Unit Four:

The End

• 1. What happens in the factor market?
• 2. What will higher interest rates in New Zealand do to NZ’s exports? DC: Why?
• 3. Two solutions for Obama in a recession.
• 4. Price level is 200 in 2005, and 300 in 2006. What was the inflation rate?

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I. Economic Growth

• Growth was taught early on as an increase in GDP, the definition is a bit more complicated.
• Economic growth-an increase in the maximum amount of goods and services an economy can produce.
• This could also be considered REAL GDP, LRAS or PPC.

Sources of Growth

• 1. Factors of Production
• Land
• Labor
• Capital
• Also known as CAPITAL STOCK. This is factories and machineries. INCREASED BY LOWER INTEREST RATES.
• Entrepreneurship
• 2. Technology improvements
• Lots of overlap with SRAS. SRAS-short term effect, LRAS=long term effect.

II. Classical Philosophy

• Economists didn’t believe in Keynesianism OR monetarism until later.
• Lasted until Great Depression.
• Classical theory of economics-markets will always self-correct back to full-employment if left alone.
• Laissez-faire.

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Tenets of ClassicalPhilosophy

• 1. Flexible pricing
• 2. Flexible wages
• 3. Self-correcting

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• If AD decreases, producers will lower prices and cut wages.
• If AD increase, producers will raise prices.

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Problems with Classical

• Classical economists didn’t believe there was a difference between short and long-run.
• Markets aren’t self-correcting and prices aren’t flexible.
• Fixed Costs-rent and sunk costs can’t be changed if prices drop.
• Sticky wages-wages are usually set in contracts, making them inflexible over time.

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Classical Matters to You: NO ACTION QUESTIONS

• You WILL see questions that say policymakers will take NO ACTION. Even though it was historically proven wrong you still have to do this.
• NO ACTION in recession=lower nominal wages=increase in SRAS to full-employment.
• NO ACTION with inflation=higher wages->decrease in SRAS->

Boot Camp

• Draw a correctly-labelled Money Market graph.
• Show what would happen if the Federal Reserve performed an expansionary open-market operation.
• Show the effects (P1, P2, Q1, Q2)

Boot Camp 1B

• Draw a correctly labelled Loanable Funds graph.
• Show the effects of an increase in government deficit spending on the LF graph. Make sure you show the changes (p1, p2, q1, q2).

II. Fiscal Policy

• The taxing and spending policies of the federal government.
• Philosophy based on Keynesianism, developed and proven correct in the Great Depression and WWII.

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Expansionary fiscal policy-

• Policies used to counteract a recession.
• 1. Increases in government spending.
• Includes transfer payments-a redistribution of income.
• Includes welfare, social security and tax credits.
• 2. Cutting taxes

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Contractionary Fiscal Policy

• Policies used to fight inflation.
• 1. Raising taxes
• 2. Decreases in government spending.

Criticisms of Fiscal Policy

• 1. Lag Time
• 2. Political Business Cycle
• Nixon used this very effectively in 1972.
• 3. Crowding Out

Types of Government Spending

• Discretionary spending-changes in fiscal policy that require an act of Congress.
• Automatic spending-changes in fiscal policy that require no action by government.

Stabilizers and the budget

• Automatic Stabilizers-spending of the government that automatically adjusts to the economy.
• Unemployment Compensation
• Increased GS in a recession
• Progressive Income Tax
• Decreased taxes in a reccession.

Automatic Stabilizers

• In a recession, what will happen to government spending automatically and why?
• In an inflationary period, what will happen to taxes and why?

MPC and the Multipliers

• MPC-Marginal Propensity to Consume-likelihood, given a change in income, that the money will be spent.
• MPS-Marginal Propensity to Save-likelihood that a change in income will be SAVED.
• MPS+MPC=1

Multipliers

• Government (Investment) Spending Multiplier- 1/MPS.
• Given an increase in government spending or investment, multiply the amount by the multiplier to find out the total effect on the economy.
• Tax Multiplier-(1/MPS)xMPC OR (GSM-1)

• Sally gets $100 as a graduation reward. She spends $75 on a new coat.
• 1. What is the MPC?
• 2. What is the MPS?
• 3. What is the spending multiplier?
• 4. What would the tax multiplier be?

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The American people spend 50% of their income. They would spend 90% of a raise though. �

• 1. What is the MPC?
• 2. What is the MPS?
• 3. What is the GSM?
• 4. What is the Tax Multiplier?
• 5. Federal Government spends $200 billion on infrastructure spending. What happens to the economy?
• 6. Instead of spending $200 billion on spending, the Republicans give $200 billion in tax cuts. What effect does this have on the economy?
• 7. Which one had more of an effect? Why?

Boot Camp 3

Draw a correctly labelled AD/AS in a recession.

Show the effects of a dramatic decrease in interest rates.

Starters

• 1. MPC is .75. What would a government spending cut of 200 billion do?
• 2. Two parts of M1?
• 3. What tradeoff does a SRPC show us?
• 4. If potential GDP is more than actual GDP, what problem is the economy suffering from?
• 5. What will happen to the dollar and why if investors believe it is a good safe haven for their financial investments?
• 6. The government passes a law to balance the budget by increasing GS and raising taxes by the same amount. What effect would this have on output and why?

III. Monetary Policy

• Monetarism furthered by Milton Friedman in the 60’s and 70’s.
• Actions by a central bank to influence the money supply and interest rates.
• Money supply can have two effects in the short-term:
• Lower interest rates and increase gross investment.
• Put cash in peoples hands, encouraging spending.

A. Federal Reserve

• FOMC conducts Monetary Policy (Federal Open Market Committee).
• 12 members: 7 Federal Reserve Board members (including Bernanke whose Chair), 5 Fed Bank Presidents (NY always has a seat, other four rotate).
• Current policies are called “quantitative easing”.
• QE I and II were MASSIVE purchases.
• Interest rates have been at zero since 2008.

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B. Tools of Monetary Policy

• 1. Open Market Operations.
• Purchasing of bonds/securities by the Federal Reserve.
• Buy Bonds- increase MS (MM), lower IR, increase Ig, increase AD.
• Sell Bonds- decrease MS (MM), raise IR, decrease Ig, decrease AD.

2. The Discount Rate

• Federal Reserve controls the Discount rate (a short term overnight loan from the Fed to banks).
• Expansionary-Lower
• Contractionary-Raise
• Changing the DR also changes the Federal Funds Rate-fee for bank-to-bank loans.
• Prime rate-key interest rate used for loans.
• Purpose of this tool is to CONTROL interest rates to manipulate AD.

3. The Reserve Rate

• The Fed mandates banks keep a percentage of ALL deposits in reserve.
• Currently at 15%, it is very rarely changed because it can have dramatic effects on AD.
• Expansionary Monetary Policy-lower the RR.
• Contractionary Monetary Policy-raise the RR

C. Limits of Monetary Policy

• Already low interest rates.
• Theory of rational expectations-in the long-run MS increases will only cause inflation (Weimar Germany). If inflation is EXPECTED, businesses will adjust preemptively thus it will have no effect.
• Reluctant lending
• Just because the Fed lowers the RR doesn’t mean they will make loans.
• May keep EXCESS RESERVES-money hold beyond the amount required.

Group Challenge: 10 points for every correct point.

• Phones out will be taken and given to AP.

Boot Camp 5

• Draw a correctly-labelled SRPC and LRPC in a recession. The natural rate of unemployment is 3%.
• Place a Point A where the economy currently is.
• Show the effects of a decrease in SRAS.

Boot Camp 5

• Draw a production possibilities curve for steel and iron.
• Label a point A that is unattainable given current resources.
• Label a point B that has more production of steel than iron.
• Label a point C that has underutilized resources.
• Label a point D where there is more production of iron than steel.

D. Quantity Theory of Money MV=PQ

• M=Money Supply
• V=Velocity of Money
• P=Price Level
• Q=Real GDP
• PQ=Nominal GDP
• Don’t confuse this with Nominal IR=Real IR + Inflation

E. The Banking System

• Banks create money by LENDING. Money is both in your account and loaned out to others. Reserves are NOT part of M1 or M2.
• Three things the AP asks for in money creation:
• 1. How much one bank creates=Excess Reserves.
• 2. How much the banking system can create= ER multiplied by the Money Multiplier (1/RR)
• 3. How much the Fed can create by buying bonds= Bond purchase multiplied by the Money Multiplier.

Additions to inventories

• Unplanned additions to inventories are a sign of RECESSION.
• Demand has fallen so goods aren’t selling!

Other Banking Terms

• Fiat vs. Commodity Money
• Commodity Money-backed up by something real.
• Example-Gold Standard
• Fiat Money-backed up by government assurance of value.

Bond Rates

• Bond yields and bond interest rates have an INVERSE relationship.
• Sally buys a $2000 bond with her christmas money at a 10% yield.
• At the end of the year, every year, Sally will get a $200 check from the American government.
• Sally can also choose to sell her bond over the course of the year for a price higher than $2000 (we’ll say $2200).
• If the Fed sells bonds at a higher yield (maybe 12%), Sally will NOT be able to get as high of a price (decreased demand for 10% yield bonds will lower the price).

Sally buys a $2000 bond with her Christmas money at a 10% yield.�At the end of the year, every year, Sally will get a $200 check from the American government. �Sally can also choose to sell her bond over the course of the year for a price higher than $2000 (we’ll say $2200).�If the Fed sells bonds at a higher yield (maybe 12%), Sally will NOT be able to get as high of a price (decreased demand for 10% yield bonds will lower the price).�INVERSE RELATIONSHIP.

Uses of Money

• Medium of Exchange-acceptable for a good.
• Portable
• Good-Coins, . Bad-horses, land, laundry machines.
• Store of Value-lasts a while
• Durable, stable.
• Good-Gold, mo
• Bad-Snickers bars, milk, meat
• Standard of value-dollar amounts
• Divisible
• Familiar
• Acceptable
• Good-dollars, shells. Bad-laundry machines.

GLOBAL TRADE

• Trade is good. Period.
• Why?
• Comparative Advantage
• More stuff
• Increases Production Possibilities
• “Through free trade the world economy can achieve a more efficient allocation of resources and a higher level of material well-being than it can without free trade.”

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Sources of Comparative Advantage

• Labor Advantage
• Cheap Labor
• Textiles, toys, electronics, everything at Walmart
• Land Advantage
• Capital Advantage
• Germany and the US
• Aircrafts, Cars, Computers, Chemicals

Protectionism

• Any policies that discourage international free trade.
• Tariffs
• Quotas
• Dumping

Arguments for Protectionism

• 1. Infant Industries
• 2. Domestic Job Protection
• 3. Diversification
• 4. Self-Sufficiency

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Balance of Payments

• The BoP is the international balance sheet that balances.
• Two accounts:
• Current Account-goods and services
• Exports -imports
• Capital/Financial Account-monetary trades
• Inflows-Outflows
• Bonds, stock purchases, loans, etc.

Main American Exports

• Chemicals
• Durable Goods
• Semiconductors
• Computers
• Aircrafts

Main Imports

• Petroleum
• Cars
• Metals
• Appliances
• Computers
• Most trade is with Canada.