The Health of the
Economy
What is wrong and
what can be done?
Measuring the Health of the Economy
Fixing the Economy
Unit 4
TC
Enduring Understandings
Government actions affect economic activity.
Economic decisions require the government to evaluate the costs and benefits of actions.
Essential Questions
How should the U.S. government carry out its economic roles?
How healthy is the American economy
Terms
Gross Domestic Production
Consumer Price Index
Unemployment rate
Inflation
Real and Nominal, per capita
Draw and identify phases of the business cycle
Aggregate
Aggregate Supply- describe both the Keynesian and Classical models
Aggregate Demand
Progressive Tax Rate
Fiscal Policy
Stagflation
Monetary Policy
Circular Flow Model
TC
Profit maximizing rule of hiring MRP= MRC
Income
Cost
Resource
Markets
Resources- factors of production
Demand
Resources
and labor
Business
MR= MC
Profit
Maximizing
Rule
Gov’t
Spending
Government
Taxes
Taxes and loans
Public Goods/Services
Government
Goods and
Services
Supply
Interest
Revenue
Public Goods/Services
MSB= MSC
Gov’t
Spending
Goods and Services
Loans
Individuals
MB= MC
Utility
Maximization
Transfer Payments
Subsidies
Investors
Financial
Resources- factors of production
Land Labor capital
entrepreneurship
Supply
Goods and Services
Demand
Product
Markets
(MC) S= D (MB) or (MR)
Spending
Consumer
Consumers
+
Investors
+
Government
+
Net Exports
__________
Gross Domestic
Production
Marginal- additional, MB= Marginal Benefit, MC= Marginal Cost, MR- Marginal Revenue, MRP- Revenue product, MRC- Resource cost,
MSB- Marginal Social Benefit, MSC- Marginal Social Cost
Identify Key terms and answer the associated questions
TC
Part 1 (GDP)
G.D.P. (Gross Domestic Product)What factors contribute to the GDP?
On another piece of paper chart the US GDP from
2000- 2011 (by year)
What goods and service are not calculated in the GDP?
by quarter
Next chart US real GDP from 2008-2011
Explain:
Nominal GDP
Real GDP
GDP per Capita
Explain how unemployment is it related to GDP?
Part 2 (Unemployment)
Explain the different types of unemployment and what is the natural rate of unemployment?
Frictional
Structural
Cyclical
Season
What is the natural rate of unemployment? Why is this ok?
If our current unemployment rate is 9% how much is the cyclical unemployment?
What groups of the population is not counted toward unemployment rates?
What is real unemployment?
What is our current unemployment rate?
Part 3: The purchasing power of money
What is inflation?
What does higher inflation do the purchasing power of money?
How does this impact price?
What is CPI (Consumer Price Index)
How does the Consumer price index measure inflation?
Part 4: The Business Cycle
Diagram and Identify the different phases of the business cycle:
If the business cycle is natural and unavoidable should the government become involved? Explain your answer
To economist when is the business cycle officially in a recession?
TC
Part 5: Government Role and the Recession:
Aggregate Supply and Demand (AS/AD)
What is Aggregate Demand
What is LRAS?
What is Aggregate Supply
Part 6:
What is the difference between Classical vs Keynesian Approach to Aggregate Supply?
How would an economist who believed in the classical approach draw Aggregate Supply? Why?
What would Keynesian economists say the Aggregate Supply , Aggregate Demand, and Price?
How does the Aggregate Supply depending on what model you are looking at? What are the three different phases?
What is Keynesian economics and what does it say about the government’s role in getting the economy out of a recession?
TC
Part 7: Phillips Curve (inflation and unemployment) (Long and Short Run)
Explain the Phillips Curve and explain how we get short run and long run Phillip’s Curve
Part 8: Fiscal Policy and Monetary policy
Explain Fiscal Policy:
Explain Monetary policy:
How do both try to fix recessions and inflation?
Recession
Fiscal
Monetary
Inflation
Fiscal
Monetary
TC
Measuring
The
Health of the
Economy
Economic Indicators
TC
Measure health of economy
Regardless of what you learn for the next two weeks
Remember these some important points:
1. Economics is the Allocation of scarce resources to their most useful
purpose.
2. Remember the key lesson on economics- don’t look at policy in isolation,
look at future phases, and measure policy by consequences and outcomes
and not by intentions. This will come into play when we learn about “fixing”
the health of the economy.
3. What is unseen is just as important as what is seen!!!!
4. Regardless of statistics and numbers the most important thing to consider is
standard of living. Very difficult to measure happiness.
5. Correlation does not mean Causation!!!!!!
Gross Domestic Product
Gross Domestic Product- the market value for all final goods and services
produced within a country during a given period of time.
A steadily growing GDP is generally considered a sign of economic health.
The Department of Commerce’s Bureau of Economic Analysis determine the
GDP.
Click here to find our current GDP.
http://www.bea.gov/
Terms:
Final Good- a new good ready to be used by a consumer- cereal, cars, toys
Intermediate good- a good that is used in the production of a final good- not
counted toward GDP. Example- grains, steel, rubber
What else is not counted. . .
The buying of financial assets are not counted because they do not reflect current production.
Secondhand sales do not count because the counted for the GDP of some previous year.
Intermediate goods are not counted in order to avoid double counting
Market Value- price buyers are willing to pay in the market place
Film on G.D.P. (Gross Domestic Product)
TC
Gross Domestic Product
How do we calculate GDP?
Household Consumption/
Consumer spending
Business Investment
Government Spending
C
I
G
Exports
Net Exports
Imports
NX
GDP
TC
Gross Domestic Product
Types of GDP
Nominal GDP:
Measuring GDP with today’s prices
Real GDP:
Measuring GDP using a base year’s value of the dollar- this
compensates for inflation
(Nominal GDP/GDP Price index) * 100
GDP Deflator= Nominal/Real *100
GDP per Capita: GDP per person, dividing GDP by the population
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Gross Domestic Product
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Gross Domestic Product
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Gross Domestic Product
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Gross Domestic Product
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Gross Domestic Product
Nominal GDP by nation 2011
GDP growth rate by nation 2011
http://www.tradingeconomics.com/gdp-growth-rates-list-by-country
TC
Gross Domestic Product
Gross Domestic Product- maps
TC
Gross Domestic Product
Gross Domestic Product- maps
TC
Gross Domestic Product
Real Growth rate
TC
Gross Domestic Product
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Gross Domestic Product
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Gross Domestic Product
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Distribution of wealth 0 = total equality 1= total inequality
Gross Domestic Product
There are some important correlations (associations/relationships)
Remember correlation does not mean causation!!!
Nations with high GDP’s generally have the following. . .
High Literacy Rates
Improved health, nutrition, and high life expectancy
Lower infant mortality rates
Higher standards of living
TC
Gross Domestic Product
There are some limitations to GDP
1. GDP leaves out unpaid work such as households and volunteer work
Volunteer firefighters, charity
2. GDP leaves out informal and illegal exchanges
Babysitting, working under the table, black markets, barter
3. GDP counts negatives as positives.
rebuilding after a hurricane, war efforts, over- exploiting resources
4. GDP does not reflect negative externalities
Pollution, people buying bottle water because of pollution
5. GDP places no value on leisure time or happiness
6. GDP says nothing about income distribution
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Gross Domestic Product
TC
There are other limitations to GDP
For example GDP measures things that were once done at home but now are considered work.
Housekeeping or gardening
Also it literally tries attempts to compare apples and oranges or more accurately bananas and
oil.
It says nothing about the time it takes to create a product.
Gross Domestic Product
TC
"The Gross National Product includes air pollution and advertising for cigarettes, and ambulance
to clear our highways of carnage.
It counts special locks for our doors, and jails for the people who break them. GNP includes the
destruction of the redwoods and the death of Lake Superior.
It grows with the production of napalm and missiles and nuclear warheads... And if GNP includes
all this, there is much that it does not comprehend.
It does not allow for the health of our families, the quality of their education, or the joy of their
play. It is indifferent to the decency of our factories and the safety of our streets alike.
It does not include the beauty of our poetry or the strength of our marriages, or the intelligence
of our public debate or the integrity of our public officials...
GNP measures neither our wit nor our courage, neither our wisdom nor our learning, neither our
compassion nor our devotion to our country.
It measures everything, in short, except that which makes life worthwhile; and it can tell us
everything about America - except whether we are proud to be Americans."
- Senator Robert Kennedy. 1968
Gross Domestic Product
TC
Gross Domestic Product
TC
Gross Domestic Product
TC
Evaluate the following quote from Milton Friedman
“Spending isn’t good, what is good is producing. What we want to have is more goods and
services. Government spending is ok for those things, those services that we believe that we
can get more usefully and more effectively through government. If people are getting their
money’s worth- fine. That’s why it is very desirable to have government expenditures occur as
much at the local level as possible, because you as a citizen of a local community can judge if
you are getting your money’s worth and you can decide if you want to spend it. But when it
comes to the federal government you tend to think that you are spending someone else’s
money. In a way you are, but he is spending yours.
The Broken Window Fallacy
What is the problem with using adding up total spending to find total production?
Spending and Production are not the same thing
Unemployment rate
TC
The Bureau of Labor Statistics tracks the unemployment rate.
Click here to track our current unemployment rate. http://www.bls.gov/
The unemployment rate is used to measure the overall health of the economy.
In general a high unemployment rate indicates an unhealthy economy.
The BLS will conduct a random survey to determine the unemployment rate.
The are 3 classifications of people in the country.
1. Employed- members of the labor force who have jobs.
2. Unemployed- members of the labor force who don’t have jobs but are looking
for work
3. Not in the labor force- those who are eligible to be in the labor force but don’t
have jobs and are not looking for jobs. This includes full time students,
disabled, retired, and those prevented by family responsibilities.
Unemployment rate
TC
The labor force is found by adding all employed and unemployed workers
together.
To find the unemployment rate the BLS divides the unemployed by the labor
force and multiples the number by 100.
number unemployed
Unemployment rate = ______________________________
number in labor force
X
100
Unemployment rate
TC
In 2008, The Phillies won the World Series
Based on the data below and using the equation provided calculate the unemployment rate
U.S. Unemployment rate October 2008
Unemployed (9.5 million)
Employed (145.3 million)
Not in labor force (79.6 million)
Adult population (234.4 million)
Unemployment rate =
9.5 million
______________________ x 100 =
154.8 million
6.1%
Unemployment rate
Types of Unemployment and Full employment
Frictional Unemployment-
TC
Unemployment lesson
When a worker enters the workforce or
quits a job to find a better job.
Structural/Technological Unemployment-
when advances in
technology eliminate jobs
Unemployment rate
Types of Unemployment and Full employment
TC
Unemployment lesson
Seasonal Unemployment-
When a business shuts down during part
of the year
Cyclical Unemployment-
Occurs when there is a decline in
business because of the economic
downturn
Unemployment rate
Types of Unemployment and Full employment
TC
Unemployment lesson
There will always be Frictional, Structural, and Seasonal unemployment.
This is the natural rate of unemployment- NRU
The NRU is about 5%.
This is also considered Full Employment
It is Cyclical Unemployment that we need to be the most concerned with.
This happens during down periods of the economy. Currently we have a 9%
unemployment rate.
Unemployment rate
TC
Unemployment lesson
Unemployment rate
TC
Problems with Unemployment rate as an indicator
1. Unemployment does not count discouraged workers or in other words those
who have given up looking for work. Some say that if we counted these people
in the unemployment calculations the our real unemployment rate is 17%.
2. Additionally, involuntary part-time workers are not counted as part of the
unemployment rate. These are the people who would like full time jobs but can
only get part-time hours. They are partially employed.
3. Does not count under the table workers or illegal activity.
Economic cost of Unemployment
1. Lost of potential output.
2. Loss of income by workers
3. The unemployed do not contribute to taxes and in fact usually collect
unemployment insurance
4. If the number of unemployed becomes too large, money from other programs
must be shifted to unemployment programs or taxes are raised on those who
have jobs.
Unemployment rate
TC
More important than unemployment rate is production.
Providing jobs for the sake of employment and not production is one of the biggest fallacies.
Inflation Rate
TC
The inflation rate is the percent of increase in the average price level
of goods and services from one month or year to the next.
In other words inflation reduces the purchasing power of money.
It is tracked by the Bureau of Labor Statistics.
http://www.bls.gov/bls/inflation.htm
Imagine living in a country where if you ate breakfast at a café your
second cup of coffee would cost more than the first or if you burned
you cash because it was worth more as fuel than as currency.
Excessive Inflation can send a nation’s economy into a tailspin.
What is inflation?
Inflation Rate
TC
Inflation is measured by using a price index.
A price index measures the average change in price of a type of good
over time.
The Consumer Price index (CPI) is a price index for a “market basket”
od consumer goods and services. Changes in the average prices of
these items approximate the change in the cost of living.
Also know as the Cost of living index.
The CPI is determined by consumer and store surveys.
The current prices are compared to a base period. 1982-1984
Base 100- 1982-1984
Inflation Rate
TC
Inflation Rate
TC
CPI is found by finding the total price of a consistent “market basket”
Item
2009
2010
2011
Hot Sausage
3.00
4.00
4.50
Pasta
1.00
1.50
2.00
Ice Cream
3.00
3.50
5.00
Eggs
1.00
1.50
2.00
Milk
3.00
3.00
4.50
Bread
1.00
1.50
2.00
Total:
(Market Basket)
12.00
15.00
20.00
Inflation Rate
TC
What is CPI (Consumer Price Index)
Market basket price for year
_____________________________
x
100= CPI
Market basket price for base year
Year
Market Basket
2009
12
2010
15
2011
20
Base year 2009
Base year 2010
Base year 2011
100
100
100
Base year is always 100
Example
Base year is always 100
Example
Market price for 2009
_______________________ x 100 = CPI
12
_______________________ x 100 = 1
Base year 2009
12
Now complete the chart
Inflation Rate
TC
What is CPI (Consumer Price Index)
Market basket price for year
_____________________________
x
100= CPI
Market basket price for base year
Year
Market Basket
2009
$ 12
2010
2011
Base year 2009
Base year 2010
Base year 2011
100 %
80
60%
$ 15
125%
100 %
75%
$ 20
167%
133%
100%
Example:
To find the increase in inflation from 2009 to 2010
15
______ x 100= 125%
12
Inflation Rate
TC
Limitations of CPI as a measure:
1. Substitution Bias- People buy substitutes if prices are too high. CPI
doesn’t take this into consideration.
2. Outlet/Discount store bias- CPI doesn’t take into account that
people may buy goods at a discount store.
Acme- average price of a chicken fryer (small whole Chicken)- $7.41
Bottom Dollar – same item or similar item- $4.00
3. New Product bias
Mobile phones in 1983- $3995, 1998 $200- but mobile phones were not
included in the CPI until 1998.
4. Quality change bias- technological improvements make items better
and last longer.
Inflation Rate
TC
Nominal cost of living- the cost in current dollars of the basic good and service that people
need.
Real cost living- the nominal cost of basic goods and services, adjusted for inflation
Nominal wages- wages based on current prices
Real wages- nominal wages that have been adjust for inflation.
Wages need to keep up with the cost of living if the standard of living is to remain the
same.
The cost of living is indeed going up—in money terms. What really matters, though, isn't what
something costs in money; it's what it costs in time. Making money takes time, so when we
shop, we're really spending time. The real cost of living isn't measured in dollars and cents but
in the hours and minutes we must work to live.
American essayist Henry David Thoreau (1817-62) noted this in his famous book, Walden:
"The cost of a thing is the amount of. . .life which is required to be exchanged for it,
immediately or in the long run."
http://dallasfed.org/fed/annual/1999p/ar97.cfm
Inflation Rate
TC
Inflation Rate
TC
In 2010, Sally started her new job making $40,000.
In 2011, Sally earned a $1,000 raise.
From 2010 to 2011 prices have increased 4%.
Should Sally be happy or disappointed? Why?
or
Sally received a 2.5% raise but her purchasing power dropped because inflation increased 4.
Inflation Rate
TC
Types of inflations
Creeping inflation- gradual inflation, in the United States the annual
rate of inflation is 3.4 percent since 1914. The rate has varied widely
but this is on average what we can expect.
Hyperinflation- when inflation goes into overdrive. Prices can double
within days, the standard of living collapses.
Germany in the 1920’s
Zimbabwean 2008
Inflation Rate
TC
Types of inflations
Deflation- Inflation rate always rises. It either speeds up or slows
down. It never drops.
If the rate becomes negative it is call Deflation. Deflation is caused
when prices drop over time.
Sounds good for consumers and savers.
Every dollar saved will have an increased purchasing power in the
future.
Who does this hurt?
This hurts borrowers- this hurts everybody because if people aren’t borrowing
they aren’t investing and this slows down the economy.
Business will slow down production and there will be an decrease in wages and an
increase in job cuts.
This is actually a very bad spiral – early days of the great depression saw deflation
Inflation Rate
TC
Causes of Inflation
1. Increase in money supply- too many dollars too few goods
2. Demand Pull- If the sectors of the economy try to buy more than
the economy can produce. The extra demand pulls up prices
3. Cost-Push- The rising cost of labor, land, or capital pushes up the
overall price in future transactions.
Or course a company does not have to extend the cost to the buyer
and the companies that don’t get the business. But to do so they will
need to make cuts in other places.
1. Wage-price spiral- higher wages result in higher prices and higher
prices result in more people asking for higher wages.
Inflation Rate
TC
Economic cost of inflation
1. Loss of purchasing power
If the price of a guitar was $200 one year. A student saved his money
for an entire year to buy the guitar. He came back to the store the
following year to see that the price is now $220.
- Hurts those on fixed incomes the most.
- Wages have to keep up with inflation
2. Higher interest rates- real interest rate is the
nominal interest rate- the inflation rate= a real interest rate
10% interest rate- 4% inflation rate= 6 % real interest rate
Dollars worth less tomorrow than today- slows lending
3. Loss of efficiency- many economist consider uncertainty about
prices to be a bigger problem than the others. Buyers and sellers don’t
have enough information to make the most efficient decisions.
The Business Cycle
Economies are always changing
There are periods of growth and decline. Booms and Bust
This is the business cycle.
Movie The Business Cycle
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The Business Cycle
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The Business Cycle
The name business cycle makes it sound like the cycle is very predictable.
The opposite is true.
Peaks and Trough are extremely difficult to predict.
The leading indicators are GDP, Unemployment, and Inflation.
Other leading indicators:
Housing construction- an increase signals confidence and a decrease slows a lack of
confidence and an increase in savings.
Others:
Real GDP
Lagging indicators are indicators that lag behind or happen after contraction or expansion
Unemployment rate
TC
The Business Cycle
Other names.
Recession- a decline in GDP lasting 6 months or 2 quarters
Depression- Severe contraction
When GDP grows – there will be inflation and low unemployment- natural
When GDP shrinks- there will be less inflations and higher unemployment- natural
Stagflation – is the worst of both worlds- high unemployment and high inflation- unnatural
TC
The Business Cycle
TC
What causes the dip?
1. Negative shock to the economy- rapidly rising oil prices, stock market crash, uncertainty
with regards to government actions, terrorist attacks
2. Increase in interest rates making it more difficult to borrow money.
3. When supply is less than demand – natural or man-made
4. Some say an increase in savings leads to an increase in inventories. Increased inventories
force firms to cut back production and layoff workers.
What causes Growth?
1. Confidence in market caused by knowledge- uncertainty is the worst enemy.
2. Increased production causes firms to hirm
3. New technology
4. Government??????- this is the question that needs to be answered for the unit.
TC
Now that we know how to measure the health
The Question is how do we fix the economy?
Just like doctors, economist will have different opinions
Some will say, “Do nothing it needs to run its course.” (Classical)
Other will say, “The Government needs to do something.”
While other may agree with doing “something” that “something” depends on the economist
Keynesians
Monetarist
Classical
Fixing the Economy
Does fixing the Indicators fix the economy?
Remember . . .
Economics – The allocation of scarce resources that have alternative uses.
Money measures wealth but it is not wealth.
Does adjusting the indicators improve standard of living and increase production?
What is the Government’s Role?
Remember . . .
The art of economics consists in looking not merely at the immediate but at the longer effects
of any act or policy; it consists in tracing the consequences of that policy not merely for one
group but for all groups.
What is unseen is just as important as what is seen!!
Video Clips for Presentation
Broken Window Fallacy
Stimulus Hearing
19:00 Economist Against Stimulus Package
45:50 Economist speaking about net gain of Stimulus Package
1 hour 32 min. Economist in favor of the Stimulus Package
Hayek vs Keynes Raps
Round 1- Fear the Boom and Bust
Fight of Century Keynes vs. Hayek Round 2
Deck the Halls with Macro Follies
http://econstories.tv/
http://www.econedlink.org/lessons/index.php?lid=593&type=educator
Supply and Demand graphs- The Basics
Price
Supply
Pe
Demand
Qe
Q
The purpose of this graph is to look at markets.
Free Market Price and Quantity
The Aggregate Market- The Basics
Long Run Aggregate Supply (LRAS)
Aggregate- all together (total)
Price Level
Aggregate Supply (AS)
Measure
of
Inflation
The purpose of this graph is to look at countries.
Total supply and demand at full employment
Pe
Aggregate Demand (AD)
Qe
G.D.P real
Qy
employment
Qy= Quantity at full employment
The law of demand is the same.
There is an inverse relationship- PL up, AD down, PL down AD up
The law of supply is the same
There is a direct relationship- PL up, AS up, PL down AS down
AD= Aggregate Demand
AD= GDP= C + I + G + NX
You may find it amazing how a graph can be
interpreted in so many different ways.
Learning the basics of the graph will provide you
an opportunity to learn fiscal and monetary
policy in different ways.
Conflicting Views
Classical Views
F.A. Hayek
Less Government
Neo-Classical
Equilibrium of market
Austrian
Supply-siders
Increase consumer or
Real Production= real Investments
wealth
SAVINGS!!!!!
1. Prices and Wages are flexible – markets quickly and
efficiently achieve equilibrium. When applied to the
resource market full employment is maintainedunemployment is not a long term problem
2. Say’s Law- supply creates it own demand- aggregate
product of goods and service produces enough income to
exactly purchase all output
3.
Savings-investment equality-any decrease in output
because of savings is offset an increase in the demand
for investment
This creates a different market – the money market
Investment is demand
Savings is Supply
Interest rates create equilibrium- Monetarist
4.
5.
Individualism
Savings leads to investments, which lead to stronger business,
which leads to more supply and more employment
Keynesian Views
John M. Keynes
More Government
Macro not Micro
Keynesians
Neo-Keynesians
Demand-siders
Multiplier
Increase Gov’t
spending!!!!!!!!
Fiscal Policy
1. Prices and Wages are Sticky- Prices and wages respond
slowly to changes in supply and demand and this results in
shortages and surplus- especially with labor.
2. Increase Aggregate Demand to increase GDP- is
influenced by a host of economic decisions both public and
private.- savings hurt The paradox of thrift
3. “In the Long Run we are all dead”- care more about
Short run and not so much about the long run. Changes in
AD have greater short run effect on real GDP and
employment but not as much on price. What is true in the
short run isn’t always true in the long run
4. The multiplier- increases in spending will increase
consumption and increase output- which will lead to more
spending
5. Steer the Market- advocated stabilization policies such
as tax, government spending, laws, and regulation in order
to defend against the sudden and unpredictable changes in
the business cycle
6. The Animal Spirits- believed growth and contraction had
much to do with confidence and trust
Keynesian’s Paradox of thrift
A Prisoner’s Dilemma for Savings
A Prisoners Dilemma between individuals in a society who want to save.
It is smart to save during the good times , but if everybody saves than Aggregate demand
drops and GDP drops now we are in a recession.
How does the government attempt to avoid this?
Save
Spend
Save
5, 5
10, 3
Spend
3, 10
7, 7
Summary
To Hayek:
Only real savings should lower interest rates, not the Fed. Interest rates drop as private savings
increase.
During recession: We will stay at full employment if prices and wages are allowed to be flexible.
To Keynes:
Spending!!!!!!!
During a recession: Only prices and wages will stay (prices and wages are sticky) and
employment drops. Government spending during a recession will increase employment, GDP,
and AD and will not have an impact on price level until full employment is reached.
How to fix the economy? According to . . .
Fiscal Policy
Increase Government
Spending
During a
Recession
Decrease Taxes
With high
unemployment
Decrease Government
Spending
During
Expansion Increase Tax
With high
inflation
Monetary Policy
Supply Side Policy
Buy Securities from banks Cut tax on Business
or dealers
Reduce Regulation
Decrease Discount Rate
Give business a chance to
Reduce Reserve
expand and hire
requirements
No capital gains tax or
All ideas intended to
marginal (progressive
lower interest rate
income tax)
Sell securities to banks
Increase Discount Rate
Increase Reserve
Requirements
All ideas intended to
increase interest rates
Do nothing the market
will take care of itself.
AS/AD/LRAS graphs- Classical vs Keynesian models
Labor Market
Wages
(AS)
We
W1
(AD) 1
Q2 Q1
Q
(AD)
Employment
Classical- believe that when demand for employment decreases- wages will fall and the market will clear (return to
equilibrium). Some people will choose not to work but most will eventually lower their wages.
Keynesians- say- no when demand for employment falls- wages and prices are sticky. We simply get a new quantity at
the same wage. This creates a surplus of supply of workers which will remain until demand increases.
Quantity demanded is less than the quantity supplied.
Aggregate Supply (The classical model)
The whole purpose of these graphs is to find
the Price level, GDP, and unemployment
(AS) much like the LRAS
P.L.
AS is vertical and at the same point of full
employment
Classical economist believe that resources
prices and wages are flexible
This model says that the government
doesn’t need to get involved because the
market will fix itself.
Pe
What will happen to price as AD falls?
P1
(AD) 1
Qy
(AD)
G.D.P real
The classical model suggest that the
economy fixes itself and that prices and
resources price will fall to create a new
equilibrium.
When Aggregate demand falls what
happens to. . .
Price?
Employment?
Wage (remember wages are price)?
GDP real?
Aggregate Supply (The classical model)
If there is a decrease in AD
There will be a reduction in price
level and higher unemployment
LRAS
P.L.
SRAS
SRAS 1
Pe
P1
This will give you a new quantity
demanded back at full
employment
(AD) 1
Q1
Qy
Q2
(AD)
G.D.P real
Whether or not the market will clear will also depend on the worker’s
wage expectations.
Rational Expectations
According to classical economist
the SRAS will eventually increase
as wages decrease and the price of
resources decrease
Adapted Expectations
This will occur as long as wages
can adjust. What can keep wages
artificially elevated? Or in other
words what can keep the market
from clearing?
Unions
Min. Wage laws
Workers will revise their
expectations instantaneously
It may take workers weeks,
months, or years but eventually
they will adapt their wage
expectations.
Unemployment benefits
Aggregate Supply (The Keynesian Model)
LRAS
P.L.
Pe
(AD) 1
Y1
(AD)
Qy
full
G.D.P real
According to Keynes, it is possible for the economy to be in a recession permanently. Prices/wages won’t
change and output will remain low.
When output is below full employment, the price level doesn’t fall because wages/resource prices don’t
fall (wages are sticky)
Aggregate Supply (The Keynesian Model)
LRAS
P.L.
Pe
(AD) 5
(AD) 3 (AD) 4
(AD) 1
(AD) 2
Y1
Qy
full
G.D.P real
According to Keynes, only with the help of the help of the government can Aggregate demand increase.
Demand side economics- focus on demand
Fiscal approach- government spending and taxation
Monetarist approach is to increase investments
Any aid past Qy- is purely inflationary
Aggregate Supply – So what Model is correct?
They Both have some
valid points
LRAS
P.L.
Classical
Phase
When in the Classical Phase
The economy is operating at full employment
Pe
Any and all increase in AD will result in an
increase in price and in increase in inflation
Intermediate
Phase
Keynesian
Phase
AD
AD
AD
Qy
full
G.D.P real
When in the Keynesian Phase
When in the Intermediate Phase
Output can increase with no change in price.
No increase in price level, no inflationary
pressure, spare room to grow.
As AD approaches the curve
An increase in AD and decrease in
unemployment
Result in a gradual increase of price and
some inflationary pressure
AS/AD/LRAS graphs- how it works during Expansion
(LRAS)
P.L.
P2
Both Prices and GDP will increase.
(AS)
C
P1
Pe
If Aggregate Demand increases
(AS) 1
In the long run – an increase in price will
not lead to an increase in output.
B
Why?
A
(AD) 1
Because as prices increase so does the price
of resources including labor, wages, and
materials.
(AD)
Qe
Qy
Q1
G.D.P real
As a result the Aggregate supply will shift to
the left (decrease) and we will find
ourselves back at full employment.
AS/AD/LRAS graphs- how it works during Recession
If Aggregate Demand decreases.
(LRAS)
P.L.
(AS)
Both Price Level and output will decrease.
(AS 1)
P1
Why?
A
Pe
B
Because as prices decrease so does the
price of resources including labor, wages,
and materials.
C
P2
(AD) 1
Q1
Qe
Qy
In the long-run a decrease in price will not
lead to a decrease in output.
(AD)
G.D.P real
As a result the Aggregate supply will shift to
the right (increase) and we will find
ourselves back at full employment.
Inflationary and Recessionary Gaps- Steering the Market
Economic
Activity
Potential
GDP
Inflationary Gap
(Full Employment)
Recessionary Gap
Time (years)
The Government can steer the economy in different ways
1. Laws and Regulations- stabilizers
2. Fiscal Policy- changes in government spending or taxation to influence the economy
3. Monetary policy- changes in monetary supply to influence the interest rates that influence economy
AS/AD/LRAS graphs- Inflationary Gap
Actual GDP > Potential GDP
Output is beyond full employment
Price
Level
LRAS
Unemployment very low
Prices very high
AS
Government wants to limit inflation by reducing
demand
How do they do it?
P1
P2
AD 2
Qy
FE
Fiscal Policy:
Q1
AD 1
GDP real
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE
Monetary Policy: Federal Reserve can decrease money supply or increase interest rates.
AD = C + I + G + NE
AS/AD/LRAS graphs- Recessionary Gap
Actual GDP < Potential GDP
Output is below full employment
Price
Level
LRAS
High unemployment
Government wants to limit unemployment by
increasing demand
AS
P2
How do they do it?
P1
AD 2
AD 1
Q1
Fiscal Policy:
Qy
FE
GDP real
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE
Monetary Policy: Federal Reserve can increase money supply or decrease interest rates.
AD = C + I + G + NE
Summary
Inflationary Gap
Actual GDP > Potential GDP
Output is beyond full employment
Unemployment very low
Prices very high
Government wants to limit inflation by reducing demand
Fiscal Policy:
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE
Monetary Policy: Federal Reserve can decrease money supply or increase interest rates.
AD = C + I + G + NE
Summary
Recessionary Gap
Actual GDP < Potential GDP
Output is below full employment
High unemployment
Government wants to limit unemployment by increasing demand
Fiscal Policy:
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE
Monetary Policy: Federal Reserve can increase money supply or decrease interest rates.
AD = C + I + G + NE
How Much is Too Much?
Fiscal Policy (Demand side)
Keynesians and Democrats
Keynesian economics
President sets the budget, Congress develops programs- they can tax and borrow
Commerce clause – etc.
Raising Revenue- Tax or Borrow
Spending- increase of Decrease (discretionary and nondiscretionary)
Leading advocates- Monetarist
Monetary Policy (Demand side)
Milton Friedman showed that people’s annual consumption is a
function of their “permanent income,” a term he introduced as a
measure of the average income people expect over a few years.
Monetarist believe that price level depends on money supply
Friedman stated that in the long run, increased monetary growth increases prices but has little
or no effect on output. In the short run, he argued, increases in money supply growth cause
employment and output to increase, and decreases in money supply growth have the opposite
effect.
Friedman’s solution to the problems of INFLATION and short-run fluctuations in employment and
real GDP was a so-called money-supply rule. If the Federal Reserve Board were required to
increase the money supply at the same rate as real GDP increased, he argued, inflation would
disappear.
He argued that the Great Depression was caused by the Federal Reserves poor management of
money. Most monetarist do not support the idea of using money supply to fix the economy- too
much lag
To keep unemployment permanently lower, he said, would require not just a higher, but a
permanently accelerating inflation rate – increase with rate of increase of real GDP
Supply and Demand of Money
Price
Interest Rate
I2
I1
I3
AD
Q2
Q1
Q3
Q
Interest rate at supply
Decreasing the supply of money will increase the interest rate
Increasing the supply of money will decrease the interest rate
If we increase the supply of money what will happen to the value of the currency?
Devaluation
In theory what should happen to our net exports?
GDP= C + G + I + NE
In theory they will increase. Why?
Below is a simple example:
If 1 U.S. dollar = 1 Euro how many Euro’s what would a $20,000 American car cost?
In America?
In Germany?
If the dollar was devalued so that 1 U.S. dollar = .5 Euros what would a $20,000 American car
cost?
In America?
In Germany?
In what situation would an American car be more appealing to the German?
In theory why does this not impact the American car manufacturer?
Sounds good.
But what is the problem?
Money is not wealth it measures wealth. If there is a devaluation of currency the Federal
Reserve is telling people that you have less than you really do.
The car example is only taking into account the final product, what it is not factoring in is the
fact that we have a global economy and that the car manufacturer must spend more dollars on
imported raw materials.
Not good for global relations, in our example European companies could impose tariffs, devalue
their currency, or even have embargos to protect their own car companies.
Open Market Operations:
The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of
excess reserves that banks have available to make loans and to create money. This is the primary
monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more
reserves which they use to make more loans at lower interest rates and increase the money
supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make
fewer loans at higher interest rates and decrease the money supply.
If the Fed. Easy money policy
Results:
Reserves increase
Excesses reserves
increase
Loans increase
$$ and Treasury Securities
$$ and Treasury Securities
If the Federal Reserve buys Treasury Securities from banks or market
The banks will have more in their reserves
and they will be able to lead at a lower interest rate
Money Supply
increases
Interest rates
decrease
More consumer and
investment
spending
Open Market Operations:
The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of
excess reserves that banks have available to make loans and to create money. This is the primary
monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more
reserves which they use to make more loans at lower interest rates and increase the money
supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make
fewer loans at higher interest rates and decrease the money supply.
If the Fed. Tight money policy
Results:
Reserves decrease
Excesses reserves
decrease
Loans decrease
$$ and Treasury Securities
$$ and Treasury Securities
Money Supply
decreases
If the Federal Reserve sell Treasury Securities to banks or market
Interest rates
increase
The banks will have less in their reserves
Less inflation
and they will have to lead at a higher interest rate
Discount Rate:
The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or
lower rates affect the amount of excess reserves that banks have available to make loans and
create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which
they can use to make more loans at lower interest rates, which then increases the money
supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use
to make fewer loans at higher interest rates, which then decreases the money supply. Changes
in the discount rate are most often used as a signal for monetary policy actions.
Easy money policy
3.0%
3.0%
3.0%
3.0%
3.0%
Fed Reserve lowers discount rate (interest rate it charges banks)
Banks Borrow more reserves
There is an increase in the money supply
There is a lower interest rates because banks can compete with other banks
There is an increase in spending by consumers and investors
Discount Rate:
The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or
lower rates affect the amount of excess reserves that banks have available to make loans and
create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which
they can use to make more loans at lower interest rates, which then increases the money
supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use
to make fewer loans at higher interest rates, which then decreases the money supply. Changes
in the discount rate are most often used as a signal for monetary policy actions.
Tight money policy
11.0%
11.0%
11.0%
11.0%
Fed Reserve increases discount rate (interest rate it charges banks)
Banks Borrow less reserves
There is an decrease in the money supply
There is a higher interest rate
There is an decrease in spending which will slow down inflation
11.0%
Reserve Requirements:
The Fed can further adjust the proportion of reserves that banks must keep to back outstanding
deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the
amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve
requirements, then banks can use existing reserves to make more loans and thus increase the
money supply. If the Fed raises reserve requirements, then banks can use existing reserves to
fewer more loans and thus decrease the money supply. This tool is seldom used as a means of
controlling the money supply.
A depository institution's reserve requirements vary by the dollar amount of net transaction
accounts held at that institution. Effective December 30, 2010, institutions with net transactions
accounts:
Of less than $10.7 million have no minimum reserve requirement;
Between $10.7 million and $58.8 million must have a liquidity ratio of 3%;
Exceeding $58.8 million must have a liquidity ratio of 10%.
Monetary Policy (Demand side)
Who- the Federal Reserve
What- increasing or decreasing the amount of money in circulation
Goal- full employment, stability, and growth
Easy Money Supply- increasing money supply and decreasing interest rates
Open Market OperationsDiscount RatesReserve Requirements-
buy securities
lower discount rate
lessen requirements
Decrease interest rates
Tight Money Supply – decreasing the money supply and increasing interest rates
Open Market operationsDiscount RatesReserve Requirements-
sell securities
increase discount rates
increase requirements
Prisoner’s Dilemma between Monetary and Fiscal Policy.
Normally, high expenditures and is a dominate strategy for Congress and tight money for the
Fed. When each selects its preferred strategy will be deficit spending with tight money.
It is important that both the Fed and Congress aligned their ideas, but they are independent of
each other and have different goals. The goal’s of the Fed can vary but the goals representatives
in Congress is the same- get reelected.
If the Fed and Congress oppose follow their dominate strategies they will find themselves in a
prisoner’s dilemma- this happen a lot in the 1980’s
Payoffs (Utility) 1-10
Congress
High
Expenditures
1 being least desirable
10 being most desirable
Low
Expenditures
Tight Money
4, 4
10, 0
Easy Money
0, 10
6, 6
The Fed.
Supply-side theory in AS/AD/LRAS
LRAS 1
v
v
LRAS 2
AS 1
LRAS 3
AS 2
v
P1
P2
AD
Supply side economics
Q1
Q2
Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.
This increases potential output (Increase abundance, decreases price).
Price drops= Increase in demand
Supply creates its own demand
There are a number of methods
a. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment benefits
b. Invest in education
c. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)
d. Lower corporate tax rates
e. Invest in infrastructure
f. reduce regulations and oversight
g. Remove barriers of entry (licenses, certs. Etc.)
4. Eliminate safety nets and allow for profit and loss
How to fix the economy? According to . . .
Fiscal Policy
Increase Government
Spending
During a
Recession
Decrease Taxes
With high
unemployment
Decrease Government
Spending
During
Expansion Increase Tax
With high
inflation
Monetary Policy
Supply Side Policy
Buy Securities from banks Cut tax on Business
or dealers
Reduce Regulation
Decrease Discount Rate
Give business a chance to
Reduce Reserve
expand and hire
requirements
No capital gains tax or
All ideas intended to
marginal (progressive
lower interest rate
income tax)
Sell securities to banks
Increase Discount Rate
Increase Reserve
Requirements
All ideas intended to
increase interest rates
Do nothing the market
will take care of itself.
The Problem with Lag.
Knowledge lag- knowledge and recognition lag, it takes time to recognize and correctly
understand the problem.
Procedure or Action Lag- In the United States our legislative process can take long and there
can be many hold ups.
Change or impact Lag- By the time change has taken place or the impacts are felt we may have
been past the initial phase of the business cycle
Deficit Spending- annually – When the government spends more that it brings in as tax
revenue.
Progressive Tax
Laffer Curve
Practice Quiz
1. List the top 3 indicators of economic health
2. GDP= ______+______+______+_____= GDP
3. Aggregate Market
A
E
D
C
F
B
4. List and explain 2 ideas of classical economist
List and explain 2 ideas of Keynesian economist
5. Draw the AS for classical economist, Keynesian economist, current model
6. Fiscal policy and monetary policy for a recession and inflationary period
1.
GDP potential
A
B
Time
Classical
Keynesian
Increase Government Spending to increase AD
Saving= investment
Wage/Price are sticky
Wage and price are flexible
Save
Spend
Supply creates its own demand
Multiplier
Economic
Activity
GDP Potential
(Full Employment)
GDP real
A
Time
GDP
AD
Unemployment
Inflation rate
Fiscal Policy
Expect Outcomes
Monetary Policy?
Expect Outcomes
What Phase on the new
Keynesian model
Economic
Activity
GDP Potential
(Full Employment)
B
GDP real
Time
GDP
AD
Unemployment
Inflation rate
Increase or Decrease
Increase or Decrease
Increase or Decrease
Increase or Decrease
Fiscal Policy?
Expect Outcomes:
Monetary Policy?
Expect Outcomes: increase or decrease
What Phase on the new
Keynesian model
Supply-Side
Idea to increase GDP
Classical
Keynesian
Increase Government Spending to increase AD
Saving= investment
Wage/Price are sticky
Wage and price are flexible
Save
Spend
Supply creates its own demand
Multiplier
Economic
Activity
GDP Potential
(Full Employment)
Recession
GDP real
A
Time
GDP
AD
Unemployment
Inflation rate
Increase or Decrease
Increase or Decrease
Increase or Decrease
Increase or Decrease
Monetary Policy?
Money Supply Increase or decrease
Interest rates ? Increase or decrease
Expect Outcomes: increase or decrease
C
G
I
Fiscal Policy?
Tax Increase or decrease
Government Spending ? Increase or decrease
Expect Outcomes: increase or decrease
C
G
I
What Phase on the new
Keynesian model
Economic
Activity
GDP Potential
(Full Employment)
Expansion
B
GDP real
Time
GDP
AD
Unemployment
Inflation rate
Increase or Decrease
Increase or Decrease
Increase or Decrease
Increase or Decrease
Monetary Policy?
Money Supply ? Increase or decrease
Interest rates ? Increase or decrease
Expect Outcomes: increase or decrease
C
G
I
Fiscal Policy
Tax ? Increase or decrease
Government Spending ? Increase or decrease
Expect Outcomes: increase or decrease
C
G
I
What Phase on the new
Keynesian model
Supply-Side
Idea to increase GDP
Classical
Keynesian
Increase Government Spending to increase AD
Saving= investment
Wage/Price are sticky
Wage and price are flexible
Save
Spend
Supply creates its own demand
Multiplier
Economic
Activity
GDP Potential
(Full Employment)
Recession
GDP real
A
Time
GDP
AD
Unemployment
Inflation rate
Increase or Decrease
Increase or Decrease
Increase or Decrease
Increase or Decrease
Monetary Policy?
Money Supply Increase or decrease
Interest rates ? Increase or decrease
Expect Outcomes: increase or decrease
C
G
I
Fiscal Policy?
Tax Increase or decrease
Government Spending ? Increase or decrease
Expect Outcomes: increase or decrease
C
G
I
What Phase on the new
Keynesian model
Economic
Activity
GDP Potential
(Full Employment)
Expansion
B
GDP real
Time
GDP
AD
Unemployment
Inflation rate
Increase or Decrease
Increase or Decrease
Increase or Decrease
Increase or Decrease
Monetary Policy?
Money Supply ? Increase or decrease
Interest rates ? Increase or decrease
Expect Outcomes: increase or decrease
C
G
I
Fiscal Policy
Tax ? Increase or decrease
Government Spending ? Increase or decrease
Expect Outcomes: increase or decrease
C
G
I
What Phase on the new
Keynesian model
Supply-Side
Idea to increase GDP