Final Review
A peak occurs when an economy shifts from an expansionary period to a contractionary period.
In other words, GDP is increasing before peak, and decreasing after a peak. A trough occurs
when economy shifts from a contractionary period. In other words, GDP is decreasing before
trough, and increasing after a trough.
A contraction is the period during which the economies real GDP decreases. When an
economy’s real GDP decreases, a graph of real GDP has a negative slope. Because the
economy’s growth rate is negative during this time, the contraction appears as a region of
negative growth on a graph showing the economy’s growth rate.
Okun’s law describes the short term relationship between fluctuations in the unemployment rate
and real GDP; it does not describe any long-run relationship between the two variables. Longrun growth in GDP is determined primarily by technological progress, whereas unemployment
tends to return to the natural rate in the long run rather than experiencing permanent increases or
decreases.
Okuns Law Formula
Percentage Change in Real GDP = 3%-2 * Change in the Unemployment Rate
The following list contains the 10 data series that compromise the index of leading economic
indicators, chosen for their ability to forecast future economic conditions over the next 6 to 9
months:
Average workweek of production workers in manufacturing, average initial weekly
claims for unemployment insurance, new orders for consumer goods and materials
(adjusted for inflation), new orders for nondefense capital goods, index of supplier
deliveries, new building permits issued, index of stock prices, money supply (adjusted for
inflation), interest rate spread (the yield between 10 year treasury notes and three-month
treasury bills), and index of consumer expectations.
Short run economic forecasts provide both business and government economies with useful
information. Forecasts on the economic environment help the government plan fiscal policy
based on the expected tax revenue, and they also influence the government’s ability to react to
the economy with appropriate monetary policy. Businesses are interested in short run economic
forecasts so they can determine the appropriate level of output to produce, workers to hire and
inventory to keep in stock.
The quantity equation (MV = PY) is composed of four variables: nominal money supply (M),
velocity of money (V), price level (P), and real output (Y). The right side of the equation
therefore gives the nominal value of output, since it is the real value of output adjusted for the
price level. Because the two sides of the equation are equal by definition, the value of the
nominal output must be equal to the product of the money supply and the velocity of money. If
velocity is held constant the money supply becomes the determinant of nominal value of output
or nominal GDP.
Quantity Theory of Money assumes velocity is fixed, the quantity equation shows that a change
in the money supply (M) must lead to a proportional change in nominal GDP (PY). In addition,
output (Y) is already determined by the factors of production and the production function, so the
only way nominal GDP can change is if the price level (P) changes. Hence, the quantity theory
of money implies that the price level must be proportional to the money supply. Because V and
Y are assumed fixed and increase in M translates into an increase in PY (nominal GDP) but since
Y is fixed it was an increase in the price level (inflation) that caused PY to increase.
If you rewrite the quantity equation in the form M/P = (M/P)d= KY, you get the equilibrium
amount of money people supply (M/P) and the demand (M/P)d as a function of real output f(Y) =
KY. This means that for each additional dollar of output Y, the amount of real money balances
supplied and demanded will increase by K.
The aggregate demand curve slopes downward because when the aggregate price level rises,
each transaction that is undertaken will need more dollars than if the price level had remained at
its initial level (holding velocity constant). This implies that the fixed nominal money supply can
support fewer transactions. As a result, the quantity of goods and services purchased will fall.
An increase in the nominal money supply (M) results in a greater amount of real money balances
at any given price level. Since velocity is assumed to remain constant, this increase means that
output must increase in order for the quantity equation (MV = PY) to hold. Hence, an increase in
the nominal money supply results in an increase in output at every price level in the short run, so
the aggregate demand curve shifts to the right.
The long-run aggregate supply curve is a vertical line at the economy’s natural rate of output.
The natural rate of output is the level of output consistent with the economy’s natural
unemployment rate, and the level to which the economy gravitates toward in the long run. The
long-run aggregate supply curve is vertical at the natural rate of output because the price level
has no bearing on economies long-run level of real output. Equilibrium price and output occur at
the current point where the long-run aggregate supply curve intersects the aggregate demand
curve.
Shifting the aggregate demand curve has no effect on potential output. Instead, long-run output is
determined by the amount of capital and labor as well as the level of technology. When
aggregate demand increases but the long-run quantities of labor, capital, and technology remain
the same, economy lacks the resources to increase production, and thus prices must rise to
equalize the increased demand with the fixed supply.
In the long run, two related propositions hold: real and nominal variables are separate (the
classical dichotomy), and changes in the quantity of money only impact nominal prices, not
production (monetary neutrality). If the Fed increases money growth, the price level will rise and
inflation rate will increase, but the economies real variables (such as the quantity of physical
capital and the size of labor force) will not change.
The short run aggregate supply curve is based on the assumption that all prices are sticky and,
therefore, remain fixed in the short run regardless of changes in demand. Changing prices (and
thus the price level) involves altering worker pay, replacing price tags, printing new menus, and
making other costly adjustments. The model therefore assumes that it is cheaper for firms to
adjust their output levels than their prices in response to short-term changes in demand (which
can be caused by changes in the money supply). It is further assumed that firms are willing to
sell as much as customers are willing to buy, and that they hire as many workers as are necessary
to produce the demanded output.
The theory of monetary neutrality, which assumes that the money supply is irrelevant in
determining real variables such as output and employment, does not hold during the short run
because the real variables (such as the quantity of physical capital and the size of labor force)
must adjust instead of prices. Because firms can adjust their output levels, they will not
experience surpluses or shortages.
The classical dichotomy which states that nominal variables (like the money supply) are separate
from real variables (like output) does not hold during the short run because these real variables
must adjust instead of prices.
Supply shocks and demand shocks are fundamentally different in their long-run outcomes. In the
absence of government intervention, the effects of a supply shock will eventually dissipate as
production levels return to normal or destroyed capital stock is rebuilt. As the SRAS (short run
supply curve) slows it moves back in the direction it came from, and the economy moves back
along the AD (aggregate demand) curve until it comes to rest at the initial intersection of the AD
and LRAS (long run supply curve) curves. If the government responds to the shock by changing
the money supply, however, the aggregate demand curve shifts to intersect the new SRAS and
LRAS curve, restoring potential output permanently changing the price level.
Demand shocks, on the other hand, cause shifts in the aggregate demand curve that will remain
in place unless the government or another economic shock causes it to shift back. In the absence
of government intervention, output will eventually return to potential, but the price level will be
permanently changed. The government’s response to a demand shock is therefore aimed at
shifting the AD curve in the opposite direction of the shock, and thus maintaining the initial level
of output and prices.
Labor productivity is one of several productivity measures, which is the ratio of total output (or
total value added) to total hours worked.
If you measure output in current dollars, much of the growth in output comes from inflation. For
example, in 1980, the dollar value of output was higher than in 1970 in large part because the
dollar prices on all goods and services had gone up. This kind of growth in output or output per
hour worked clearly does not raise living standards. (If it did, we could raise living standards
merely by changing the price tags on all the goods and services in the economy.) When we
measure productivity, we want to exclude growth in output caused by inflation. So when
economists measure growth in labor productivity, they measure the growth in real output per
hour worked.
About two thirds of all the income generated in the private business sector is paid to labor as
employee compensation -- salary, wages, and fringe benefits such as health insurance. The
remaining third is paid to the owners of capital. Payments to capital could take the form of
dividend payments to the shareholders in a company or rent paid to the owners of real estate. So
if you multiply output (Q) in the private business sector by 2/3, you get total employee
compensation from that sector. If you then divide it by hours worked (HW), you have a measure
of average hourly compensation. Switching the order (so you multiply 2/3 times Q / HW) gives
the same result (average compensation = 2/3 x [Q / HW]). However, Q / HW is labor
productivity. So 2/3 times labor productivity gives you a measure of average compensation per
hour worked.
M1 – includes currency (like a jar of coins), traveler’s checks, and demand deposits (checking
account).
M2- includes everything in M1 plus money market deposits accounts, savings deposits,
certificates of deposit (such as CD’s), and small-time deposits.
Fisher Effect
I = r+ π; i= nominal interest rate, r = real interest rate, π = inflation
Nominal variables – are measured in monetary units. Any price or wage denominated in money,
such as $20 per hour wage, is an example.
Real variable – are measured in physical units. Any price or wage stated in terms of goods is a
real variable. For example, in 2009 the relative price of an A-object was 0.2 B-objects.
U/L = 1/(1+f/s); U/L = natural unemployment rate, U=unemployed, L= labor force, f=job
finding rate, s=job separation rate or the rate at which people lose their jobs.
Frictional Unemployment – unemployment caused by the time it takes workers to search for a
job.
An economy’s planned-expenditure function can be calculated using the following equation
(assuming a closed economy): Y=C+I+G
The government- purchase multiplier is the change in equilibrium output caused by a $1 increase
in autonomous expenditure (ex. Government purchases can increase equilibrium output)
Government-Purchase Multiplier = 1/(1-MPC) = ∆Y /∆G
Change in equilibrium income = change in plan expenditure * government purchase multiplier
The IS-curve characterizes the relationship between the real interest rate and the level of income.
It does this by combining the interaction between R and I (through the investment function) with
the interaction between I and Y (through the Keynesian cross). Specifically, each point on the IS
curve represents equilibrium in the market for goods and services.
When the real interest rate increases, investment decreases, causing the planned expenditure
function to shift downward. When the planned expenditure function shifts downwards, the
equilibrium level of income will decrease because the intersection of this new line and the 45°
line occurs at a lower level of income. Because a higher real interest rate results in a lower level
of income, IS curve must sloped downward to represent the negative relationship between the
real interest rate and income.
Disposable income (Y - T) is a major determinant of consumption: C(Y-T) = MPC(YT)+Constant
When taxes in an economy decrease, this increases disposable income and, therefore,
consumption. Specifically, consumption will increase by the change in taxes (∆T) multiplied by
the marginal propensity to consume (MPC) or ∆T*MPC = ∆Y.
The tax multiplier measures the overall effect on income of a change in taxes: Tax Multiplier =
∆Y/∆T = -MPC/(1-MPC) [NOTE: the tax multiplier is always negative. This is because an
increase in taxes decreases consumption and, therefore, equilibrium income, whereas a decrease
in taxes increases consumption and, therefore, equilibrium income.]
Real money balances = money supply (M)/price level (P)
The real interest rate represents the opportunity cost of holding money. That is, it is what you
give up when you hold some of your assets as liquid money rather than as interest-bearing bank
deposits or bonds. Therefore, a higher real interest rate makes it more expensive to hold money
and, thus, decreases the quantity of real money balances demand. Therefore, the demand for real
money balances is downward sloping.
Real Money Balances
Income is one of the determinants of the demand for money. When income is high, expenditure
is also high, causing consumers to engage in more transactions that require the use of money.
Therefore, a higher level of income must cause demand for real balances to increase. Therefore,
an increase in income causes the demand for real balances to shift to the right, leading to an
increase in equilibrium real interest rate. Because higher levels of income are associated with
high real interest rates, the LM curve must slope upward.
RIR
IS
LM
Income
A lower interest rate stimulates plant investment, which increases planned expenditure,
production, and income. This process is called monetary transmission mechanism. The theory of
liquidity preference refers to the consumer’s preference for holding money, not the actual change
in the IS LM model because of the monetary policy fluctuations.
The aggregate demand curve expresses the relationship between the price level and the level of
quantity of output. Recall that aggregate demand (AD) curve is drawn for a given level of the
money supply, government purchases, and taxes. Therefore, a change in one of these
components of the model will result in a shift of the AD curve, rather than a movement along the
curves such as when the price level changes.
The short run aggregate supply curve is a horizontal line at the price level in the economy
because this represents aggregate supply when prices are sticky in the short run. Recall that the
LM curve is always drawn for a fixed price level. The short run equilibrium occurs where the
SRAS curve intersects the AD curve.
The Keynesian equilibrium represents economies situation in the short run, that is, when prices
are held constant.
The classical equilibrium represents the economy situation in the long run, that is, when output is
fixed at the natural level.
Deflation causes a falling price level that increases the real value of debt. This harms debtors
because it means that the value of their debts increases in real terms. In contrast, lenders are set
to gain because the real value of their outstanding loans increases from deflation. However, some
lenders may end up losing if their borrowers become excessively burdened by debt and are
forced to default.
Delays between the occurrence of a shock and the implementation of a policy to counteract the
shock are known as inside lags. This type of lag is due to the fact that it takes time for
economists to recognize shocks and for the Congress and the president to agree upon an
appropriate policy response. Outside lags occur after the implementation of policy, because the
policy change may not immediately impact the economy. In order to avoid these lags,
economists try to forecast future economic conditions so that appropriate policy can be made in
advance. However, the leading indicators used to predict future economic conditions give
inprecise measurement of economic conditions, and can lead to inaccurate predictions of future
conditions.
Automatic stabilizers or policies designed to stimulate or depress the economy without requiring
any active deliberation. Because they result in automatic change during contractions and
expansions, they help to counteract economic fluctuations without a lag associated with active
policymaking. For example, because income taxes are calculated as a percentage of income, the
total amount taxed rises in expansions when income is higher. Similarly, the total amount
decreases during recessions when income is lower. Thus, Texas decrease the magnitude of either
a rise or fall in income, and thus, decrease the effects of an economic fluctuations.
The Lucas critique argues that standard evaluations of macroeconomic policy fail to take into
account the effect of the policy change on expectations. The Lucas critique points out that if the
analysis fails to recognize a change in expectations, then it cannot correctly predict the effect of
the change in expectation on outcomes. For instance, in response to an expansionary monetary
policy, standard models predict the increase in the supply of dollars will decrease the exchange
rate and the interest rate. The Lucas critique says these models do not adequately account for the
fact that many people anticipate a higher price level and, thus, adjust their behavior in response
to their expectations. Demanding a higher salary in anticipation of higher future price level is
different from the standard responses to actual changes in the interest rate where exchange rate,
such as an increase borrowing or more foreign tourism.
Passive monetary policy specifies a constant growth rate that is independent of other economic
conditions. Active monetary policy response to changes in the economy an attempt to counteract
fluctuations. Although some rules can be active and others passive, no rule can be discretionary.
Discretionary policy is, by definition, not based on rules, but rather, based on what policymakers
think is appropriate for the current economic situation. Critics of discretionary monetary policy
fear that the Federal Reserve may abuse its power by following policies to influence an election.
Another argument against discretionary policy is that the public does not always believe that the
federal reserve will be sufficiently tough on inflation and therefore might expect higher inflation.
Economist who believe in inflation targeting advocate increasing the money supply growth rate
when the inflation rate falls below a specified target and decreasing the money supply growth
rate when the inflation rate rises above the target rate. This is based on the belief that monetary
policy should be used to counter act economic fluctuations. By decreasing the money supply,
said Fed can decrease aggregate demand, which will put downward pressure on the inflation rate.
Another approach would be to adjust the money supply based on target growth path for nominal
GDP, in which case the Fed would increase or decrease the money supply in response to nominal
GDP falling below or rising above the target. Monetarists, on the other hand, do not believe that
money supply should be used to counteract economic fluctuations at all.
Budget Deficit/Surplus = Tax Revenues – Government Expenditures [NOTE: negative result is a
Deficit, positive result is a surplus]
National Debt decreases with a budget surplus and increases with a budget deficit.
Capital budgeting is a budget procedure that accounts for both assets and liabilities. The budget
deficit equals the change in debt minus the change in assets. Therefore, when calculating a
budget deficit, capital budgeting offsets an increase in liabilities by an increase in assets or a
decrease in liabilities by a decrease in assets. Consequently, an increase in liabilities will increase
over debt, whereas an increase in assets will decrease overall debt.
Budget Deficit = Government Spending – Tax Revenues; Under capital budgeting: Budget
Deficit = (Government Spending – Tax Revenues) – Change in assets.
Contingent liability is the liability that is due only when a specified event occurs. An example of
contingent liability is state insurance programs.
Government’s budget deficit can be misleading because it does not include liabilities that are
implicit or contingent. Implicit liabilities are future liabilities the government has committed to
spend but are not included in a measure of government debt. Contingent liabilities are the
liabilities that are due only if the specified event occurs. Contingent liabilities are not included in
government debt measurement partly because it is difficult to measure the dollar value attached
to these liabilities. Salaries for civil servants and current expenditures on public investment
projects are current government expenditures and are included as part of the budget deficit.
People earn higher incomes during expansion. Since personal income tax is based on a fraction
of personal incomes, personal income tax revenues rise during expansions when income is high.
These taxes therefore decrease the budget deficit (or increase the budget surplus) during
expansions.
A cyclically adjusted budget deficit measures the government spending and tax revenue as they
would have been if the economy were operating at its natural level of output and employment.
According to the traditional view of government debt, a tax cut will reduce national saving,
which in turn will raise the interest rate. Since local interest rate is assumed to be equal to the
global interest rate under the Mundell Fleming model, a higher local interest rate leads to a
appreciation of the US dollar against foreign currencies through capital inflow. Domestic goods
become more expensive abroadwhile foreign goods become cheaper in the US. This will lead to
a fall in net exports. A fall in net exports will partially offset the short run expansionary impact
of the tax cut on output and employment.
According IS-LM model, the tax cut will lead to an increase in aggregate demand. Since prices
are stickly in the short run, higher aggregate demand will result in a higher level of output and a
lower level of unemployment. However, as prices adjust over time, the economy will return to
the natural level output. Hence, the tax cut will lead to only a higher price level in the long run.
LR
RIR
IS2
AD
P
IS1
2
AD
SR
Income
1
Income
The Ricardian view of government debt is built on the assumption that consumber are forward
looking enough to find current and future taxes as equivalent, and they will make speding
decisions based on current and expected future income. One criticism of the view is that
consumers are shortsighed, or they fail to fully comprehend the implication of the budget
deficits. Although the government expects to further increase its spending in the next few years,
consumers who do not foresee this increase in futuer government spending and expect that
furture tax will remain at the current level will increase their consumption. Another criticism is
that when consumers face borrowing constraints, current income is more important than future
income. Therefore, when consumers face borrowing constraints, the tax cut expands their
opportunities and, hence, stimulates their consumption.