. Bil.)
2400
2200
Up 60%
2000
1800
1600
1400
Down 50%
1200
1000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Total Consumer Credit Outstanding
($ Bil.)
2600
2550
2500
2450
2400
2350
2300
2250
JAN APR JUL OCT JAN APR JUL OCT JAN APR JUL OCT JAN APR JUL OCT JAN
2006
2007
2008
2009
2010
And You Thought HELOC Growth Was History!
(%, Y -O-Y )
50
(%)
8.4
7.8
40
7.2
6.6
30
6.0
20
5.4
4.8
10
4.2
3.6
0
3.0
-10
2.4
MAY OCT MAR AUG JAN JUN NOV APR SEP FEB JUL DEC MAY OCT MAR AUG JAN
2003
2004
2005
2006
2007
2008
2009
2010
Hom e Equ i t y (Left )
Pr im e Ra t e (Ri gh t )
Chapter 30
Money Growth and Inflation
The Classical Theory of Inflation
 Inflation is an increase in the overall level of prices.
Inflation erodes purchasing power of money.
 Hyperinflation is an extraordinarily high rate of
inflation.
 Historical Aspects
– Over the past 60 years, prices have risen on average about
5 percent per year.
– In the 1970s prices rose by 7 percent per year.
– During the 1990s, prices rose at an average rate of 2
percent per year.
– Deflation, meaning decreasing average prices, occurred in
the U.S. in the nineteenth century.
– Hyperinflation refers to high rates of inflation such as
Germany experienced in the 1920s.
Money Supply, Money Demand
and Monetary Equilibrium
 The money supply is a policy variable that is controlled by
the Fed.
– Through instruments such as open-market operations,
the Fed directly controls the quantity of money
supplied.
 Money demand has several determinants, including interest
rates and the average level of prices in the economy.
 People hold money because it is the medium of exchange.
– The amount of money people choose to hold depends
on the prices of goods and services.
 In the long run, the overall level of prices adjusts to the
level at which the demand for money equals the supply.
Money Supply, Money Demand, and the Equilibrium
Price Level
Value of
Money, 1/P
(High)
Price
Level, P
Money supply
1
1 (Low)
3
1.33
/4
12
/
Equilibrium
value of
money
(Low)
A
2
Equilibrium
price level
14
4
/
Money
demand
(High)
0
Quantity fixed
by the Fed
Quantity of
Money
Copyright © 2004 South-Western
Figure 2 The Effects of Monetary Injection
Value of
Money, 1/P
(High)
MS1
MS2
1 (Low)
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
Copyright © 2004 South-Western
The Classical Theory of
Inflation
The Quantity Theory of Money
– How the price level is determined and why it
might change over time is called the quantity
theory of money.
The quantity of money available in the economy
determines the value of money.
The primary cause of inflation is the growth in the
quantity of money.
Velocity and the Quantity Equation
 The velocity of money refers to the speed at
which the typical dollar bill travels around the
economy from wallet to wallet.
V = (P  Y)/M
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
 Rewriting the equation gives the quantity
equation:
MV=PY
Velocity & Quantity Equation
 Velocity ( V )
= Nominal GDP/ Money Supply
=(PxY)/M
 Example: V
= ($10 x 100 ) / $ 50
= 20
Velocity & Quantity Equation
 The quantity equation relates the quantity of
money (M) to the nominal value of output
(P  Y).
 The quantity equation shows that an increase in
the quantity of money in an economy must be
reflected in one of three other variables:
– the price level must rise,
– the quantity of output must rise, or
– the velocity of money must fall.
Velocity and the Quantity
Equation
The Equilibrium Price Level, Inflation Rate,
and the Quantity Theory of Money
– The velocity of money is relatively stable over
time.
– When the Fed changes the quantity of money, it
causes proportionate changes in the nominal
value of output (P  Y).
– Because money is neutral, money does not
affect output.
Nominal GDP, the Quantity of Money,
and the Velocity of Money
Velocity of Money (M2)
2.2
2.1
2.0
1.9
1.8
1.7
1.6
1.5
1961
1965
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005 2009
The Inflation Tax
When the government raises revenue by
printing money, it is said to levy an
inflation tax.
An inflation tax is like a tax on everyone
who holds money.
The Fisher effect refers to a one-to-one
adjustment of the nominal interest rate to
the inflation rate.
The Nominal Interest Rate and the
Inflation Rate
Costs of Inflation
1.
2.
3.
4.
Shoeleather Costs – resources wasted when inflation encourages
people to reduce their holdings of money.
Menu Costs – the costs involved in actually changing prices
around the economy.
Relative Price Variability and the Misallocation of Resources
– If firms only occasionally change their prices (like once per
year), then they have to guess at the future level of inflation. Their
prices will be too high early in the year and too low late in the
year, resulting in sales that are artificially low early in the year
and artificially high late in the year.
Inflation-Induced Tax Distortions – Taxes like capital gains and
interest income taxes are imposed on the nominal value of assets
or on interest income. From studying real versus nominal interest
rates, you know that part of the nominal interest rate exists to
compensate people for the effects of inflation. The higher is the
rate of inflation, the higher is this distortion caused by these taxes.
Continued..
5. Confusion and Inconvenience – Money, being the economy's
unit of account, is used to quote prices for goods and services
throughout the economy. Confusion and inconvenience arise as
a cost of inflation because inflation makes valuing dollars over
time difficult. Many important items in the economy are
measured over time (like the value of a firm, for instance), and
inflation creates difficulties in the valuation of assets or debts
that occur over time.
6. Arbitrary Redistributions of Wealth – "Inflation is good for
borrowers and bad for lenders" is a common phrase that rings
out in economics principles courses. Here's a personal example
for you to consider (and a personal example for your website
author as well). When you graduate from college, you will
likely owe money on student loans that you took out during
your college years. Between the time you borrowed the money
and the time when you repay the loan, you will be better off if
inflation is high.
Overhang of
Toxic Debt
Bad Luck for Streets of Buckhead
As of the 4th quarter, about 20% of $440 billion of
construction loans outstanding were more than 30
days past due, compared to 11.4% a year ago.
Banks will have their hands full in the coming
months. About $566 billion is commercial real estate
debt, the majority of which was provided by banks,
comes due in 2010 and 2011.
(Foresight Analytics)
Source: The Wall Street Journal, January 22, 2010
Atlanta’s Irrational Building Update
Two Alliance Center
Planned Opening: June 2009
Occupancy Rate: 31%
Financial Situation: project amount $116 million
Terminus 200
Planned Opening: Aug 2009
Occupancy Rate: 8.8%
Financial situation: took a $39 mm write-down
3630 Peachtree
Planned Opening: Aug 2009
Occupancy Rate: no leasing deal reported
Financial Situation: took a $50 mm write-down
Phipps Tower
Planned Opening: March 2010
Occupancy Rate: No leasing deal reported
Financial Situation: project amount $95 million
Source: The Wall Street Journal, April 22, 2009
Atlanta’s Office and Industrial Vacancy
Source: Atlanta Office Market Analysis for 2009Q4. Cushman & Wakefield
Commercial Bank Loan Charge-Off Ratio
(%)
2.5
S&Ls Crisis
2.0
1.5
1.0
0.5
0.0
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Meanwhile, in the Early 90’s…
Households
Labor
Large Firms
Labor
Financial Institution
Goods
Small Firms
Figure 1: Return Function of the Intermediary
p*l
pl(L)
K*
K
MPL ( high capital) > MPL (low capital)
Table: Steady state welfare calculations
Base Case
Steady state
Output
Consumption
Investment
Capital stock
K/L
Spread
Hours
Welfare cost
(DC/C)*100
(DC/Y)*100
w=0.0
1.1441
0.8419
0.3021
12.085
39.8
0.00%
0.3038
-
Experiment
w=0.006
1.1027
0.8155
0.2872
11.487
37.7
3.69%
0.3046
3.50%
2.60%
Fear of Fire Sales and the Credit Freeze
Douglas Diamond
Professor of Finance
University of Chicago
Raghuram Rajan
Professor of Finance
University of Chicago
…an “overhang” of impaired banks that may be
forced to sell soon can reduce the current price of illiquid
securities sufficiently that banks have no interest in selling. This
creates high expected returns to holding
cash for potential buyers and an aversion
to making term loans.
Source: NBER working paper #14925, April 2009
Cease & Desist Orders in Georgia
Institution
2007
2008
2009
FDIC
1
13
49
NCUA
2
0
1
OTS
1
0
3
CCANB
1
2
5
5
15
58
Total All Institutions
As of December 31th 2009, there were 309 banks in Georgia.
FDIC
NCUA
OTS
CCANB
= Federal Insurance Deposit Corporation
= National Credit Union Administration
= Office of Thrift Supervision
= Comptroller of the Currency Administrator of National Banks
Source: Georgia Bankers Association and each institution’s website.
Definition of Depression
Los A n gel es Em pl oy m en t
(%)
100
98
Aerospace Bust
Led to a Real
Estate & Jobs
Bust in Early 90s
96
94
Real Estate Recovery
was Led by Hispanic
Buyers; Hollywood
Fills in the jobs
Vacuum somewhat
92
90
88
86
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Beverly Hills
South Central L.A.
Source: UCLA Business Forecasting Project Report,
September 1996
Case-Shiller Tiered Home Price Index
Case-Shiller Tiered Home Price Index
A t lant a
Mia m i
140
350
300
120
250
100
200
150
80
100
60
1993
1995
Low T ier
1997
1999
2001
2003
2005
2007
2009
50
High T i er
1989
1991
Low T ier
Case-Shiller Tiered Home Price Index
1993
1995
1997
1999
2001
2003
2005
2007
2009
High T i er
Case-Shiller Tiered Home Price Index
Los A n gel es
New Yor k
(%, Y -O-Y )
300
350
300
250
250
200
200
150
150
100
100
50
1989
1991
Low T ier
1993
1995
1997
High T i er
1999
2001
2003
2005
2007
2009
50
1989
1991
Low T ier
1993
1995
1997
High T i er
1999
2001
2003
2005
2007
2009
Excess Reserves of Depository Institutions
($ Bil.)
1200
1000
800
600
400
200
0
-200
AUG SEP OCT NOVDEC JAN FEBMAR APR MAY JUN JUL AUG SEP OCT NOV DEC JAN
2008
2009
2010
Inflation Outlook
(%, Y -O-Y )
6
4
2
0
-2
-4
FEB
2007
MAY
AUG
CPI In dex
NOV
FEB
2008
MAY
Cor e CPI
AUG
NOV
FEB
2009
MAY
AUG
NOV
FEB
2010
Article: Haute Con Job (PIMCO)
aka Bill Gross’s Beef With Inflation
Methodology
 Bill Claims that Hedonic Pricing a.k.a. Haute Con
Job is Keeping Inflation Rate Low
 Low Inflation => Higher Productivity (Calculations)
 => FED Can Keep Rates Low, Keep the Consumption
Boom, and Greenspan His Legacy!
 Government Can Keep Social Security Payments Down
 It Hurts Investors, Especially His TIPS Holders
 Bill Says Core Inflation is Not the Real Metric of
Measuring the Cost of Living as We Still Have to
Pay for Food & Energy in Real Life!
Article: Con Job Redux (PIMCO)
by: Bill Gross

Bill claims that CPI inaccurately calculates Americans’ cost of
living.

Example: Say you buy 1 bag of gumdrops for $1 which has 100
of those. Productivity makes it 110 gumdrops but for $1.10.
Hedonic pricing says that CPI hasn’t gone up as per-capita cost
is the same (1 cent). But you have to shelve out $1.10 to get
the bag, which is an increase in cost of 10%. They must fork
out an extra dime even though they’re getting more for their
money.

We can’t buy individual pieces of memory in a computer-we
have to buy the entire package!
Inflation Outlook
(%, Y -O-Y )
6
4
2
0
-2
-4
FEB
2007
MAY
AUG
CPI In dex
NOV
FEB
2008
MAY
Cor e CPI
AUG
NOV
FEB
2009
Hou si n g
MAY
AUG
NOV
FEB
2010