AC 2203 Francisco M. Largo fmlargo@usc.edu.ph CHAPTER 1 Limits, Alternatives, and Choices The Economic Perspective Economics · Social science concerned with making optimal choices under conditions of scarcity. · Wants exceed society’s productive capacity. · Resources are limited to create goods/services Economic Perspective Scarcity and choices Opportunity Cost Purposed behavior to increase utility Marginal analysis(when u look at things by changes) by comparing the marginal benefits and marginal cost Scarcity and Choice resources are scare Choices must be made Opportunity Cost: The sacrifices made due to the decisions There is no free lunch Purposeful Behavior Rational self-interest Individuals and utility Firms and profit Desired outcome Marginal Analysis comparison of marginal benefits and marginal cost, usually for decision making Marginal - Extra or additional Sunk Cost - Irrelevant Theories, Principles, and Models The scientific method is the procedure for the systematic pursuit of knowledge involving the observation of facts and the formulation of testing hypotheses to obtain theories, principles, and laws. It consists of several elements: 1. Observe. 2. Formulate a hypothesis. o Logic - Mathematical o Falsifiability - Can be proven wrong 3. Test the hypothesis. 4. Accept, reject, or modify the hypothesis. 5. Continue to test the hypothesis, if necessary. Generalizations Other-things-equal assumption: The assumption that factors other than those being considered did not change. (Also called the "ceteris paribus assumption.") Graphical expression Microeconomics: The study of the individual consumer, firm, or market. Macroeconomics: The study of the entire economy or a major aggregate of the economy. Positive economics: Economic statements that are factual and focuses on cause and effect. Normative economics: Economic statements that involve value judgments. The economizing problem: Limited income and unlimited wants. The Budget Line (Budget constraint) * Attainable and unattainable combinations * Trade-offs and opportunity costs * Choice * Income Changes Society’s Economizing Problem Scarce Resources: 4 Resource Categories: 1.Land: Includes all natural resources used in the production process. 2. Labor: Physical actions and mental activities that people contribute to production. 3.Capital (investment): All human-produced physical objects and intangible ideas used in production. 4. Entrepreneurial ability: Special human resource distinct from labor. Production Possibilities Models Full employment The economy is employing all of its available resources. ∙ Fixed resources The quantity and quality of the factors of production are fixed. ∙ Fixed technology The state of technology (the methods used to produce output) is constant. ∙ Two goods The economy is producing only two goods: pizzas and industrial robots. Pizzas symbolize consumer goods, products that satisfy our wants directly; industrial robots (for example, the kind used to weld automobile frames) symbolize capital goods, products that satisfy our wants indirectly by making possible more efficient production of consumer goods. Production Possibilities Table: List of different combinations of 2 products that can be produced with a specific set of resources. Production Possibilities Curve: Data from the table presented shown graphically Law of Increasing Opportunity Cost 1.Shape of the curve – increasing opportunity is reflected in the shape 2.Economic rationale – Many resources are not completely adaptable to the users Optimal Allocation – Marginal Benefit = Marginal Cost Unemployment, Growth, and the Future A Growing Economy 1.Increase in Resource Supplies – Curve shifts outward and to the right (Economic Growth) 2.Improvement in resource quality 3.Advances in Technology Present Choices = Future Possibilities (Cannot determine whether good or bad since it depends on the preference and priorities.) International Trade: allows a nation to get more of a desired good at less sacrifice of some other good. CHAPTER 2 Economic Systems Set of institutionalized arrangements Coordinating mechanism Difference in system exist by Degree of decentralized use of markets and price in decision making Degree of centralized government control Laissez-Faire Capitalism (Pure Capitalism) Keep the government from interfering. Power of government needed to: ● Protect private property from theft. ● Provide a legal environment for contract enforcement. People interact in markets to buy and sell. Command System ● known as socialism or communism. ● Government ownership of resources. ● Decisions made by a central planning board. The Market system ● mix of decentralized decision making with some government control ● Systems found in much of the world ● Private markets are dominant force ● Private ownership of resources ● Self-interested behavior Characteristics of the Market System ● Private property ● Freedom of enterprise and choice ● Self-interest ● Competition ● Markets and prices ● Technology and capital goods ● Specialization ● Use of money ● Active, but limited, government Technology and Capital Goods ● Advanced technology and capital goods are encouraged ● Specialization ● Division of labor ● Geographic specialization Active, but Limited, Government ● Government may be needed to alleviate market failures ● Government can increase effectiveness of a market system ● Possible government failure 5 Fundamental Questions ● What will be produced? ● Profit ● Consumer sovereignty ● “Dollar Votes” allows consumers to indicate which to produce ● How will the goods be produced? ● Technology ● Price ● Who will get the output? ● Willingness to pay ● Ability to pay ● How will the system accommodate change? ● Changes in consumer tastes ● Changes in technology ● Changes in resource prices or availability ● How will the system promote progress? ● Technological advance ▪ Creative destruction: the hypothesis that the creation of new products and production methods destroys the market power of existing monopolies ● Capital Accumulation The “Invisible Hand” The tendency of competition to cause individuals and firms to unintentionally but effectively promote the interests of society even when each individual firm only attempts to pursue its own interest. 1776 Wealth of Nations by Adam Smith - Unity of private and social interest Virtues of the market system - Efficiency - Incentives - Freedom The Demise of Command System - Fails to deliver adequate amounts of goods and services - Coordination problem: must correctly set output targets for all goods and services - Incentive problem: no adjustments for surplus or shortage The Circular Flow Model How the Market System Deals with Risk Business owners and investors face risk: - Losses due to input shortage - Changes in consumer tastes - Natural disasters that affect the supply chain Employees and suppliers have security: - Paid whether the firm makes a profit or not Business risks are restricted to owners. Attracts needed inputs: Inputs easier to obtain since many dislike risk. Focuses Attention: - Owner personally responsible for outcome - Will encourage prudent decisions. Manage risk well and the others will prosper CHAPTER 3 Markets - Interaction between buyer and sellers - Markets may be Local, National, or International - Price is discovered in the interactions of buyer and sellers Demand - Schedule or curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during specified periods of time. - Demand schedule (table) or demand curve (graph) - Amount consumers are willing and able to purchase at a given price assuming: o Other things equal o Individual demand o Market demand Law of Demand - Other things equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls - Explanation: o Price acts as an obstacle buyers o Law of diminishing marginal utility o Income effect (weaker) and substitutional effect Determination of Demand - Change in consumer tastes and preferences - Change in the number of buyers - Change in income o Normal goods o Inferior goods - Change in prices of related goods o Substitute good o Complementary goods - Change in consumer expectations o Future prices o Future income Supply - A schedule or curve that shows that various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specified period of time. Supply Schedule (Supply Curve) - Amount producers are willing and able to sell at a given price Law of Supply: Other things equal, as the prices rises, the quantity supplied rises and as the price falls, the quantity supplied falls. Explanation: - Price acts as an incentive to producers - At some point cost will rise Determinants of supply - Change in resource prices - Change in technology - Change in taxes and subsidies - Change in prices of other goods - Change in producer expectations - Change in the number of sellers Individual Supply Market Supply Market Equilibrium - Equilibrium occurs where the demand curve and supply curve intersect - Equilibrium price and equilibrium quantity - Surplus and shortage - Rationing function of prices - Efficient allocation Production efficiency - Producing goods in the least costly way - Using the best technology - Using the right mix of resources Allocative efficiency - Producing the right mix of goods - The combination of goods mostly highly valued by society Changes in Supply, Demand, and Equilibrium Effect on Change in Supply Change in Demand Equilibrium Price Effect on Equilibrium Quantity Increase Decrease Increase Decrease Decrease Increase Increase Decrease Decrease Increase Indeterminate Indeterminate Indeterminate Indeterminate Increase Decrease Application: Government-Set Price Price Ceiling - Set below equilibrium price - Rationing problem - Black markets - Example: rent control Price Floor - Price are set above the market price - Chronic surpluses - Example: minimum wage law CHAPTER 26 Performance and Policy Business Cycle: Recession Real GDP (Gross Domestic Product): Corrects for price changes Nominal GDP (Gross Domestic Product): Uses current prices Unemployment Inflation: Increase in overall level of prices The Miracle of Modern Economic Growth Saving, Investment, and Choosing Between Present and Future Consumption Saving: Trade-off current for future consumption\ Investment - Financial Investment - Economic Investment Bank and financial institutions Uncertainty, Expectations, and Shocks The importance of expectations and shocks Expectations affect investment Shocks: what happen is not what was expected Demand Shocks Demand shocks and flexible prices - Prices falls if demand is low - Sales unchanged Demand shocks and sticky prices - Maintain inventory - Sales change - Business cycle Supply Shocks How Sticky are Prices? Inflexible prices/sticky prices Flexible prices: corn oil, natural gas Sticky Prices: Consumers and Firms Many Prices are sticky in the short run: - Consumers prefer stable prices - Firms want to avoid price wars All prices are flexible in the long run: Firms adjust to unexpected, but permanent changes in demand. Categorizing Macroeconomics Models Using Price Stickiness Sticky prices rather than stuck Aggregate expenditures model Aggregate demand-aggregate supply model Reason for sticky prices: - Consumer preference - Business price wars Wages and salaries 70% of costs Reduction in per- unit labor costs self-defeating. CHAPTER 27 Assessing the Economy’s Performance National income accounting measure economy’s overall performance Bureau of Economic Analysis compiles National Income and Product Accounts: - Assess health of economy - Track long-run course - Adjust economic policy Gross Domestic Product (GDP): Measures of aggregate output Avoid multiple counting - Market value final goods and services - Ignore intermediate goods and services - Count value added Domestic output only GDP: Transactions Exclude financial transactions: - Public transfer payments - Private transfer payments - Financial asset transactions Exclude secondhand sales: example: sell used to a friend Include Depreciation The Expenditures Approach - Count sum of money spent buying the final goods - Who buys the goods Personal consumption expenditure (C) - Durable goods - Nondurable goods - Consumer expenditures for services Gross private domestic investment (𝐼𝑔 ) includes: - Machinery, equipment, and tools - Residential construction - Research and development - Creation of new works of art, music, etc. - Changes in inventories Creation of new capital assets Financial investment transactions excluded Government purchases (G) - Expenditures for goods and services - Expenditures for publicly owned capital - Expenditures on R&D - Excludes transfer payments Net exports (𝑋𝑛 ) - Add exported goods - Subtract imported goods - 𝑋𝑛 = exports – imports GDP = C + 𝐼𝑔 + G + 𝑋𝑛 The Income Approach - Count income derived from production - Wages, rental income, interest income, profit Compensation of employees Rents Interest Proprietor’s income Corporate profits - Corporate income taxes - Dividends - Undistributed corporate profits Taxes on production and imports From national income to GDP - Net foreign factor income - Consumption of fixed capital - Statistical discrepancy Other National Accounts - Net domestic product (NDP) - National Income - Personal Income - Disposable Income Nominal GDP versus Real GDP GDP is a dollar measure of production Using dollar values create problems Nominal GDP: based on prices that prevailed when output was produced Real GDP: - Reflects changes in the price level - Uses base year price Shortcomings of GDP - Nonmarket activities - Leisure and psychic income - Improved product quality - The underground economy - GDP and the environment - Composition and distribution of output - Noneconomic sources of well-being CHAPTER 28 Economic Growth - Economic growth = Increase in real GDP or real GDP per capita over some time period - Percentage rate of growth - Growth as a goal - Arithmetic of growth: Rule of 70 70 Approximate # of years required to double real GDP = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐺𝑟𝑜𝑤𝑡ℎ Modern Economic Growth Modern economic growth: Began with the industrial revolution in late 1700s - Ongoing increase in living standards - Time for leisure - Social change - Democracy - Human lifespan doubled Institutional Structures of Growth - Strong property rights - Patents and copyrights - Efficient financial institution - Literacy and widespread education - Free trade - Competitive market system Supply Factors - Increase in; o Quantity and quality of natural resources o Quantity and quality of human resources o Supply or stock of capital goods o Improvement in technology Determinants of Growth Real GDP = Labor inputs (hours of work) x Labor productivity (average output per hours) Labor Inputs - Size of employee labor force - Average hours of work Labor Productivity - Technological advance - Quantity of capital - Education and training - Allocative efficiency - other Accounting for Growth Factors affecting productivity growth - technological advance (40%) - quantity of capital (30%) – INFRASTRUCTURE - education and training (15%) – HUMAN CAPITAL - Economies of scale and resource allocation (15%) Recent Fluctuations in Average Productivity Growth Product Growth Average rate of Growth - 1.5% per year 1973 – 1995 - 2.8% per year 1995 – 2010 - 1.2% per year 2010 – 2021 Affects real output, real income and real wages Pay higher wages without lowering profit Why the Rise in Average Productivity Growth Between 1995 and 2010? - Microchip and information technology - Start-up firms and increasing returns - Sources of increasing returns; o More specialized inputs o Spreading of development costs o Simultaneous consumption o Network effects o Learning by doing Global competition Productivity Slowdown - High debt levels - Overcapacity - Free Internet Apps - Slowdown in technological progress Is Growth Desirable and Sustainable The antigrowth view: Environmental and resource issues - Pollution, climate change, species extinction - Little compelling evidence that growth has solved social problems - Growth does not give “the good life” - High rates of growth may not be sustainable In defense of economic growth - Growth is the path to greater material abundance - Results in higher standards of living - Increase leisure time - Allows for the expansion and application of human knowledge Ladies First - 60% of American women work - Woman make up almost half the US workforce - Better educated and professionally trained - Discrimination persists - 78 cents for every dollar earned by men CHAPTER 29 The Business Cycle - Alternating increases and decreases in economic activity over time - Phase of the business cycle: o Peak o Recession o Trough o Expansion Business Cycle Fluctuations - Economic shocks - Prices are “sticky” downwards - Economic response entails decrease in output and employment Causation: A First Glance Causes of Shocks - Political events o Example: Aquino assassination - Financial instability o Example: First Marcos administration - Irregular innovation o Example: AI - Productivity changes - Monetary factors Cyclical Impact Durable goods affected most: - Capital goods Consumer durables Nondurable consumer goods affected less: - Services Food and clothing Unemployment Rate + # 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑦𝑒𝑑 𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒 𝑥 100 Who is employed or unemployed - Are u between 15 and 64 if Are u willing to work Looking for work not worked 1 hour this week then unemployed Students are unemployed Criticism of Unemployed - Involuntary part time workers counted as full time Discouraged workers are not counted as unemployed Types of Unemployment 1. Frictional Unemployment: individuals searching for jobs or waiting to take jobs soon 2. Structural Unemployment: Occurs due to changes in the structure of the demand for labor 3. Cyclical Unemployment: caused by the recission phase of the business cycle Economic Cost of Unemployment GDP GAP - - Actual GDP – Potential GDP Can be negative or positive If negative: Actual GDP< Potential GDP measures output economy sacrifices; high unemployment and big gap o Some resources are unemployed, that is, cyclical unemployment If positive: Actual GDP > Potential GDP low unemployment rate means small gap o Create inflationary pressures and cannot be sustained indefinitely Okun’s Law: Every 1% of cyclical unemployment creates a 2% GDP gap Unequal Burdens - Occupation Age Race and ethnicity Gender Education Duration Noneconomic Cost - Loss of skills and loss of self-respect Plummeting morale Family disintegration Poverty and reduced hope Heightened racial and ethnic tensions Suicide, homicide, fatal heart attacks, mental illness Can lead to violent social and political change Inflation General rise in the price level Inflation reduces the “purchasing power” of money Consumer Price Index (CPI): CPI = 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑚𝑜𝑠𝑡 𝑟𝑒𝑐𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑎𝑟𝑡𝑖𝑐𝑢𝑙𝑎𝑟 𝑦𝑒𝑎𝑟 𝑃𝑟𝑖𝑐𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 1982−1984 278.8 −260.5 CPI = 260.5 x 100 x 100 Demand Pull Inflation - Excess spending relative to output Central bank issues too much money Example: Stimulus checks and unemployment during COVID-19 pandemic Cost-Push Inflation - Due to rise in per unit productions costs Supply shocks Example: Disruptions to supply chain during COVID-19 pandemic Redistribution Effects of Inflation Nominal Income: Unadjusted for inflation Real Income: Nominal Income adjusted for inflation Unanticipated Inflation versus Anticipated Inflation Percentage change in real income Percentage change in nominal income – Percentage change in price level Who is hurt by inflation? - Fixed income receivers: Real Income fall Savers: Value of accumulated savings deteriorates Creditors: Lenders get paid back in “cheaper dollars” Who is Unaffected by Inflation? Flexible-income receivers - Cost of living adjustment (COLAs) Society security recipients Union members Debtors: Pay back the loan with “Cheaper dollars” Anticipated Inflation - Real interest rate: Rate adjusted for inflation Nominal interest rate: Rates not adjusted for inflations Other Redistribution Issues - - Deflation Mixed effects: o Income may rise o Fixed asset values may fall o For fixed rate mortgages, real debt declines Arbitrariness – Redistributions effect occur regardless of society’s goal and values Nominal Interest Rate = Real Interest Rate + Inflation Premium Does Inflation affect output? - - Cost push inflation and real output: o Reduces real output o Redistributes a decreased level of real income Demand pull inflation and real output: o One view is that zero inflation is best o Another view is that mild inflation is best Hyperinflation - - Exceeds 50% each month Extraordinary rapid inflation Adverse effects: o Germany after WWI o Japan after WWII Causation Motivation Termination CHAPTER 30 In the case of CMA, interest rates are crucial to see how viable projects are since they rely on management decisions because management actions rise depending on the interest rate. The higher the interest rates the more less viable and vice versa. Not crucial for CPA because they rely on authenticity. ● ● ● ● ● ● ● ● ● What determines central banks act that way? Cost/Action to macro economy Action of monetary authority determines interest rates Why are foreign rates dependent on interest? Fund managers assigned to portfolios, invest in countries with higher return Invest on currency not on their own Increase demand for dollars and decrease amount of other exporters Importers allowing to pay more for imports The Income-Consumption and Income-Saving Relationship Consumption and Saving - Primarily determined by DI (Disposable Income) Direct relationship DI and C Consumptions schedule: Planned household spending (in our model) Saving schedule: - DI (Disposable Income) minus C (Consumption) Dissaving can occur The COVID 19 Pandemic Between 2019 and 2020, consumption fell despite an increase in disposable income - COVID 19 stimulus payment increased disposable income People save rather than spent much of that Inverse relationship lasted only 1 year Things went back to normal between 2020 and 2021 Income > Spending = + Savings Income < Spending = - Savings Average Propensities Average Propensity to Consume (APC): Fraction of total income consumed 𝐴𝑃𝐶 = 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝐼𝑛𝑐𝑜𝑚𝑒 Average Propensity to Save: Fraction of total income saved 𝐴𝑃𝑆 = 𝑆𝑎𝑣𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 Marginal Propensities (MPC + MPS = 1) Marginal propensity to consume (MPC): Proportion of a change in income consumed 𝑀𝑃𝐶 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 Marginal propensity to save (MPS): Proportion of a change in income saved 𝑀𝑃𝐶 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑣𝑖𝑛𝑔 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 Non-income Determinants of Consumption and Saving Non-income Determinants Amount of disposable income is the main determinant Other determinants: - Wealth Borrowing Expectations Real interest rates Other Important Considerations - Switching to real GDP Changes along schedules Simultaneous shifts Taxation Stability paradox The Interest Rate-Investment Relationship Expected rate of return The real interest Investment demand curve Shifts of the Investment Demand Curve - Acquisition, maintenance, and operating costs Business taxes Technological change Stock of capital goods on hand Planned inventory changes Expectations The Multiplier Effect - Change in spending changes real GDP more than the initial change in spending The multiplier determines how much larger that change will be Future round of spending that occur 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 Change in GDP = Multiplier x Initial change in spending Multiplier and Marginal Propensities - Multiplier and MPC directly related: Large MPC results in larger increase in spending Multiplier and MPC inversely related: Large MPs results in smaller increase in spending 1 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 1−𝑀𝑃𝐶 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 1 𝑀𝑃𝑆 How Large is the Actual Multiplier? - Actual multiplier is lower than the model assumes Consumers buy imported products Households pay income taxes Inflation Multiplier may be 0 CHAPTER 31 Assumptions and Simplifications Use the Keynesian aggregate expenditures model “Stuck Price” model Begin with private, closed economy: - Consumption spending Investment spending Assume GDP = DI Consumption and Investment Schedules Planned Investment - Investment schedule showing the amounts business firms collectively intend to invest Represents the investment plans of businesses in the same way the consumption schedule represents the consumption plans of households Equilibrium GDP: C + Ig = GDP Real Domestic Output - Consumption + Investment Aggregate Expenditures Equilibrium GDP Disequilibrium Other Features of Equilibrium GDP Saving equals planned. Investment: - Saving is a leakage of spending Investment is an injection of spending No unplanned changes in inventories: Firms do not change production Changes in Equilibrium GDP and the Multiplier Adding International Trade Adding International Trade - Include net exports spending in aggregate expenditures: private, open economy Exports create production, employment, and income Subtract spending on imports Xn can be positive or negative International Economic Linkages Prosperity abroad: Can increase US exports Exchange rates: Depreciate the dollar to increase exports A caution on tariffs and devaluations - Other countries may retaliate Lower GDP for all Adding the Public Sector Government purchases and equilibrium GDP: Government spending is subject to the multiplier Taxation and equilibrium GDP - Lump sum tax Taxes are subject to the multiplier DI = GDP Equilibrium versus Full-Employment GDP Recessionary expenditure gap: - Insufficient aggregate spending Spending bellow full-employment GDP Increase G and/or decrease T Inflationary expenditure gap: - Too much aggregate spending - Spending exceeds full-employment GDP Decrease G and/or increase T Application: The COVID Recession of 2020 February 2020 recession began Aggregate expenditures declined: - Consumption spending declined Investment spending declined Recessionary expenditure gap Keynesian Policies Federal government undertook Keynesian policies: - Lowered interest rate sharply Passed $2.2 trillion CARES Act CHAPTER 32 Aggregate Demand Aggregate demand a key element of the aggregate demand-aggregate supply model (AD-AS model) Real GDP desired at each price level Inverse relationship: - Real balances effect Interest rate effect Foreign purchase effect Changes in Aggregate Demand Determinants of aggregate demand: Shift factors affecting C, I, G, X 2 Components Involved: 1. Change in one of the determinants 2. Multiplier effect Consumer Spending - Consumer wealth Consumer expectation Household borrowing Personal taxes Investment Spending Real Interest Rates Expected Returns: - Expectations about future business conditions Technology Degree of excess capacity Business taxes Government Spending Government spending increase: - Aggregate demand increase (as long as interest rates and tax rates do not change) More transportation projects Government spending decreases: - Aggregate demand decreases Less military spending Net exports spending National income abroad Exchange rates: - Dollar depreciation Dollar appreciation Changes in Aggregate Supply Determinants of aggregate supply: Shift factors - Collectively position the AS curve Changes raise or lower per-unit productions costs Input Prices Domestic resource prices: - Labor Capital Land Prices of imported resources: - Imported oil Exchange rates Productivity Real output per unit of input - Increases in productivity reduce costs Decreases in productivity increases cost - Productivity = 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑝𝑢𝑡𝑠 - Per-unit productions cost = 𝑇𝑜𝑡𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑝𝑢𝑡 𝐶𝑜𝑠𝑡 𝑇𝑜𝑡𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡 Legal-Institutional Environment Legal changes alter per-unit costs of output: - Business taxes and subsidies Government regulation Decreases in AD: Recession and Cyclical Unemployment Prices are downwardly inflexible: - Fear of price wars Menu costs Wage contracts Efficiency wages Minimum wage law Last Word: The COVID-19 Inflations Inflation in the US had a 7% annual rate in 2021 – the highest since 1981. This was the result of rightward AD shift and a leftward AS shift, featuring both costpush inflation and demand-pull inflation. Massive government spending pushed AD to the right, while supply chain disruptions pulled the AS curve left CHAPTER 34 Money, Banking, and Financial Institutions The Functions of Money Medium of exchange: used to buy and sell goods Unit of account: goods valued in dollars; gold Store of value: hold some wealth in money form; o Assets: Real estates highly liquid Money has the advantage of liquidity - Currencies apples in terms of oranges and oranges in terms of banana - Anything that is widely accepted as a medium of exchange can serve as money. Money def M1 M1: - Currency (coins and paper money) o Token money, this means that the face value of any piece of currency is unrelated to its the value of physical material out of which that piece of currency is constructed. - Checkable deposits - Other liquid deposits Institutions offering checkable deposits: Commercial bank Universal banks offer investment banking unit inv trust funds buys and sells other securities int rates on deposits are low o Net interest margin cover administrative cost; o brick and martyr bank conserve cuz the have to pay for land and equipment like building Thrift institution o Savings and loan associations o Mutual saving banks o Credit unions Currency: coins plus paper money Federal reserve notes Token money value is less then what it claims to be The value of any piece of currency unrelated to Money, M1 = currency + checkable deposits M2: - M1 plus near-monies - Small denoted time deposits - Money market mutual funds The Components of the money supply Graph - 6-702,582,000,000 Reused money Money, M2 = - M1 + savings deposits, including MMDAs + small-denominated (less than $100,000) time deposits + MMMFs held by individuals What "banks" the Money Supply? - Guaranteed by government's ability to keep value stable. - Money as debt - Why is money valuable? o Acceptability o Legal tender o Relative scarcity - Obligation of the central bank of the Phil - Money is dependent to the government - Mandate pesos as payment of debt - Accepts pesos in school and you Money and prices - Prices affect purchasing power of money - Hyper inflation renders money unacceptable - Stabilizing money's purchasing power: o Intelligent management of money supply monetary policy o Appropriate fiscal policy $V = 1/P To find the value of the dollar $V, divide 1 by the price level P expressed as an index number (in hundredths). The Federal reserve and Banking System Historical background Board of governors 12 federal reserve banks: o Serve as the central bank o Quasi public banks o Banker's bank-reserve balances Federal open market committee, commercial banks and thrifts Federal open markets committee - Aids board of governors in setting monetary policy - Conducts open market operations Commercial banks and thrifts - 4300 commercial banks o why so many commercial banks Individual unit banking one branch one bank o Phil no no sa individual banking because land bank absorb USPB merger o BPI and Robinson bank merger - 7000 or so thrifts Fed Functions, Responsibilities, and Independence 1. Issue currency 2. Hold reserve requirements 3. Lend money to financial institutions 4. Control money supply 5. Collect checks 6. Act as fiscal agent 7. Supervise the money supply Established by congress as independent agency because you cannot print your way out of trouble Protects. Fractional reserve banking and money supply The Goldsmiths: - Stored - Gold and gave a receipt - Receipts used as money by public - Made loans by issuing receipts Characteristics: - Banks create money through lending - Banks are subject to "panics" - 10 M gold 9 M liabilities- Invest or credit out excess - Money kept in the vaults of banks is not counted - Banks come from the word banko did business from a bench - Break bench is bankruptcy Fed influence over lending and money supply - Fed can alter money supply by modulating incentives and restrictions it places on banks and thrifts - When fed policy prompts banks to increase lending, access to credit is easier - Fed policy which prompts banks to decrease lending can result in a lesser volume of loans and higher int rates Banks are issued to keep ten percent of reserves in central bank Interest rates - The price paid for the use of money - Many different interest rates - Speaks as if only one int rate - Determined by the money supply and money demand Demand for money Transactions demand for money - Determined by the nominal GDP - Independent of the interest rates Asset demand for money - Money as a store of value - Varies inversely with the int rates - Liquid increase purchasing power - Money for emergencies in form of money Total demand for money - Total money demand Wealth as money Equilibrium int rates: changes with shift in money supply and money demand Int rates and bond prices: - Inversely related - Bonds payable fixed annual int payments - Lower bond price will raise the int rates Money supply the same interest increases thus discouraging spending Annual int rates and bond rates/price are inversely related Int rate goes up The Last word: Cryptocurrencies - Bitcoin only up to 21 M sure scare Other Blockchain - a sequence of updates that tracks the ownership of digital money Central bank digital currencies may eclipse private cryptocurrencies - Nothing banks bitcoin, no one controls it - Also highly volatile - 1 bitcoin is 4M - Legal in the Philippines but - Paper currency can print more - downside Digital currency qr code nalang ang peso bill - Everything you buy could be traced by the government CHAPTER 35 Fractional Reserve System The goldsmiths: - Stored gold and gave a receipt Receipts used as money by public Made loans by issuing receipts Characteristics: - Banks create money through lending. Banks are subject to “Panics”. Balance Sheet for a Bank Balance Sheet: - Assets = Liabilities + Net Worth Both sides are balance Necessary Transactions: - Create a bank Accept deposits Lend excess reserves Required Reserves Depositing reserves in a Federal Reserve bank: - Required reserves Reserve ratio Reserve ratio = Commercial bank’s required reserves / Commercial bank’s checkable-deposit liabilities Excess Reserves Excess Reserves: Actual reserves – required reserves Required reserves: Checkable deposits x reserves ratio Example: - Checkable deposits $100,000 Reserve ratio 20% Control Profits, Liquidity, and the Federal Funds Market Conflicting goals Earn Profit: - Make loans to earn interest Buy securities to earn interest Maintain liquidity Alternative? - Overnight bank loans Federal funds rate The Banking System Multiple-deposit expansion Assumption: - 20% required reserves - All banks “loaned up” Banks lend all of their excess reserves A $100 bill is found and deposited Multiple deposits can be created The Monetary Multiplier Maximum amount of new money created by a single dollar of excess reserves Higher R, lower m Reversibility: - Making loans creates money Loan repayment destroys money Last word: Banking, Leverage, and Financial Instability - Leverage is the use of borrowed money to magnify profit and losses Modern banks use lots of leverage Thus small losses can drive banks into insolvency CHAPTER 36 Interest Rates and Monetary Policy Interest Rates - The price paid for the use of money Many different interest rate Speak as if only one interest rate Determined by the money supply and money demand The Demand for Money Why hold money? Transaction demand, Dt - People hold money because it is convenient for purchasing goods and services. - The demand for money as a medium of exchange - Determined by nominal GDP Independent of the interest rate Asset demand, Da - Money as a store value Varies inversely with the interest rate Total money demand, Dm - horizontally adding the asset demand to the transactions demand Interest Rates Equilibrium interest rate: Changes with shifts in money supply and money demanded. Interest rates and bond prices: - Inversely related (IR Increase, BP Decrease, vice versa.) Bonds pays fixed annual interest payment Lower bond price will raise the interest rate The Consolidated Balance Sheet of the Federal Reserve Banks Federal Reserve Balance Sheet Assets: - Securities Loans to commercial banks Liabilities: - Reserves of commercial banks (Deposits held at the Fed + cash in vault) Treasury deposits Federal Reserve Notes outstanding (held by the general public) Tools of Monetary Policy Fed's tools to control reserves - - - Open market operations (Most important) ▪ Buying and selling of government securities or bonds ▪ Commercial banks and the general public ▪ Used to influence the money supply o When the Fed sells securities, commercial bank reserves are reduced. o Fed sells bonds to the public – same effect as selling bonds to commercial banks Discount window operations o Discount loan: Fed's loans to banks o Discount rate: Interest rate on discount loan Interest on Reserves Fed's tool to change multiplier - Reserve ratio (last changed in 1992) o Changes the money multiplier o The discount rate: ▪ The Fed as lender of last resort ▪ Short-term loans o Term auction facility: ▪ Introduced December 2007 ▪ Banks bid for the right to borrow reserves o Lowering the reserve ratio transforms required reserves into excess reserves and enhances the ability of banks to create new money by lending. o Raising the reserve ratio in- creases the amount of required reserves banks must keep. As a consequence, either banks lose excess reserves, diminishing their ability to create money by lending, or they find their reserves deficient and are forced to contract checkable deposits and therefore the money supply. Fed Targets and the Taylor Rule The Fed’s Dual-Mandate Policy Targets The Fed has developed 2 specific target numbers to help it fulfill the dual mandate: - A 4.3% target unemployment rate (= Fed’s current best estimate of the fullemployment rate of unemployment) A 2-percent target inflation rate Taylor Rule Definitions To express the Taylor Rule mathematically, we must define: - Inflation gap = the current actual rate of inflation minus the Fed’s 2.0 percent target rate for inflation Unemployment Gap = the current actual unemployment rate minus the Fed’s 4.3 percent target rate for the unemployment rate Real risk free interest rate = 2 percent The Taylor Rule Equations Fed target interest rate = real risk-free interest rate + current actual inflation rate + 0.5* (Inflation Gap) – 1.0* (Unemployment Gap) Note: the 1.0 coefficient in front of the Unemployment Gap is twice as large as the 0.5 coefficient in front of the inflation Gap. This is how the Taylor rule equation incorporates professor Taylor’s assumption that the Fed is twice as concerned about reaching its unemployment target as it is about meeting its inflation target Monetary Policy, Real GDP, and the Price Level Effect on real GDP and price level Cause-effect chain: - Market for money Investment and the interest rate Investment and aggregate demand Real GDP and prices Expansionary monetary policy - Economy faces a recession Lower target for federal funds rate Fed buys securities Expanded money supply Downward pressure on other interest rates Expansionary Monetary Policy Process (Cause and effect chain) Problem: unemployment and recession -› Fed buys bonds, lowers reserve ratio, lowers the discount rate, reduces the interest rate on excess reserves, or initiates repos -› Excess reserves increase -› Federal funds rate falls -› Money supply increases -› Interest rate falls -› Investment spending increase -› AD increases -› Real GDP increases Evaluation and Issues Advantages over fiscal policy: - Speed and flexibility Isolation from political pressure Monetary policy is more subtle than fiscal policy After the Great Recession - Slow recovery especially in terms of employment Zero interest rate policy Zero lower bound problem Quantitative easing Quantitative tightening Problems and Complication Lags: - Recognition and operational Cyclical asymmetry Liquidity trap The “Big Picture” CHAPTER 40 International Trade The Economic Basis for Trade Some Key Trade Facts - U.S. trade deficit in goods: $891 billion in 2018 U.S. trade surplus in service: $270 billion in 2018 Canada largest U.S. trade partner Trade deficit with China: $419 billion in 2018 Exports are 12 percent U.S. output Principal U.S. Exports Principal U.S. exports include: - Chemicals Agriculture products Consumer durables Computer software and services Aircraft The united states provides about 8 percent? of the world’s exports Principal U.S. imports include: - Petroleum Automobiles Metals Household appliances Computers Economic Basis for Trade - Nations have different resource endowments Labor-intensive goods Land-intensive goods Capital-intensive goods Assumption and Opportunity Cost Ratio Assumption - Two nations Same size labor force Constant costs in each country Different costs between country United States has absolute advantage in both Opportunity cost ratio - Slope of the curve Vegetables sacrificed ton of beef Comparative advantage - Self-sufficiency output mix Specialization and trade Produce the good with the lowest domestic opportunity cost Opportunity cost of 1 ton of beef o 1 pound f vegetable in United States o 2 pounds of vegetables in Mexico Supply and Demand Analysis of Exports and Imports Trade Barriers and Export Subsidies The Case for Protection: A Critical Review Multilateral Trade Agreements and Free-Trade Zones
