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1

3 Facts of Economic Fluctuations

1. Economic fluctuations are irregular and unpredictable
2. Most macroeconomic statistics fluctuate together
3. As output falls, unemployment rises

2

Y = C + I + G + NX

Y an economy’s GDP is the sum of:
its consumption (C),
investment (I); business, new residential, inventory even for next year,
government purchases (G),
and net exports (NX):

only count goods when new, when they reach the end user, include anything inside boundaries regardless who owns or if exported.

3

The Price level and Consumption: the wealth effect.
explain

The Wealth Effect
-if P rises, each dollar (real value of money) is worth less. and makes consumer more poor.
-Being poor, they will buy less.
-Increase in P --> Decrease in C

4

The Price Level and Investment: the interest rate effect.
explain

The Interest Rate Effect
-If P rises, households need more money to buy C
-This reduces the supply of loans and increases interest rates.
-Higher interest rates reduce the quantity demanded of loans
-Increase in P --> Decrease in I

5

The Price Level and Net Exports: the exchange rate effect.
explain

The Exchange Rate Effect
-If P rises, US interest rates rise
-Foreign investors want to invest in US bonds
-Increases demand for exchange of dollars for foreign currency, and US exchange rate rises
-US exports become more expensive, foreign imports become cheaper
-Increase in P --> Decrease in NX

6

Three related reasons a fall in the price level increases the quantity of goods and services demanded:

1. Consumers are wealthier, which stimulates the demand for consumption goods.
2. Interest rates fall, which stimulates the demand for investment goods.
3. The currency depreciates, which stimulates the demand for net exports.

7

Three reasons a rise in the price level decreases the quantity of goods and services demanded:

1. decreased wealth depresses consumer spending
2.higher interest rates depress investment spending
3. a currency appreciation depresses net exports.

8

Quantity theory of money

a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate

9

monetary neutrality

the proposition that changes in the money supply do not affect real variables

10

Shifts on AD
Suppose Americans suddenly become more concerned about saving for retirement and, as a result, reduce their current consumption.

Because the quantity of goods and services demanded at any price level is lower, the aggregate-demand curve shifts to the left.

11

Shifts on AD
imagine that a stock market boom makes people wealthier and less concerned about saving.

The resulting increase in consumer spending means a greater quantity of goods and services demanded at any given price level, so the aggregate-demand curve shifts to the right.

12

Shifts on AD
When the government cuts taxes, what happens?

it encourages people to spend more, so the aggregate-demand curve shifts to the right.

13

Shifts on AD
When the government raises taxes, what happens?

people cut back on their spending and the aggregate-demand curve shifts to the left.

14

Shifts on AD
imagine that the computer industry introduces a faster line of computers and many firms decide to invest in new computer systems.

Because the quantity of goods and services demanded at any price level is higher, the aggregate-demand curve shifts to the right.

15

Shifts on AD
if firms become pessimistic about future business conditions, they may cut back on investment spending, shifting...

shifting the aggregate-demand curve to the left.

16

Shifts on AD
an investment tax credit (a tax rebate tied to a firm’s investment spending) increases the quantity of investment goods that firms demand at any given interest rate and therefore...

shifts the aggregate-demand curve to the right.

17

Shifts on AD
The repeal of an investment tax credit reduces investment and shifts

shifts the aggregate-demand curve to the left.

18

Shifts on AD
an increase in the money supply lowers the interest rate in the ____ run. This decrease in the interest rate makes borrowing less costly, which stimulates.. what?

the short run.
investment spending and thereby shifts the aggregate-demand curve to the right.

19

Shifts on AD
a decrease in the money supply raises the interest rate, discourages ....

investment spending, and thereby shifts the aggregate-demand curve to the left

20

Shifts on AD
suppose Congress decides to reduce purchases of new weapons systems. Because the quantity of goods and services demanded at any price level is____, the aggregate-demand curve...

price level is lower.
shifts to the left.

21

Shifts on AD
if state governments start building more highways, the result is a _____ quantity of goods and services demanded at any price level, so the aggregate-demand curve...

greater quantity of goods.
shifts to the right.

22

Shifts on AD
when Europe experiences a recession, it buys _____ goods from the United States. This____ U.S. net exports at every price level and shifts the aggregate-demand curve for the U.S. economy...

fewer goods from US.
reduces US net exports
to the left.

23

Shifts on AD
When Europe recovers from its recession, it starts buying U.S. goods again and the aggregate-demand curve..

shifts to the right.

24

Shifts on AD
Suppose that speculators lose confidence in foreign economies and want to move some of their wealth into the U.S. economy. In doing so, they bid ___ the value of the U.S. dollar in the foreign exchange market. This appreciation of the dollar makes U.S. goods more _____ compared to foreign goods, which _____ net exports and shifts the aggregate-demand curve...

bid up the value of the US dollar in foreign exchange market.
expensive compared to foreign goods.
depresses net exports.
shifts to the left.

25

Shifts on AD
speculation that causes a depreciation of the dollar stimulates net exports and shifts the aggregate-demand curve..

shifts to the right.

26

The exchange rate effect example:
as the price level falls, the impact on the domestic interest rate will cause the real value of the dollar to _____ in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore _____ , and the number of foreign products purchased by domestic consumers and firms (imports) will _____ . Net exports will therefore _____ causing the quantity of domestic output demanded to_____

FALL in foreign exchange markets
(exports) will therefore RISE
(imports) will FALL
Net exports will therefore RISE
quantity of domestic output demanded to RISE

27

AD shifts right when.. changes in C

- More consumers
- Greater perceived wealth
- Change in preferences, spending rather than saving

28

AD shifts right when.. changes in I

- Increased need for new equipment, structures
- Increase in money supply
- Larger tax incentives for investment
- Optimistic expectations

29

AD shifts right when.. changes in G

- Increased government spending (Federal, State, or Local)

30

AD shifts right when.. changes in NX

- Booms in countries that buy our exports
- Depreciation of the dollar (for reasons other than price level changes)

31

Shifts along vs. Shifts of the AD curve

Shift along AD:
- When price level rises, C, I and NX each fall

Shifts of AD:
-At every price level, C, I, G, or NX is higher

32

Long Run Aggregate supply

Determined by existing resources and technology
- unaffected by price level
-Hence, a vertical slope at the natural rate of output (or potential output or full-employment output)

33

LRAS shift right when

More Resources
- labor force increases
- natural rate of unemployment falls
- more physical capital
- more human capital
- more natural resources
Better Technology
-Other resources becomes more productive

34

As LRAS shifts right, GDP ____

GDP grows

35

As AD shifts right, price level will ___

price level will rise.

36

In the long run, the aggregate-supply curve is _____, whereas in the short run, the aggregate-supply curve slopes _____.

long run: aggregate-supply curve is VERTICAL ( because price level does not affect the long-run determinants of real GDP)
short run: the aggregate-supply curve slopes UPWARD.

37

In the long run, an economy’s production of goods and services (its real GDP) depends on its

supplies of labor
capital
natural resources
the available technology used to turn these factors of production into goods and services.

38

natural level of output

the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate

39

LRAS shift
an economy experiences an increase in immigration. Because there would be a greater number of workers, the quantity of goods and services supplied would ____. As a result, the long-run aggregate-supply curve would...

the quantity of goods and services supplied would increase.
shift to the right.

40

LRAS shift
if many workers left the economy to go abroad, the long-run aggregate-supply curve would...

shift to the left.

41

LRAS shift
if Congress were to raise the minimum wage substantially, the natural rate of unemployment would ____ and the economy would produce a ____ quantity of goods and services. As a result, the long-run aggregate-supply curve would

natural rate of unemployment would rise
economy would produce a Smaller quantity of goods and services
shift to the left.

42

LRAS shift
if a reform of the unemployment insurance system were to encourage unemployed workers to search harder for new jobs, the natural rate of unemployment would ____ and the long-run aggregate-supply curve would...

natural rate of unemployment would fall.
shift to the right.

43

LRAS shift
An increase in the economy’s capital stock increases productivity and, thereby, the quantity of goods and services supplied. As a result, the long-run aggregate-supply curve

shifts to the right.

44

LRAS shift
a decrease in the economy’s capital stock decreases productivity and the quantity of goods and services supplied, shifting the long-run aggregate-supply curve

shift to the left.

45

LRAS shift
An increase in either type of capital will raise the economy’s ability to produce goods and services and, thus, shift the long-run aggregate-supply curve

shifts to the right.

46

LRAS shift
The discovery of a new mineral deposit shifts the long-run aggregate-supply curve

shifts to the right.

47

LRAS shift
A change in weather patterns that makes farming more difficult shifts the long-run aggregate-supply curve

shifts to the left.

48

LRAS shift
The invention of the computer, for instance, has allowed us to produce more goods and services from any given amounts of labor, capital, and natural resources. As computer use has spread throughout the economy, it has shifted the long-run aggregate-supply curve

shift to the right.

49

LRAS shift
opening up international trade has effects similar to inventing new production processes because it allows a country to specialize in higher-productivity industries; therefore, it also shifts the long-run aggregate-supply curve

shift to the right.

50

LRAS shift
if the government passes new regulations preventing firms from using some production methods, perhaps to address worker safety or environmental concerns, the result is a _____ shift in the long-run aggregate-supply curve.

leftward shift

51

LRAS shift
Why move to the right and why to the left?

Any policy or event that raised real GDP in can be described as increasing the quantity of goods and services supplied and shifting the long-run aggregate-supply curve to the right.
Any policy or event that lowered real GDP can now be described as decreasing the quantity of goods and services supplied and shifting the long-run aggregate-supply curve to the left.

52

compute CPI

only measures purchase by consumers
1. Find basket goods (same for all years)
2. gather the prices of all goods (in all years)
3. compute the total price of the basket
4. Choose a base year, and compute the index relative to that year.
CPI t += (P t / P baseyear) * 100

5. compute inflation rate
π = (CPI t - CPI t-1) / CPI t-1

53

inflation rate

π = (CPI t - CPI t-1) / CPI t-1

54

CPI concerns
-Substitution Bias
-Unmeasured Quality Change
-Discount Shopping Bias
-Introduction of New Goods

-Substitution Bias: people adjust their basket when relative prices change. but CPI's basket says fixed.

-Unmeasured Quality Change: a 10% increase in prices is not inflation if the good is 10% more useful. The BLS tries to adjust CPI prices for quality.

-Discount Shopping Bias: CPI prices are only sampled from standard retailers (i.e. not walmart, costco)

-Introduction of New Goods: New products improve the standard of living.

55

GDP deflator

(nominal GDP / real GDP) * 100

-basket changes each year to reflect goods currently produce domestically.
-Includes input prices (unlike CPI)
-Excludes imports (unlike CPI)

56

Why concerns with CPI matter

Overstated inflation: all work in same direction. even when the BLS tries to correct for these, it still overestimates inflation by 0.5%year

Contract Cost of Living Adjustments: COLAs are based on CPI. An inaccurate CPI means bigger pay raises, social security checks.

57

PPI

producer price index
-basket of inputs

58

Correcting for Inflation (price comparing)

to make old prices comparable to current prices
Price in year x dollars = Price in year y dollars.

do CPIx / CPIy

59

Real vs Nominal Interest rates

-Nominal interest rate: the % the bank pays you for each dollar you lend them.

-Real interest rate: = nominal interest rate - inflation rate

Why it matters: when i get my deposits and interest ack from the bank next year, how much will it buy?

60

Employed

Paid employee, self-employed, or unpaid worker in family business

61

Unemployed
types of unemployment

Not working, but have looked for work in past 4 weeks.

-Frictional: occurs as workers search for a job that better matches their tastes and skills. moving between jobs.
Sectoral shifts require moving workers from one industry to another

-Structural: occurs when labor markets are not in equilibrium. ex. wage problems-unions, min wage, efficiency wage
union: a worker association that bargains with employers over wages, benefits, and working conditions

62

Unemployment rate:

-% of labor force that is unemployed

=100*(# unemployed / # in labor force) == 100*(# unemployed / # employed + # unemployed)

63

labor force participation rate

= 100*(# in labor force / # in population)

64

Choices that affect growth: savings and investment
how to get more physical capital

-Reduce consumption today --> more capital today --> more goods tomorrow.
physical capital is linked to indiv savings.
the catch-up effect. (diminishing returns)

-Policies promote saving: Tax Incentives

65

catch-up effect

the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich

66

Effect of Population Growth

fewer natural resources per worker
less capital per worker
-growing populations will reduce GDP per capita. rapid growth in the number of workers forces the capital stock to be spread more thinly
-more technological innovation possible

67

Increase in RR and DR. what with money supply?

decrease in money supply

68

Decrease in RR and DR. what with money supply?

increase in money supply

69

Gov't sells bonds. what with money supply?

decrease in money supply

70

Gov't buys bonds. what with money supply?

increase in money supply

71

Suppose the US educational system improves, making workers more productive. If the federal reserve is trying to stabilize the price level in response, they should

lower the reserve requirement.

The shock will cause a right shift in the LRAS curve (and SRAS), leading to a downward movement in the CPI both in the short run and even farther in the long run. To counteract this, the AD curve need to shift right as well, which the Fed can do by buying bonds, lowering the reserve requirement, or lowering the discount rate. Taxes and government spending are not controlled by the federal reserve.

72

Suppose that the federal reserve has decided to increase the reserve requirement. Congress worries about the short run effect that this might have on GDP, so to offset this action, they could

decrease taxes.
The higher reserve requirement will decrease the money supply and thus shift AD to the left, which would cause output to fall in the short run. To offset this, congress has to shift AD to the right, which they can do by cutting taxes or increasing spending. Congress does not have the ability to conduct open market operations or change the discount rate.

73

Suppose businesses anticipate that the CPI will rise, and write contracts to increase their prices. The federal reserve worries about the effect this will have. If they their goal is to stabilize GDP, they should ____________. If their goal is to stabilize CPI, they should ____________.

The anticipated change in CPI shows up as a left shift of the SRAS curve. This would cause prices to rise in the short run, but output to fall. To counteract the fall in output, the Fed would need to increase AD. To counteract the rise in prices, the Fed would need to decrease AD.

74

DR and RR

DR: fed will offer short term loans to banks at this interest rate. this is the only rate the Fed directly controls
RR: explicitly sets a reserve ratio

75

M*V = P*Y

M*V = P*Y
M: money supply
V: velocity
P: price level is 1 for base year unless stated diff
Y: real gdp

76

Value of money

= 1/P

77

Actual real interest rate=
fisher effect
Nominal (mkt) interest rate =

Actual real interest rate = nominal interest rate - actual inflation rate
fisher effect: inflation rate raises, then nominal mkt interest rate raises

Nominal (mkt) interest rate = Actual real interest rate + actual inflation rate