Introduction to Economics
Macroeconomics
The US Economy
Llad Phillips 1

Quiz: Median = 32
Score Grade Number
39-40 A 8
37-38
35-36
33-34
30-32
27-29
24-26
21-23
-20
C+
C
C-
D+
A-
B+
B
B-
16
14
8
3
12
18
21
31

Outline

Economics in the News

Review of Chapters 20, 21, and 24

The banking system and the Federal Reserve

Monetary Policy: Does the Fed get the timing right?
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Conference Board

Index of Consumer Confidence falls 14.3 points in September to lowest level since
1993!

Index is at 79.3 (1985=100)

Is consumer spending going to collapse?

Is it going to be a rough Christmas for retailers?
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Impact of the Business Cycle on the Public Sector

The University of California
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California State Budget

Governor Davis Warns of a 15% Budget Cut for 2002-2003

Daily Nexus, Thursday October 13, 2001

Policy Implications: Raising Student Fees?
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UC Budget, General Fund Component, Millions of Nominal $
4000
3500
3000
2500
2000
1500
1000
500
0
68
-6
9
70
-7
1
72
-7
3
74
-7
5
76
-7
7
78
-7
9
80
-8
1
82
-8
3
84
-8
5
86
-8
7
88
Fiscal Year
-8
9
90
-9
1
92
-9
3
94
-9
5
96
-9
7
98
-9
9
00
-0
1
00
-0
3
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How has UC Fared Over Time?

Does UC get a fair share of state money?

UC Budget Share = UC Budget/CA Gen Fund
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UC Share of CA General Fund Budget
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
68
-6
9
70
-7
1
72
-7
3
74
-7
5
76
-7
7
78
-7
9
80
-8
1
82
-8
3
84
-8
5
86
-8
7
88
Fiscal Year
-8
9
90
-9
1
92
-9
3
94
-9
5
96
-9
7
98
-9
9
00
-0
1
00
-0
3
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Trends in California Government

Proposition 13 (1970’s): limited local property tax, shifted fiscal power to the state

Gann Initiative(1970’s): tried to limit state government to constant real expenditures per person, ie limit the size of government

Relative Size of Government = CA Gen
Fund Expenditures/ CA Personal Income
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CA General Fund Expenditures As a % of CA Personal Income
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
68
-6
9
70
-7
1
72
-7
3
74
-7
5
76
-7
7
78
-7
9
80
-8
1
82
-8
3
84
-8
5
86
-8
7
88
Fiscal Year
-8
9
90
-9
1
92
-9
3
94
-9
5
96
-9
7
98
-9
9
00
-0
1
00
-0
3
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UC Budget Forecast for 2002-2003
UC Budget, GEN FUND = UC Budget Share x Relative Size of Government x CA Personal Income
UC Budget = (UC Budget/CA Gen Fund) x ( CA Gen Fund/
CA Personal Income) x CA Personal Income
UC Budget, GEN Fund = 0.045 x 0.07 x CA Personal Income

CA Personal Income, Billions of Nominal $
1200
1000
800
600
400
200
0
68
-6
9
70
-7
1
72
-7
3
74
-7
5
76
-7
7
78
-7
9
80
-8
1
82
-8
3
84
-8
5
86
-8
7
88
Fiscal Year
-8
9
90
-9
1
92
-9
3
94
-9
5
96
-9
7
98
-9
9
00
-0
1
00
-0
3
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Chapter 20
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Production, Income, and the Circular Flow
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
The circular flow diagram shows how production of goods and services generates income for households and how households purchase goods and services produced by firms.
15

U.S. Real GDP
1930-2000
• Real GDP has grown substantially over this period.

Consumption Expenditures

Consumption expenditures are purchases of newly produced goods and services by households. Consumption is broken down into:
• Durable goods that last for a long time.
• Nondurable goods that last for a short time.
• Services that reflect work done in which people play a prominent role in the delivery.
• Consumption comprises 67% of total purchases.
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U.S. Trade Balance as a Share of
GDP, 1960 - 2000
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Who Gets the Income?
Composition of U.S. National Income, Second
Quarter 2000 (billions of dollars)
National income 7,983
Compensation of employees 5,603
Corporate profits
Rental income
Proprietor’s income
Net interest
964
141
709
566
• Approximately 70% of all national income goes to workers in the form of wages and benefits.

GDP as a Measure of Welfare

GDP is our best measure of the value of output produced, but not a perfect measure.
There are several recognized flaws in the construction of GDP:
3) GDP ignores the underground economy, where transactions are not reported to official authorities.
4) Finally, GDP does not value changes in the environment that arise from the production of output.
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Chapter 21
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Definitions

The unemployment rate is the percentage of people in the labor force who are unemployed.
• The labor force participation rate is the fraction of the population that is over 16 years of age that is in the labor force.
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U.S. Inflation Rate, 1950-2000,
Based on Chain Price Index
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Chapter 24
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Business Cycles and Economic Fluctuations

A recession is a period when real GDP falls for two consecutive quarters. It starts at the peak of an increase in output, and ends at a trough , the time at which output stops falling in a recession.
• A depression is a prolonged period of decline in output, or a severe recession. During the
Great Depression, 1929 through 1933, real
GDP fell by over 33%, and unemployment rose to 25%.
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The 1990 Recession
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Nine Postwar Recessions
Peak
November 1948
July 1953
August 1957
April 1960
December 1969
November 1973
January 1980
July 1981
July 1990
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Trough
October 1949
May 1954
April 1958
February 1961
November 1970
March 1975
July 1980
November 1982
March 1991
Percent Decline in Real GDP
1.5
3.2
3.3
1.2
1.0
4.9
2.5
3.0
1.4
27

The Unemployment Rate
During Recessions

During periods of recession, marked by the shaded bars, unemployment rises sharply.

Money, the Banking System and the Federal Reserve

What is money?
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
The Functions of Money medium of exchange
 instead of barter, i.e. exchange of goods & services for goods and services, we can exchange goods & services for money and vice versa
 eliminates the search costs & inconvenience of barter
 store of value
 we can hold money as an asset
 because it is a medium of exchange, it is liquid, i.e. we can convert money into goods & assets quickly
 unit of account measure of value, “ a dollar’s worth of ...”
30

Definitions of Money

M1(a measure of media of exchange) =
 currency held by the public, outside of banks
 checkable deposits
 demand deposits

NOW (negotiable order of withdrawal) accounts
• savings & loans, mutual savings banks
 traveler’s checks

M2 = M1 +
 money market accounts at banks
 money market mutual fund accounts
 certificates of deposit, CD’s, less than $100,000

M3 = M2 + CD’s over $100,000
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Summary of Monetary Policy
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The Federal Reserve System: Purposes & Functions
Llad Phillips http://www.bog.frb.fed.us/ PDF format: Adobe Acrobat
33

The Federal Reserve System: Purposes & Functions
Llad Phillips http://www.bog.frb.fed.us/

How Effective Has the Fed Been?

Fed Goals: A Stable Economy
 maximum employment
 stable prices
 moderate long-term interest rates

Fed Objectives or Targets
 quantity of reserves
 price of reserves: Federal Funds Rate
 federal funds rate, FFR, is the interest rate banks charge one another for borrowing reserves for a day or so; mostly large urban banks borrowing from small suburban and rural banks
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20
15
25
Misery Index = Unemployment Rate + Inflation Rate
Misery Index: 1929-1996 .
10
5
0
Hoover Roosevelt Truman Ike Year LBJ Nixon/
JFK
Reagan Bush
Ford Carter
Clinton

How Effective Has the Fed Been?

Fed Objectives or Targets
 quantity of reserves
 price of reserves: Federal Funds Rate
 federal funds rate, FFR, is the interest rate banks charge one another for borrowing reserves for a day or so; mostly large urban banks borrowing from small suburban and rural banks
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Impact of the Supply of Reserves on the Federal Funds Rate
Demand for Reserves by Banks
FFR, price of reserves
Supply of Reserves: Fed quantity of reserves
38 Llad Phillips

Impact of the Supply of Reserves on the Federal Funds Rate
Demand for Reserves by Banks
FFR, price of reserves
Supply of Reserves: Fed quantity of reserves
39 Llad Phillips

Fed: Lender of Last Resort to Banks at Discount Rate, 00-02
Source: Federal Reserve Bank of Minneapolis
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Nation’s Commercial Banks, 10/22/01
Assets $B
Com Loans
Liabilities
1050.1 Trans Dep 634.4
Pers Loans 559.1 Sav Dep 3530.2
Real Estate L 1723.3 Dep>$100K 970.2
Home Equity L 148.6
US Gov Sec
Other Sec
Total
817.4
649.2
4947.7
Bank Loans (credit) = $3928.8 B, WSJ 10/22/2001, p. C 2
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What is at stake?
US Postwar Expansions
Trough - Peak
Oct. ‘45 - Nov. ‘48
Oct. ‘49 - July ‘53
May ‘54 - Aug. ‘57
April ‘58 - April ‘60
Feb. ‘61 - Dec. ‘69
Nov. 70 - Nov. ‘73
March ‘75 - Jan. ‘80
July’80 - July ‘81
Nov. ‘82 - July ‘90
March ‘91 – April ‘01
Duration, Months
37
45
39
24
106
36
58
12
92
121
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Monetary Policy Tradeoff

Is the Fed too Inflation Oriented?

Note: the CPI inflation rate tends to decrease during and after recessions
 to control inflation, the Fed may be tempted into policies that precipitate recessions and/or make them more severe

Note: the unemployment rate tends to increase during and after recessions
 some critics in Congress think the Fed is too restrictive, i.e. not sufficiently expansionary in policy
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Other Measures of Fed Effectiveness

Reserve Aggregates

Excess Reserves

Free Reserves
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Definitions

Total Bank Reserves = Vault Cash +
Deposits with Fed + Loans from Fed

Required Bank Reserves = Deposits x
Required Reserve Ratio

Excess Reserves = Total Reserves -
Required Reserves
Llad Phillips 47

Consumers, Firms, Banks, and the Fed Determine Reserve Aggregates
Banks
Banks
Fed
Deposits with Fed
Loans from Fed,(OMO) Bank Deposits
Consumers
Businesses
+ x
Bank Vault Cash Reserve ratios Fed
=
Total Reserves
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Required Reserves =
Excess
Reserves
48

Llad Phillips 49

Fed Sets Ratio of Minimum
Bank Reserves to Bank Deposits

Helps Prevent Liquidity Crises

For Example: Dec 1999
 deposits of 0-$44.3 M (small banks)
 required minimum reserve ratio: 3%
 deposits of $44.3 + M (large banks)
 required minimum reserve ratio: 10%
Cutoff: $44.3 M as of 2000
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Did the Fed Run too tight a monetary policy before 1980?

Kept excess reserves too low in the banking system

This forced banks to borrow reserves from the Fed at the discount window

In the 1980’s and 1990’s, the Fed allowed more excess reserves, there was less borrowing at the discount window

Much longer expansions ( boom times) resulted
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10000
Fed Policy Record, 48.01-97.07
8000
6000
4000
2000
0
Source: Survey
50 55 60 65 70 75 80 85 90 95 of Current Business,
January, 1995
Fed Loans Excess Reserves

Fed Monetary Policy:

Insufficient Excess Reserves?
Expansionary Policy
 ease credit
 provide positive free reserves

Contractionary Policy
 tighten credit
 force banks to borrow at discount window, causing negative free reserves
Llad Phillips 53

Bank Reserve Aggregates, 10-19-01
Total Reserves( cash in Bank Vaults
& Deposits with Fed)
Nonborrowed Reserves
Required Reserves
Excess Reserves*
Free Reserves**
$44.1 B
$44.0 B
$43.0B
$1.1 B
$1.0 B
* Excess Reserves = Total Reserves - Required Reserves
** Free Reserves = Excess Reserves - Borrowed Reserves
Source: The Wall Street Journal, 10/19/2001, p.C13
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Before the 1980”s

Did the Fed dry up “free reserves” too much with tight monetary policy?

Free Reserves = Excess Reserves -
Borrowed reserves

If banks are forced to the discount window, borrowed reserves may dominate excess reserves
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10000
Fed Policy Record, 48.01-97.07
8000
6000
4000
2000
0
Source: Survey
50 55 60 65 70 75 80 85 90 95 of Current Business,
January, 1995
Fed Loans Excess Reserves

Fed Policy: 48.01-97.07
2000
0
-2000
-4000
-6000
-8000
50 55 60 65 70 75 80 85 90 95
Free Reserves


Fed Loans of Reserves to Banks
Before each recession, Fed loans peak and exceed excess reserves

As a consequence, free reserves are negative before each recession
 recall: free reserves = excess reserves - Fed loans
 negative free reserves are called “net borrowed reserves”
 they are an index of the Fed trying to tighten credit
 evidently the Fed was tightening credit sufficiently to contribute to the recession

Note: Fed keeps excess reserves low during inflationary 70’s; opposite policy in the 90’s
Llad Phillips 58

Summary of Monetary Policy

Federal Reserve Needs to Avoid Bank
Panics and Bank Failure
 tool: FDIC
 tool: Bank Supervision & Education

Federal Reserve Needs to Keep the
Economy Healthy: Low Unemployment &
Inflation Rates
 tool: Open Market Policy: Fed Sells Securities to Decrease Commercial Bank Deposits and
Tighten Credit
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More Review Material
Llad Phillips 60

Review: Lecture Nine

Macroeconomic Policy
 fiscal policy
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
Fiscal Policy
Preventing Depressions
 role for autonomous federal spending: the federal government as spender of last resort

Keynesian model

Automatic Stabilizers in Federal Budget
 counter-cyclical effect
 progressive income tax

Limit to Fiscal Policy from 1980 to 1998
 the federal deficit
 federal government income-expense statement
• surplus(deficit) = receipts - expenditures
Llad Phillips 62

Less than Full Employment Equilibrium
GDP= C+I+G
Consumption, C
Investment, I
GDP = C + I
GDP
C = C
0
+ mpc* Y
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I
0
45
GDP = Y
Full Employment Income
Source: Lecture Six
Y
FE
Income, Y
63

Less than Full Employment Equilibrium
GDP= C+I+G
Consumption, C
Investment, I
GDP = C + I
GDP
GDP+ C+I
C = C
0
+ mpc* Y
C= C
0
+mpc*Y
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0
45
GDP = Y
Full Employment Income
Source: Lecture Six
I
I
Y
FE
Income, Y
64


Automatic Stabilizers
Progressive Income Tax Rates
 as personal incomes rise
 many move to a higher tax bracket
• disposable income does not grow as fast as income because income taxes take a larger bite
 as personal incomes fall
 many move to a lower tax bracket
• taxes take a smaller fraction of income and dispoable income does not fall as fast as personal income

Transfer Payments may grow in recession
 entitlement program payments
 unemployment insurance

Aid to Families with Dependent Children(AFDC)
Llad Phillips

Social Security Pensions 65

Federal Surplus (Deficit) $ Millions
150000
100000
50000
0
-50000
1880
-100000
-150000
-200000
-250000
-300000
-350000
1900 1920 1940 1960 1980
Fiscal Year
Llad Phillips
2000 2020
66

Perspective:Is the economy growing less rapidly in the decade of the Nineties?

Growth in real GDP over time
Llad Phillips 67

Real GDP Billions 96$, 1929-1999
12000
10000
8000
6000
Real GDP Billions 96$ exponential trendline
4000 y = 8E-29e
0.0369x
R
2
= 0.9767
2000
0
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 year
Llad Phillips 68

Midterm Review

O’Sullivan and Sheffrin

Ch. 20, 21, 24, 25 , 27, 28, 30
Llad Phillips 69

20: The Big Ideas in Macro

Circular Flow

Labor Market

Goods Market

Measuring the Output of the Economy

GDP

National Income

GDP: Is it a measure of welfare?
Llad Phillips 70

Measuring a Nation’s Production and
Income

GDP: Expenditure Perspective

Consumption

Gross Private Investment

Government Purchases

Net Exports
Llad Phillips 71

21: Unemployment and Inflation

What is Unemployment

Consumer Price Index (CPI)

Percentage Rate of Change of CPI: Inflation
Llad Phillips 72

Review Part II: Chapter Three

Conceptual Framework: Circular Flow
Income
Firms
Households
Labor
Firms
Supply
Goods
Households
Demand
Goods
Income Perspective Expenditure Perspective
Llad Phillips 73

Expenditure Perspective: Open
Exports
(Sales)
Firms
Supply
Goods
Households
Demand
Goods
Imports
(puchases)
Government
Households: Consumption of Goods and Services
Firms: Investment in Plant and Equipment
Government: Purchase of Goods and Services
All Three: Exports - Imports = Net Exports
Llad Phillips 74

21: Behind the Economic Statistics

Is a recession coming?
 how would you figure that out?
Llad Phillips 75

21: Behind the Economic Statistics

Expenditure Perspective: GDP

Consumption

Gross Private Investment

Government Purchases

Net Exports

Inflation
 what is it?
 how do we measure it?
 why is it a problem?
Llad Phillips 76

The Inflation Rate Since 1980
Llad Phillips
Source: http://www.yardeni.com
77

21: Behind the Economic Statistics

Expenditure Perspective: GDP

Consumption

Gross Private Investment

Government Purchases

Net Exports

Inflation
 what is it?
 how do we measure it?
 why is it a problem?

Unemployment
Llad Phillips 78

14
12
10
8
6
4
2
0
Unemployed Persons, Millions, 1929-1997 .
1933 trough
1938 trough
1982 trough
1991 trough
1945 trough
Year
Llad Phillips 79

Unemployment Rate: unemployed/ (employed + unemployed)
Unemployment Rate: unemployed/ (labor force)
Llad Phillips 80

24: Coordinating Economic Activity

If nominal GDP grows faster than real GDP, what happens?

If real GDP stops growing or declines, what happens?
Llad Phillips 81

25: Keynesian Economics and Fiscal Policy

The Keynesian Cross

The Basic Ideas

GDP = National Income (equilibrium)
 equilibrium GDP can differ from full employment GDP

What Should We Do IF We Slip Into
Depression?
Llad Phillips 82

Less than Full Employment Equilibrium
Consumption, C
Investment, I
GDP
GDP = C + I
C = C
0
+ mpc* Y
Llad Phillips
I
0
45
GDP = Y
Full Employment Income
Y
FE
Income, Y
83

1998 Midterm
Part IV ( 28 points) Answer both essay questions.
1. One reason for the Great Depression was a sharp drop in consumer spending.
a. Assuming the economy was initially at the full employment level of output, describe the effect of a drop in consumer spending.
b. What was Keynes’ policy recommendation for escaping from the Great Depression?
Llad Phillips 84

2. Opinions about the US economy have been quite changeable this Fall quarter. At the moment, the rate of growth of the economy is slowing, but growth is still positive. How would you satisfy yourself whether a recession might be coming or not? How would you assess whether the likelihood of a recession in 1999 is low? or high?
a. What conceptual framework would you use to answer this question about a prospective recession?
b. What data and which economic measures or statistics would you look at?
c. How would you deal with the fact that you need a “crystal ball” to see into 1999 and the future?
Llad Phillips 85

Part III (20 points) Answer both questions.
1. This is a Keynesian economics diagram of the determination of equilibrium GDP.
Aggregate
Expenditures
45 degrees
Full Employment
Income
Aggregate Income
Llad Phillips a. Label the aggregate expenditures line
86

b. Label the equilibrium condition line, for which aggregate expenditures equals aggregate income, i.e. GDP = Y.
c. On this diagram, indicate the equilibrium level of aggregate income, Yeq .
d. Is this equilibrium level of income higher or lower than the full employment level of income? ________________.
e. Given your answer to part d, does this indicate a recession or an inflationary boom? ____________________.
Llad Phillips 87

2. This diagram illustrates the market for reserves and the determination of the federal funds rate. This is the rate which commercial banks charge one another for borrowing, usually overnight.
Federal
Funds
Rate
Quantity of Reserves a. Label the demand curve for reserves.
Llad Phillips 88

b. Which institution(s) demand(s) reserves?______________
c. Label the supply curve for reserves.
d. Which institution(s) affect(s) the supply curve for reserves?_______________
e. If the Federal Reserve raises the ratio of required reserves to deposits, which curve will shift to the right, resulting in a _______________ federal funds rate? ____________..
Llad Phillips 89