Principles of Macroeconomics Notes

Roll of Financial Institutions G Financial Markets in
Capitalist Economies
-
money
-
central banks -
The Fed
-
banking system
-
impact on macroeconomic performance -
financial crises
Can governments manage the business cycle ?
Current Environment
-
monetary policy : Fed normalizing policy slowly
-
fiscal policy
-
budget
I
debt ceiling
tax reform

Circular Flow
.
very simple description of an
aggregate economy
-
focuses on production :
the flows of inputs loutputs
-
focuses on expenditures { income : flows of payments
-
2 types of agents : households 4 firms
-
assumptions :
no government 4 taxes , spending is
by
households Only , no savings ,
no international trade
revenue ( =
GDP )
spending ( = GDP )
Markets for
G E S Sold
.
Goods E Services
GE S bought
Firms Households
Markets
factors of production for Factors Of labor ,
land , capital
Production
wages ,
rent , profit income L= GDP )
( = GDP )
Income =
Expenditures
Gross Domestic Product :
Definition
.
National accounts developed in 19305 E after WWII
.
designed to be comprehensive , timely ,
G accurate
↳ tradeoffs
-
measures the market value of all final goods { services
produced within a
country in a
given period of time
-
Market value used when available ; Consider public
school teachers ,
R E D efforts ,
national defense :
produce
output ,
but not priced at market ,
need to come up with
imputed values

-
very comprehensive but excludes home production G
certain illicit activities C illegal drugs )
-
only includes final GE 5 to avoid double Counting :
generally
excludes the production of intermediate goods
-
GDP reflects production of G G S in a time period
( a
quarter or
year ) -
not necessarily sales of
goods
( I . e .
Car produced in 2017 but sold in 2018 Counts toward
2017 GDP )
-
includes production within borders of US
-
location of
production matters ,
not
nationality
GDP :
Accounting Identities
.
expenditure approach
*
.
income approach
.
production approach
Components of GDP :
Expenditure Approach
Y =
( + I +
G + NX
Y :
GDP
C :
consumption
I :
investment
G :
government spending
NX :
net exports =
exports
-
imports
GDP :
Consumption
.
spending by households on G 2 S
-
excludes purchases of new houses
-
includes payments by health insurance company
-
includes an imputed payment for rent for houses that
Own their home :
"
increases household income
"

GDP : investment
spending on new equipment ,
new structures ,
G other tools
that is Used to produce goods G services in the future
( capital goods )
-
includes intellectual property products such as software ,
RED ,
movie production , literary production
-
includes residential investment L including new houses )
-
includes inventories :
when goods a services are produced
but not sold they are included in investment
Y = ( t 1 +
G +
NX
T period good is produced
T t period good is sold :
Cancel out
GDP :
government
.
government spending on GE S
-
includes payroll of federal employees
-
excludes transfer payments ( social security payments ,
Unemployment Compensation )
-
Makes no distinction blw gov't investment expenditures
{ gov't Consumption expenditures
GDP :
net exports
.
exports
-
imports
.
exports are the purchase of
domestically produced
GES by entities outside the Us
-
The neutral effects of imports on GDP
Y = C + 1 +
G +
( Ex -
lm )
T or T or T T
←DPT GDP to
4 cancel outh

.
US GDP measured in nominal value
-
GDP rises over time bk
economy is
expanding but also
bk the
prices of G E S have increased
Real GDP : Def
-
the variable that economists use to compare changes in
GDP over time
-
holds prices constant at a base
year

8/25/17
1
Coffee & Donuts
Coffee and Donuts Economy
Year Col. 1
Price of Coffee
($)
Col. 2
Cups of Coffee
(Quantity)
Col. 3
Price of Donuts
($)
Col. 4
Number of
Donuts
(Quantity)
Col. 5
Nominal GDP
2014 2.50 100 1.00 75
2015 2.65 105 1.15 85
2016 2.85 108 1.25 80
Nominal GDP (Col. 5) = (Col 1. x Col. 2) + (Col. 3 x Col. 4) = Total Coffee Revenue + Total Donuts Revenue
Year Col. 1
Price of Coffee
in 2014 ($)
Col. 2
Cups of Coffee
(Quantity)
Col. 3
Price of Donuts
in 2014 ($)
Col. 4
Number of
Donuts
(Quantity)
Col. 5
Real GDP in
2014 Base Year
Prices
2014 2.50 100 1.00 75
2015 2.50 105 1.00 85
2016 2.50 108 1.00 80
Real GDP (Col. 5) = (Col 1. x Col. 2) + (Col. 3 x Col. 4) = Total Coffee Revenue using 2014 Prices+ Total Donuts
Revenue using 2014 prices
2014 : (2.50×100)+(1.00×75)
=
325
2015 : ( 2 . 65×105 ) i ( 1. 15 ×
85 )
325 =
37
376
407 .
80
*
arbitrary base year
2014 :
(2.50×100)+(1.00×75)=325
201 S : (2.50 ×
105)+(1.00×85)=347.50
33435.52016 : ( 2.50×108 ) +
(1.00×80)=350
350
real GDP E nominalGDP is
same for base
year

8/25/17
2
Year Nominal GDP Real GDP using
2014 base
prices
Nominal
Growth Rate in
GDP (%)
Real Growth
Rate in GDP
(%)
2014 325.0 325.0 - -
2015 376.0 347.5
2016 407.8 350.0
!"# %& 2015 − !"# %& 2014
!"# %& 2014
× 100% =GDP Growth =
376.0 − 325.0
325.0
× 100% = 15.7% (Column 4: nominal
growth)
GDP Deflator
• The GDP Deflator is a broad measure of prices for the economy.
• The differences in the growth rates in Col (4) and Col (5) on the previous slide
reflects growth in prices that is contained within Col (4) growth of nominal GDP
but not in Col (5).
• One can construct an index of prices (GDP Deflator) using the formula:
GDP Deflator =
3456789 :;<
=>89 :;<
x 100
Year Nominal GDP Real GDP using
2014 base
prices
GDP Deflator
2014 Base Year
Growth Rate in
GDP Deflator
(%)
2014 325.0 325.0
2015 376.0 347.5
2016 407.8 350.0
?@A%&BC !"# %& 2015
DEBC !"# %& 2015
× 100 =GDP Deflator in 2015 =
376.0
347.5
× 100 = 108.2
!"# "EFCBG@H %& 2015 − !"# "EFCBG@H %& 2014
!"# "EFCBG@H %& 2014
× 100 =
108.2 − 100.0
100.0
× 100 = 8.2Growth in Deflator =
15.7 6.9
8. 5 0.7
100
-
108.2 8.2
116.5 7.7

GDP Growth
t.tl ( A
.
B)
~~ 1 .
Q A + t .
4 B
% a ( D .
Y ) =
'
1 . a Prices +
'
1. a Real GDP
-
GDP Deflator Economic Growth
- in real terms
Inflation
*
approximation works better for smaller changes
US GDP Growth Statistics are presented at a quarterly
frequency at an annual rate
EX : 2014 Q4 ,
Real GDP
grew at 3% at a
quarter
frequency at annual rate
↳ The actual growth → 3%14 a. 751
Different for Europe
Weaknesses of GDP ( Deaton )
GDP per Capita G Happiness
.
Gallup Poll Happiness Ladder
-
measures satisfaction with life path
-
issues :
-
bk
including different countries ,
cultural
differences about happiness
-
time analysis
-
Compare 1950 to 2017 responses wl in a
country ? across countries ?
.
limitations
-
misses home production
-
doesn't control for environmental externalities
-
doesn't inform about income distribution
-
doesn't Control for differences in health
'
Cross-country comparisons
-
held to adjust for differences in prices of similar goods

Cpl :
Measuring the Cost of
Living
( Pl :
The Consumer Price Index
.
measure of changes in prices
Cost of
purchasing basket of goods in
year t
CPI in Year t =
cost of
purchasing basket of
goods in base year
-
fixed basket over short period of time
Cpl in year t -
Cpl in year ( t -
1 )
× 100%Inflation (
year th t -
11 =
( p , in
year Lt -
1)
1. Establish basket of
goods by surveying consumers on their
expenditures
-
helps define what basket weights should be attached to each
consumer item
-
basket of goods is held fixed for a period of time
-
representative of urban consumer
2 .
Each month collect prices for the
goods in the basket . Uses
shopper surveyors ,
scanner data ,
E other means
3. From price data G basket weights , Compute Cost of basket
4. Construct Cpl index in a month by comparing the Cost of
basket in current
year to base
year
5. Construct inflation rate
Using the Cpl to Adjust Nominal Variables
.
the Cpl is also Used to adjust for inflation
Amount in
today 's $ = amount in
year
T dollars ×
Price level today
price level in
year t

Base Year Adjustments
.
transform the entire Cpl series by dividing through by CPI
by index value for the
year of dollars you want to measure
Average Annual Percent Changes
.
take %
change
for interval E divide by # of years
1970 -
1980 :
( Pl 1980
-
( Pl 1970 ×
100.1 .
÷ 10
( Pl
, a 70
( PI VS GDP Deflator
.
Cpl Uses fixed basket of Consumer GES While GDP includes
all
good domestically produced
.
GDP deflator allows for substitution in response to relative
price changes ,
but CPI does not
.
Cpl includes imports of GE S in basket . The price Of imported
oil 4 refined products is included in CPI but not GDP
deflator
.
similar goods will have different Weights
-
physician services
Criticisms of Cpl
1. substitution bias
2. introduction of new goods
3. Unmeasured quality change
Economic Growth :
Questions
I .
Why do some countries have a
higher standard of living ?
2 .
Why do some Countries grow faster ?
I . How do
technology , physical ,
an human capital
influence economic growth ?
2. What are roles of political E economic institutions in the
prices ?
3 . Does geography matter ? 4. Can some countries be caught in
a poverty trap ?

5 . How is inequality related to economic growth ?
6 .
What is the role of foreign aid in helping the poorest countries ?

Economic Growth
Growth in Real GDP ( Y ) for a
country
:
Y
Y = - .
[
L
% 4 Y ~~ % 4 ¥ + % a L
Growth in GDP can be broken into growth in productivity
E growth in the labor input
Rule of 70
.
approximation for how long it takes a variable to double
for a
given growth rate :
70
Number of Years to Double =
Annual Growth Rate in %
The
Wellbeing of the World : Ch I ( Deaton )
1. relates health to income :
Preston curve , hinge point
2. World has experienced widespread improvements in
health E income over last 50
years
3 .
*
:low Model of Economic Growth
1. Used to explain differences in standard of
living across
Countries G economic growth rates
2.
policies related to
growth
3. linking production { expenditures w1 a focus on how
capital accumulates
4. The Capital accumulation gives the model its growth dimension

Three Building Blocks
1. Production Function :
y
= A k×
2. Investment -
Savings Relationship : i = s .
Akin
3. Capital Accumulation :
Llk = i -
8k
Equations ZG 3
identify equilibrium E adjustment →
determines the level of K
Equation 1 Solves for the level of y
-
income per worker
Production Function
.
relationship blw input E output ( GDP )
.
aggregateproduction function
.
Cobb -
Douglas production function wl constant returns
to scale
-
math is easy
-
fits the data
1
.
Doubling all inputs doubles the output
2. exhibits diminishing returns to the use of an input
Y I=== .
-
,
ftp.
T input C holding other inputs
- -
1
1
Constant )
'
, the T in output declines as the
! ! 1
input increases
k
, kz k
} Ky K
3. Two inputs :
capital ( k ) 4 labor ( L ) du produces
output ( Y )
Y = A .
Ka Ll
- a
4 .
A is an index of technology G alpha ( x ) is a
parameter
that is between IO ,
1 ] E tells how responsive output is to
Changes in Capital an ( I -
x ) tells Us how responsive
Output is to changes in L
y = A .
Ka
Think about the case a =
.
5 →
y = A if
Y
-
Y = Ark
K

y A =
technology
k= Capital per worker
a =
parameter that captures
y ,
- - - - -
M
A ,
K
'
yo
#
Aok
×
responsiveness of y to changes
in K
I
y
=
output per worker
: "
o k Along the prod . function ,
exhibit
diminishing returns to capital
Improvement in
technology increasesA .
A o to A ,
:
y increases from yo to y ,
but there has been
no Change to K .
K -
capital intensity :
changes in K result in movements
along the production function
:z
-
f
-
g
-
B
AK ×
y.fiH
k
, kz K
Saving E Investment
1.
help determine the Capital stock of a
country
2 .
Y = C + I + G + NX
3 .
Simplifying assumptions : closed
economy da no
gov't
Y =
C + I
y= income per worker
i =
y
-
c = s .
y C =
consumption per worker
W i = investment per worker
savings
s =
savings rate ( proportion of income
i =
S .
A .
k& that is saved ) S ~ [ .
10 ,
. 50 ]
Investment { saving are linked to the production function

:#
A. ka
Remember y
-
c+ ,
}c Along the saving
-
investment
iffy
s '
Ai *
relationship .
investment is
equal to
saving
K K
Capital Accumulation
Ak = i -
SK
1. Ak =
change in Capital stock per worker
2 .
i =
investment per worker
3 .
8k =
depreciation × the capital stock
4 .
8 =
depreciation rate -
the proportion of the capital
Stock that wears out .
It is a number like . 05 or st
.
Ak > 0 if i > 8 k :
investment exceeds depreciation ,
so that the is
adding capital for each worker
,
workers
are
getting more tools to work with
.
As more K is added ,
8k is
increasing →
slows down
"
net accumulation
"
of Capital
-
gap blw i 4 8 will shrink as
Ok
→ 0
8k
}
8k
*K
,
K
, kz K
}

8k
E
• s .
Aka
too=
-
-
=
-
===
=
1
k , z
k } K
*
ky
At point E ,
investment -
saving E depreciation lines
cross
i = 8k
action
}
othfueguiwinbrouemmientanesgowmoaei
° "
steady state equilibrium
' '
41<=0
At K , ,
i > SK
implies that
Llk> 0
AR
,
=
i
,
-
8k ,
At kz ,
kz =
K ,
+4k ,
41<2 =
Cz -
8 kz
kz =
kz +
Llkz
↳ continue to
point E
At Ky ,
8k ) i

Economic Change :
Savings
-
Changes
in
savings rate ,
the proportion of income saved ,
affects the amount of investment a
country can undertake
-
affects level of capital available to a worker
$ yz , A .
Kt
y ,
r
. F
8 K
- z
-
-
-
-
-
•=
- -
SZAK
×
#EF S , Aka
.
-
/
=
-
/ = =
K , kz K
What if savings increase from S , to Sz
After the increase in the savings rate ,
the
economy
Starts at k ,
→
At K ,
,
i > 8k
Economy accumulates Capital bk i > 8k Until reach Ez
At Ez ,
equilibrium is restored → i =
8k
Economic growth Occurred when economy moved from
E ,
to Ez ,
increasing K from K .
to kz , increasing y
from y ,
to
yz

-
-
-
Az Kt
-
= A K
×
.
1
.
÷
/ •
s .
A Kt
=what if improvement in
technology goes from A ,
to
Az ?

Economic Growth :
optimal k ?
Y Aka Aka
Y ,
1 I 1 I 1 1 1
EµgkY*i¥skEM.siAk×
=
.
-
.
-
K
,
K K *
.
K
*
=
steady state level that maximizes consumption
.
It occurs where the
gap blw the 8k curve G the Aka
curve is widest
Algebraic Example
( l ) y = A kt
(2) i =
s .
Aka
(3) dk =
i .
8k
Assume the
economy is in
steady state
↳ 41<=0
(2) i =
s .
Ak
×
(3) 0 = I -
8 k
↳ i =
8k
Assume a =
.
S → Use ✓ function
i =
s .
A
fk*i = 8k*
NOW this for Steady state Level of K → k*
8k *
=
s .
A ✓k*
*
in
=
sja
kY÷= ( sjap
k
*
=
( sign )
2

1. If ST ( savings rate ) ,
k*T
2. If AT ( technology ) ,
k*T
3. If 89 ( depreciation rate ) ,
k*t
Y Aka
÷I I / 1 l
yyi_ifkak.ca.
-
= =
kz K , K
Economic Growth :
Catch -
up effect
-
the
property by which countries that start out poor
tend to grow more
rapidly than rich Countries
YBZ
4.1
1 1 1 1 1 , , ,
A K&
YB ,
1 1 1 1 1 1 1 1
9 =
F: -
yaz
pl1 1
•_- -
ya , 11 1 •
-.
-
-
Ok -
-
ok
-
- -
-
=
KA , KAZ KB , KBZ

Economic Growth :
Human Capital
.
model leaves out human capital
.
not all workers have same skills
.
some workers W/ higher skills can produce more output
↳ weigh each Unit of labor by how efficient the labor
was → H
-
H would reflect the human Capital for a workforce
:
y
= A .
F ( k ,
h )
.
typically measure human capital as # of years
of education ( Or work experience )
Y -
-
- A .
F ( k
,
hz )
-
- .
F ( k ,
h )
/
i
a
.
8k
/
-
←
-
-
s .
A .
FCK , hz ) h ,
to hz
a#
s .
A .
FCK ,
h
,
)
r K

Deaton Ch .
5
.
income growth in US
.
poverty in the US
.
inequality
.
inequality E labor market outcomes
Poverty
-
absolute measure of poverty in US
-
price changes only using the Cpl
.
poverty in Us has decreased only a little from 19605
-
# Ofpeople in
poverty are about the Same
Measuring Income inequality
:
income shares
.
income shares : the share of total income going to specific
income percentiles
1. Market Income :
earnings from employment , owning
a business , capital income , capital gains
2. Before tax income :
market income +
gov't Transfers
3. After tax income : market income +
gov't transfers -
federal taxes
Gini Coefficient
.
index blw 0 E I { measures the dispersion of incomes
of all individuals in a
country-
0 =
everyone has same income
-
I = 1
person has all income
-
higher
Gini coefficient =
higher inequality
Cumulative Share
of Income
91A
'
t .
4
Point A on the economy 's ( Loernz
. = Curve ) curve measures the share of
450 -
-
income for the share of the population
0
.
oo
1
,
below a specific level of income
Cumulative share of the population from lowest →
highest income

Income Share
Gini Coefficient :
at A
B
-
A + B
Population Share
person owns all income :
AAFB -
a¥o=l
A B Equal Income :
AF.
=
00+7=0
Inequality : Deaton explanations
.
labor markets reward skilled individuals bk of Tech
-
demand for skilled workers increase →
higher wages.
labor market polarization :
middle skill workers have
fared poorly
'
Correlation blw individuals that make investments in
education E the accumulation of wealth
-
inequality linked to unequal political power
-
economic elite write rules →
reducing equality of
opportunity
-
minimum Wages ,
social security ,
Union power
.
earnings { families :
some shifts have reduced
inequality
blw families -
women
increasing labor force participation ,
but others have increased inequality
-
sorting of high
income couples

Inequality :
Alternative explanations
.
high returns to capital :
( Pike # y ) profits ,
dividends ,
rents
.
Capata list economies were driven toward high levels
of inequality ,
as the high rate of return on capital
Would exceed return on labor
-
inequality will continue to rise

Economic Growth
A :
y
= it
,
1<=100 ,
8 =
. 05
B :
y
= ZVK ,
1<=25 ,
8 = . 05
Maximize consumption :
I . Do we have enough into to figure out which country
has a greater consumption per worker .
A :
y
= Tk B :
y = ZVK A =
2
A = 1
y
= too
y
= 2525 Country B has twice
y
= 10
y
= 2 (5) =
10 the level of tech
as A
2. How much investment ?
A :
i = 8k B : i = 8k
i =
0.05400 ) i =
0.5 ( ZS )
i = 5 i =
1. 25
3 .
What is consumption ?
y = i + C
c =
y
-
i
A :
( = 10 -
S B : C =
10 -
1.25
C =
5 C =
8.75

Population Growth
.
Population growth causes L to increase over time
-
K 1L or K will decline as L increases
-
need to provide additional capital for the net addition
to the workers entering the workforce
.
Malthus : limit of resources Would lead to limited population
-
missed Component of
technology
Long Run Economic Growth
.
Consider the chart
I .
hockey
.
stick
growth path OF UK reflects Industrial
Revolution
2. Industrial Revolution -
sustained increase in the
Creation of new
goods En new
technology
3. Industrial Revolution shifts up aggregate production
function G encouraged Capital accumulation
4. US also went through Industrial Revolution
5. substantial increase in new
knowledge about science {
engineering
6. much of the impetus of the industrial revolution was
due to actions by private sector -
entrepreneurship ,
innovation ,
G commercialization
Long Run Economic Growth :
Ideas
I . Ideas → movement up in production function
2. Non -
rival goods
3.
generate positive externality
4.
suggests a role for government to subsidize idea
creation through grants ,
university support ,
etc .
5. idea
generation normally is done in private sector →
need to focus on incentives

Ideas
.
Intellectual Property Protection
-
provide protection from copying idea for limited #
of
years
-
property rights
-
incentives to innovate
.
human capital development
-
subsidization of schools { universities
-
attendance requirements L positive externalities )
.
Science E
technology
-
Support for basic science -
grants , government labs ,
STEM students
Why lagging countries ?
I .
poverty traps
2. location al disadvantages
3. political 1 economic institutions
Poverty Traps { Threshold Effects
1. level of economic activity in Solow model below where
necessary to initiate the catch -
up growth cycle
2. human capital not at a level to adopt new innovations
{ shift production function
3. Capital intensity ( infrastructure ) not deep enough to
allow for adoption of new tech
4. Caught in a bad equilibrium
-
some versions of Solow
models can
yield multiple equilibriums with some
getting stuck in bottom left
Y
poverty
trap
I
K

Location al Disadvantages
I .
Jeffrey Sachs
2. tropics
:
tropical diseases 4 bad agricultural
productivity
3. landlocked :
less open to trade
Political 4 Economic Institutions
1.
Acemoglu E Robinson
2. property rights , transparency in governments ,
political stability , legal system
3.
property rights create incentives
4. political stability encourages long
-
term
investing
5 .
Inclusive economic institutions ( I El ) :
protect property
rights , legal system , entrepreneurship
6. Extractive economic institutions ( EEI ) :
protect own
allies
,
manipulate market outcomes
Shift Of Countries from EEI to IEI
Treatment Group :
Countries that
change to democracies
Control Group :
EE Is that don't
change status
•
15 -
20%
Conomic
Growth :
Differential in
sy .
Growth blw •
Treatment 2
0%
Control , • i
s
years
democratization
Far'sYater

Midterm I Review
GDP Expenditure G Income Approaches :
-
Income =
Expenditures
Circular Flow :
.
assumptions
-
no
government 4 taxes , Spending is by households
only ,
no savings ,
no international trade
revenue t GDP )
Markets for < spending (= GDP )
>
Goods &
✓ GES sold
services
Gqs bought ✓
Firms Households
n
labor , income
, n
factors of production Markets for < Capital
factors Of
> production
wages ,
rent
, profit ( =
GDP ) income ⇐ GDP )
GDP Definition :
'
measures the market value of all final goods 's services
produced within a country in a given period of time
-
excludes home production G illicit activities
-
includes production wlin borders of US
GDPVS .
GNP :
GDP GNP
.
determined by geo
- .
determined by nationality
graphic boundry of worker
.
GNP =
GDP + factor payments from abroad
-
factor
payments to abroad

Components of GDP :
.
Y =
( + I +
G + NX
.
Y = GDP
.
C =
consumption
-
Spending by households On GGS
-
excludes purchases of new houses
-
includes payments by health insurance companies
-
includes an imputed payment for houses that own
their home
.
I =
investment
-
spending on new equipment ,
new structures ,
G
other tools that are used to produce goods 4 services
in the future
-
includes intellectual property
-
includes new
housing
-
includes inventories
.
G =
government
-
government spending on G G S
-
includes payroll of federal employees
-
excludes transfer payments
.
NX = net exports =
exports
-
imports
-
exports are the purchases of domestically produced
GE S by entities outside the US
-
imports have neutral effect
Nominal GDP :
.
GDP evaluated at current market prices
Real GDP :
.
holds prices constant at a base
year
.
Calculated by using base
year prices ,
but current quantity

GDP Deflator :
:
GDP Deflator =
Nominal GDP
Real GDP
× 100
.
Inflation =
GDP deflator of current year
-
GDD deflator of base year
× | 00
GDP deflator of base
year
Percent Change of a Product Formula :
if D ( A .
B) ~~ % D A + % D B
.
y . D ( P .
Y ) = % D prices + % D real GDP
GDP G Alternative Measures of Well -
being :
'
Gallup Poll Happiness Ladder
.
GDP limitations
-
doesn't include home production
-
doesn't account for environmental externalities
-
doesn't inform inequality
-
doesn't Control for differences in health
Cpl Construction :
.
( p , =
Cost Of purchasing basket of goods in
year t
Cost of
purchasing basket of goods in base
year
.
fixed basket of goods determined by Surveying
Consumers on expenditures
-
held fixed for a period of time
Cpl Inflation Rate
.
Inflation =
CP ' in
Year t -
CPI in
year
t -
1
× 100%
Cpl in
year
t -
1

Criticisms of Cpl :
-
substitution bias
.
introduction of new goods
'
Unmeasured quality change
CPI Vs. GDP :
CPI GDP
.
fixed basket .
all goods produced
domestically
.
substitution bias
.
allows for substitution
.
includes imports
.
Only includes domestic
products
Adjusting Economic Variables for Inflation :
'
Amount in
today 's $ = amount in
year
t dollars × price level today
price level in
year t
EconomicGrowth Patterns :

Intro to the financial model
Savings ,
Investment ,
4 the Financial System
Financial System
.
links up Savers wl people who held to borrow to fund
projects ( investment )
.
financial markets E financial intermediaries ( bank )
Financial Markets
.
direct finance channel
.
stock market E bond market
Bond Market
.
companies or the government borrow by issuing bonds
-
claim on future flow of income
.
certificate of indebtedness
-
maturity date :
when the principal is repaid
-
interest rate
.
debt financing
.
coupon payment
:
payment made every year
to
Compensate person who buys bond
Real vs .
Nominal Interest Rate
.
Nominal interest rate
-
not corrected for inflation
-
rate of growth in the dollar value
.
real interest rate
-
corrected for inflation
-
rate of growth in
purchasing power
.
Real interest rate = nominal interest rate
-
inflation rate

.
Ex :
Deposit $1000in one
year
-
NOM . Interest Rate :
9% → $90
-
Inflation :3 .
5%
-
Real interest rate = 9% -
3.5% =
5.51 .
Bond Market
.
price Of bond depends on characteristics of bond
1. term : how long Until bond matures or is paid off .
longer terms =
higher interest rates typically ( riskier )
2. Credit risk
3. tax treatment :
some bonds have preferential tax treatment
-
no or reduced taxes on
many municipal bonds
( typically lower interest rates )
Stock Market
.
companies sell equity
.
gives holder of stock a right over future profits
.
equity finance
.
Only at issuance , does the firm gain access to resources
from Savers
.
price of stock in market depends on people 's expectation
of the future profitability of the
company
.
Some stocks pay dividends on a per share basis at
regular intervals
Financial Intermediaries
.
indirect finance
.
banks En mutual fund companies
.
solve certain problems
-
adverse selection
-
moral hazard
-
perform these services by screening loan
applications ,
writing detailed contracts , E
monitoring investment
projects
-
audits

Y = C + 1 + G +
NX
( Assume :
NX = 0 → Closed economy
:
no borrowing or
lending overseas )
( Assume Y is fixed in all our analyses not explaining
business Cycle investments )
Y =
( + 1 +
G
* Y -
T =
disposable income
Y -
C -
G = 1
rewrite * Y .
t -
C =
savings
[ Y -
T -
C ] + [ T -
G ] = 1 +
/ . T * T -
G =
budget position of
government
Private Saving Government * T > G :
budget surplus
SP Saving SG ¥FEE:bbauidanoretadeutacitet
SN National Saving
SP + SG =
Investment
↳
private spending on capital goods ,
new
housing ,
RED ,
etc .
TG :
[ Y -
T -
C ] +
[ T
-
Gt ]
}
SP +
SG → Snt →
It
SP :
no ¢ SG 1
↳ This is the crowding out effect
-
In
government spending ,
t private spending
.
supply of Kanable funds :
savings
.
demand Of loanable funds : investment

Saving { Investment in the Macro
economy.
Only one financial market
-
all Savers deposit savings in this market
-
all borrowers take loans in this market
-
one interest rate
-
supply Of funds
-
households wl extra income
-
government saving
-
if positive ,
adds to supply of funds
-
if negative , reduces supply of funds
.
demand for funds
-
firms borrow funds to
buy equipment ,
factories ,
etc
-
households borrow funds
Supply of Loanable Funds L saving )
.
saving in this model is positively related to the interest
rate
-
as the interest rate increases ,
households substitute away
from consumption E into savings
-
higher interest rate provides incentive to HH to increase
saving
r s ( r )
+
S :
saving ( measured in
$ )
r : interest rate ( measured
in %)
S

Demand for Loanable Funds ( Investment )
.
investment is negatively related
-
as interest rate increases ,
it is more costly →
reduce
quantity of projects they undertake
r
I :
investment
spending
L measured in $ )
I ( r )
I
Equilibrium in
Saving E Investment Market
excess in supply of
Saving
g
r
-
Equilibrium :
S .
-
I
r I I 1 1
11 I I I 1
z J L
u . ( national saving :
privateJ L
re i i l i i l i
•
Saving +
gov't saving )
7 - r
,
7 -
rr
r
,
1 1 11 I
.
I
-
I I I
-
re :
equilibrium interest rate
Shortage of -
savings or
excess of
demandtortures I At re , equilibrium saving is Se {
Se=Ie s ,
I equilibrium investment is Ie
Shifters of the Saving Curve Shifters of the Investment Curve
.
Income
.
# Of firms
.
Taxes
.
characteristics of Capital firm
.
Population , demographics already has
.
Medical Insurance System
.
public policy
-
tax policies
.
Wealth .
business expectations

An increase in private saving :
I .
Saving curve →
but In private savings leads to 4 in Consumption
r
SA
SB
-
Private Saving 4
Eo
saving curve →
to 1 I 11 1 1 11 '
= E ,
SA to SBt
,
I I I I I 1 I 11 -
l l '
-
= .
interest rated
=T ro to r
,
-
-
-
o
Soto Si I ,
S ,
I
5. IT from So Io to
S
,
I ,
An increase in investment demand :
1. investment demand curve →
-
due to 4 business expectations
r
So Is from IA to IB→
ri 1 1 11 i i i , , ,
E ,
TT from to TO r
,
= S
,
IT from Solo to 5,1 ,
ro I 11 1 11 '
Eo
:= -
= = IA IB
SOIOSII , S ,
I

•
Y =
20,000 Y= C + I +
G ( NX=O )
•
G =
4,000 Y -
C -
G =
I
•
T = 2 ,
500
-
•
C= 14,000 -
150 ,
national
saving
•
1=3,200-
Sor national savings investment
*
equilibrium condition
s = l
Y -
C -
G =
S
S = 20000 -
( 14000 -
ISOR ) -
4000
S =
2000 +
ISOR
r s
6 111 ' ' 1 '
I 1
2000 p 3200 S ,
1
5=1
2900
2000+150 r =
3200 -
SOR
ZOOR =
1200
r = 61 .
I =
3200 -
SO (6) =
2900=5
GT from 4000 to 4500
S =
20000 -
( 14000 -
ISOR ) -
4500 r
5 ,
so
S =
1500 +
15 Or ←
5=1
E,
8.5 11 1 1
191500+1508=3200 -
SOR - • Eo
r =
8.5 = I
S ( 8. 5) = 1500+150 ( 8. S ) =
2775
1500200Or 3200 S ,
1
2775

Crowding Out :
TG L
government spending )
IS ,
Tr ,
t I (
quantity demanded of investment
declines ) -
this is a movement along the 1
schedule
from Eo to E ,
What happens to private savings ?
Private savings increase because r increases

US Budget Deficits & Surpluses
.
US fiscal position looks to be
deteriorating WIO
changes to
policy
.
gov't spending is set to increase in the next decade
because of increases in entitlement spending
( social security ,
Medicare ,
Medicaid )
-
tax revenues will be under
pressure as recent tax
cuts reduce tax rates
.
increase in federal gov't debt funds

The Flow of Goods G Services
.
Net Capital outflow ( NCO ) =
,
purchases of foreign assets by domestic residents
-
purchases of domestic assets by foreigners 2
.
If you buy Stock ,
bonds or real estate in a
foreign
Company ,
it is 1
.
If a foreigner buys in the US ,
it is 2
.
lots of exchanges that occur are just swaps of assets
SO
"
net out
"
-
trade is asymmetric ( has capital flow )
The
Equality of NX { NCO
.
NX =
NCO
.
When a foreigner purchases a
good from US
-
US exports { NX increase
-
the foreigner pays with currency or assets ,
so the
US acquires some foreign assets , causing US NCO to
rise
.
When a US citizen buys foreign goods
-
US imports rise ,
NX falls
-
NCO falls
.
If NX 70 :
trade surplus ( positive net Capital outflow )
-
capital outflow
.
If NX < 0 :
trade deficit ( negative NCO )
-
capital inflow

Open economy : Y = C + I + G + NX
[ Y -
T -
C ] + [ T -
G ]
-
I =
NX
g private
s gov 't
÷ -
N ×
s -
1 =
NCO
Us case :
NX < 0 Grade deficit )
Trade surplus :
exports > imports
.
Nx > 0
.
Y > domestic
spending
( Ct I + G )
⇒
NCO > 0
Trade deficit :
exports <
imports
.
Nx < 0
.
Y ( domestic Spending
*NCOCO

r S
NX
to 11111 1)
iq@
•
S -
1=N×
-
= S -
1=NCO
= -
So > Io
=
-
Nx > 0
- =
= -
- =
1
Io So 5,1
r s
So > 10
Nxco
Ncoco
to
11111191111
_•
= =
- - - -
1
So Io 5.1

Case 1 :
Closed economy
÷ 1200+200 r
} 1200+200 r =
2700
-
100 r
1 =
2700 -
100 r t = 5 %
,
5 =
1200 + 200 ( S ) = 2200 = 1
5
4 -
1111300
1 1 1 1
1200 2000 2300 2700
Case 2 :
open economy
NX =
-
300
S - 1 =
NX
1200+200 r
-
( 2700 -
100 r ) = -
300
t = 4 it ,
S =
1200+200 ( 4) =
2000 ,
1 =
2700 -
100 (4) = 2300

s -
I =
NX
s Private +
s Government t imps NX t
( T in trade deficit )
Link between gov't deficit E trade deficit
t
twin deficits problem

Chapter 6 :
Deaton
.
importance of measurement
-
purchasing power parity
-
things such as rent E services that are untraceable
influence difficulties
.
Figure I E 2
-
vs .
Solow model
Purchasing Power Parity ( Deaton 220 -
229 )
1
.
Adjust
' '
exchange rates
"
to account for the fact that
prices or the cost of
living differ across countries
2. Price levels differ across Countries
3. Currency exchange rates fail to account for these differences
4 . PPP controls for differences in purchasing power across
Countries
.
Big Mac Index
-
How many US dollars does it take to purchase a
Big Mac
around the World ?
Cost of Big Mac in US : $5.30
Exchange rate :
18 pesos per dollar → 95.4 pesos
Cost of Big Mac in Mexico : 50 pesos
↳ Cost of living is less in Mexico than Us
GDP per capita charts
.
24 rich Countries :
Consistent with Solow model -
clear catch
up effects Over time
-
convergences.
all countries :
median increases ,
but variance is about the
same -
not consistent wl Solow model ,
no Catch Up

Global
Inequality
.
difficult to draw conclusions about trends in income
inequality
.
average country grew at 1. St . since 1950
.
average person lived in a
country that was
growing at 3%
-
improvements in standard of
living in China G India
.
cross -
country inequality hasn't declined much
-
every country is weighted the same

Money
.
money is the asset that people use to
buy goods {
services from each other
functions :
1. medium of exchange
: an asset that can be traded for goods
2. Store of value :
an asset that people can use to transfer
purchasing power from present to future
3. unit of account :
yardstick that people use to post prices E
settle debt
Monetary Systems
1. Commodity money : a valuable
good that serves as a
medium of exchange
:
gold ,
silver ,
grain ,
etc .
2. Fiat Money
:
money w/o intrinsic value that Is used as the
medium of
exchange by gov't decree
-
strong belief that others will accept fiat money
Monetary History in US
*
Money Stock
.
Monetary aggregates
:
M , ,
M 2 ,
M }
•
M ,
=
currency + demand deposits +
traveler 's Checks +
Other Checkable accounts
-
M ,
:
medium of exchange vehicles
•
Mz =
M ,
+
savings deposits + time deposits ( smaller CDs ) +
retail
money market funds
-
Mz :
includes less liquid monetary assets + M ,
•
liquidity : ease of converting an asset into the medium of
exchange
•
demand deposits :
checking E debit accounts

Central Banks
.
modern economies use Central banks to control
money Supply
-
Us :
Federal Reserve system
-
Europe : ECB
.
Federal Reserve System
-
established in 1913
-
updated in 1934 during Great Depression
Federal Reserve System
.
Objectives
-
promote maximum
unemployment ,
stable prices ,
E
moderate long
-
term interest rates
-
promote stability of financial system
-
promote safety
2 soundness of individual financial
institutions
-
help maintain an efficient payments system
-
promote consumer protection E community development
( CRA )
-
lender of last resort
*
.
3 Main parts
-
board of governors ( DC ) :
F R B
I
12 regional banks :
RB
federal open market Committee :
FOMC
.
independent from executive 1 Legislative branches
-
self financed
-
not financed by Congress
-
RB are private entities
-
board of governors
:
appointed for 14
year terms
.
Board of Governors
-
7 governors
-
nominated by POTUS ,
confirmed by Senate
-
chair :
serves 4 year terms

-
responsibilities of BOG
-
supervision of member banks
-
support monetary policy
-
Oversight of RBS
-
Community reinvestment act
.
regional banks
-
12 district banks
-
private board of directors
-
bank President
.
responsibilities of RBS
-
supervision E regulation of banks wl in districts
tend to bank Wlih district
-
provide financial services
.
FOMC
-
sets
monetary policy
-
created during Great Depression
-
12
voting members
-
8 meetings a
year
.
Responsibilities of FOMC
-
sets
monetary policy
-
set interest rates 4 expand 1 contract
supply of
money
-
Communicates to public
-
foreign exchange operations

Money Supply 4 Banks
.
central banks
manage money supply through banking system
-
individual hold a significant amount of
money in the
banking system
-
as deposits
-
banking system can use deposits to create
money through
loans
-
referred to as the
Money multiplier process
Balance Sheets
.
fractional reserve
banking system
-
banks keep a fraction of deposits as reserves and Use the
rest to make loans
-
Fed establishes reserve requirements
-
regulations on the min . amount of reserves that banks must
hold against deposits
-
banks may hold more than this minimum
.
the reserve ratio ,
R
,
is the fraction of deposits that banks
hold as reserves
Bank T -
Account
Money Multiplier Process
Start wl $1000 in
currency
Banks Will hold 101 .
of deposits as reserves
Money supply
=
currency
+
deposits
Bank I Bank I
Assets Liabilities Assets Liabilities
Reserve $1000 Deposit $1000 →
Reserve $100 Deposit $1000
Loan $900
M = C +
D
M =
900+1000 =
1900

Chad deposits $900 in bank 2
Bank 2
Assets Liabilities M= 810+900+1000=2710
Reserve $90 Deposit
$900Loan $810
1 :
1000
2 :
900
3 :
810
4 :
729
.T
Formalize the Money Multiplier Process
M=
money supply
C =
currency
D= deposits
B=
monetary base L elements of
money controlled by the
central bank
R= reserves
M=C+D Money Multiplication
B=C + R YD →
Currency to deposit ratio G
M
=
C + D reflects cash
holdings in an
B C + R
economy
_M=€DVD
RID → reserve -
to .
deposits →
B ( C +
RVD reflects the proportion of
M 41>+1-
=
-
deposits a bank holds as
B YD -
MD reserves
4D =
I
M= -
•
B
4D+R/D Back to EX
:
- W
r/D= .
10
money monetary
multiplier base c1D= 0
by assumption
M=
00¥ .B=÷B= IOB
=
10 ( 1000 ) =
10,000

Ex 2 :
B= 1000
R/D= .
10
4 D= . 20
M =
¥1.4 .
1000 =
¥ .
1000=4 .
1000=4000
A More Realistic Balance sheet
.
Assets :
besides reserves E. loans ,
banks also hold securities
.
Liabilities :
besides deposits ,
banks also Obtain funds from
issuing debt G equity
'
Bank Capital
-
the resources a bank obtains by issuing equity to its
Owners
-
also :
Bank assets -
bank liabilities
.
leverage ratio :
ratio of assets to bank capital
Assets Liabilities
Reserves $200 Deposit
$800Loans $700 Debt $100
leverage Ratio :
1
00%0=20
Securities $100 Capital $ SO For
every $20 in assets
,
$1
is
from bank owners ,
$19 is
owed
.
Capital requirement
-
a
gov't regulation that specifies a Minimum amount of
capital
-
intended to ensure banks will be able to
pay off
depositors { debts
.
leverage
:
-
Use of borrowed funds to supplement existing funds
for investment purposes
-
amplifies profits E losses

Case I C in millions )
Assets Liabilities
Reserves 4Deposits 18
Loans 16 Capital 2
20 20
Leverage =
Assets
Capital
=
-202=10
Assume banks earn 5% on loans
Bank pays 2. St .
on deposits
profit =
Revenue -
Costs
=
16 x. 05
-
18×-025=800,000
-
450,000=350,000
Return on
Equity ( capital )
=
Profits
Capital
× 100%
=
350,000
Case z
2,000,000×100
't =
17.5%
Assets Liabilities
Loans 26 Capital 2
30 30
leverage ratio =
-302=15
Profits = 26×05 -
28×-025 =
1,300,000
-
700,000
=
600,000
Return on Equity =
600000
×
1001=30%2,000,000
Case lwl 10% loan loss 10% loss →
Assets Liabilities 16 -
-146 )= 14.4
Loans 14.4 Capital 0.4
18.4 18.4
If Owner 's capital 70 ,
the bank is solvent

Case 2 Wl 101 .
loan LOSS 10 % loss →
Assets Liabilities 26 -
.
1 ( 26 ) =
23.4
Loans 23.4 Capital
-
.
6
27.4 27 .
4
If Capital < 0 ,
bank is insolvent
↳
bankrupt
Bank is shut down or sold by regulator
Leverage E the Financial Crisis
.
banks suffered losses On
mortgage loans G
mortgage
backed securities due to widespread defaults
.
many banks became insolvent
.
many other banks found themselves w/ too little capital ,
responded by reducing lending , Causing a credit Crunch
To ease the credit Crunch
.
Fed { US Treasury injected billions of dollars
'
Worth of
capital into the banking system
.
temporarily made US
taxpayers part -
owners of banks
.
recapitalized banking system E somewhat helped to restore
lending
Fed Monetary Policy Tools
.
Open market operations G federal funds rate
.
federal reserve lending : discount window G term
auction facility
.
reserves :
required reserves regulation G interest
On reserves

Open Market Operations
.
buying E
Selling Of US
government bonds
by the Fed
.
If Fed buys bonds ,
the Fed exchanges bonds held by the
bank for money . The increase in
money held at the bank
increases the reserves at the bank ,
which increases the
money supply.
If Fed sells bonds ,
decrease in money held in banks ,
decreases money supply
Scenario I :
Fed
buys $10 of T -
securities from a bank
A L A L
Reserves 10 Deposits 100 Reserves
20
Deposits 100
Loans 100 Debt 10
→
Loans 100 Debt 10
T -
securities 10 Capital 10 T -
securities 0 Capital 10
120 120 120 120
*
leverage ratio =
'
2%0=12 T -
Securities t 10
Reserves T 10
Banks Can make more loans
with reserves
First step :
injection of $10 through the open market purchase
second step : the increase in the monetary base will be multiplied
through money multiplication process
Money Supply =
currency
+ deposits
Monetary Base =
currency + reserves
Money Multiplier = 4 D t 1
CID =
. 2
YD +
R/D R 1 D= .
1
4 Money Supply =
"
21.3 .
A Monetary Base
=
4 .
10 =
40

scenario
Fed sells $10 of T -
securities to a bank
A L A L
Reserves 20 Deposits 100 Reserves 10 Deposits 100
Loans 100 Debt 10
→
Loans 100 Debt 10
T .
securities 0 Capital 10 T .
securities 10 Capital 10
120 120 120 120
Reserves t 10
T -
securities TIO
4 Money Supply =Yb¥rb '
4 Monetary Base
=Yi¥rb .
#
reduction in reserves
Monetary Base =
Currency
treserves

Open Market Operations
.
used to
target federal funds rate
-
market interest rate
-
prior to Great Recession ,
banks with excess reserves would
lend to other banks
-
overnight market
.
The Fed Would influence this market by Carrying out open
market operations that would either increase bank reserves
or decrease bank reserves
Reserves
.
Fed regulates reserves a bank must hold
through reserve -
to -
deposit ratio
.
required reserve ratio is the fraction of deposits that a bank
must maintain as reserves
.
Current required ratio is 10 't on demand deposits E zero
on
savings accounts
.
Fed rarely changes required
-
reserve ratio
.
During Great Recession ,
Fed was authorized to
pay interest
on reserves that banks hold at the Fed
-
Banks began holding more reserves 4 fewer treasury
securities
.
Fed can lower / raise interest rate on reserves
-
influence the holdings of reserves →
altering the
reserve -
to -
deposit ratio E the
money multiplier

Lending by the Fed
tendingby the Fed by banks requesting loans
'
discount window
"
lending
.
the Fed charges a rate
-
the discount rate
.
By raising E
lowering that discount rate ,
the Fed makes it
less or More costly to borrow
.
stigma about borrowing from the Fed
.
A new
lending vehicle is called the Term Auction Facility
LTAF )
-
designed to reduce
"
discount window stigma
"
G give Fed
more Control Over
quantity of loans made
-
Fed auctions Off a fixed amount of reserves to the
highest
bidder
-
Fed says
-
on this date -
we will action - dollars in
loans
-
interested bidders ( banks ) submit bids of how much
they want & the interest rate they 're willing to
pay
-
loans are awarded to
highest bidders but all at
the same interest rate
Term Auction Facility
.
banks submit bids on
quantity of loan E interest rate they
are willing to pay
.
Fed ranks bids from highest to lowest based on interest
rate & award loans until Fed reaches set amount of
money
-
all banks pay same interest rate of lowest accepted offer
successful :
goal to improve banks
'
liquidity
'
have stopped doing these auctions after recession ended
Summary of Monetary System d Fed
.
see slides 1 Week 9
,
slide 19 )

Money E Inflation
Money E the Price Level
.
Cpl or GDP deflator are measures of price level
.
As the Cpl / price level increases ,
the purchasing power
Of a dollar falls
.
inverse of price level is the value of
money
.
Central bank determines the value of Money
Money Demand G Money Supply
.
Money Supply :
assume the Fed controls
.
Money Demand :
determined by a
range
of factors
-
price level
-
payments technology
-
transactions level
-
asset portfolio interactions ( Opportunity Cost of holding
money )
Money Supply da Money Demand Model
.
the model relates the quantity of
money in an
economy
to the price level
.
Money Demand
-
the quantity of
money demanded increases as the
price level in the
economy increases
-
rationale :
Consumers need more
money
for transactions
as the price level in an
economy increases
-
Money demand increases as the value of
money declines
-
recall :
the value of
money is YP

Money Demand
.
AS the value of money declines ,
the
quantity of
money demanded increases
Value , -
•
Ms
-
,
Price Level
Money
at
÷ -
( -
z
increases
÷ -
•
M D -
4
'
- - • - 8 ✓
8
I I I I
100 200 400 800
Quantity of Money
P
YP Quantity Of Money Demanded
1
100
2 1/2
2004'
14 400
8
'
18 800
Money Supply
.
determined
by Central Bank
.
represented by Vertical
supply Curve
.
The CB chooses the
money supply for an
economy
-
Central bank chooses Prive level { value of
money

Suppose the central bank increases the money supply
Value , -
•
ME
ME -
,
Price Level
Money
( pt ) excess
Supply
÷ ,
•a,,,_,,•
.
z increases
I -
•
B
µ D - 4
-
-
l - • - 8 ✓
8
I I I I
100 200 400 800
Quantity of Money
we start :
CB sets
money at 200
-
Ms , cuts the ×
-
axis at 200
-
CB doubles the Money Supply.
Ms , to ME →
200 to 400
-
shift right
-
equilibrium goes from A to B
-
price level increases from 2 to 4
-
Value of money decreases from YZ to
'
14

The Quantity Theory of Money
.
David Hume E John Stuart Mill
.
argued that money affects nominal values only ( nominal
GDP ) through prices ,
would not affect real economic
activity ( real GDP )
-
if quantity of money doubles ,
prices in
economy will
double but relative prices Will remain unchanged
.
money neutrality is the idea that the
changes in the
Money supply do not affect real variables or relative
prices
-
Occurs
only over the
long term
Quantity Equation of
Money.
the rate at which money changes hands in an economy
.
4 Components
-
money ( M )
-
price level ( P )
-
real output ( Y )
-
Velocity of money ( V ) :
# of times a unit of money is used
for transactions in an
ECONOMY
p .
Y spending
•
P •
Y - V = - = -
M # Of units of
- - - money
money # of nominal GDP
supply trans .
Or
spending
actions
per unit
of money
Nominal GDP : P .
Y= 10,000 → ✓ =
10000--5M =
2,000 2000

M .
V =
p .
Y
t.AM +
t.LV a 1. Llp +
t.LY
Assumptions :
1.
Velocity is stable over time
% AY = 0
2 .
t.LY :
driven by factors that determine the Solow model
( t.LK ,
% 4 L
,
1 .
4 technology )
Analytical Framework :
long run view of economic relationship
'
1 .
a M +
'
1 .
LW = 1 .
Llp + t.LY
- ^ -
0 economic growth
determined by Solow
t.am +
-1 .
LW = 1 Llp + t.LY
. .
money inflation
growth -
The Fed 's objective is to deliver 2% ~~ 1 .
AP
Assume economic growth
→ 2%
Lil .
Y =
2%
% AM +
t.LV ~~ t .
A P +
% AY
t 0 = 2.1 . +
2%
implies
t.AM =
41 .

M is M {
Value of
Money
as
*A
p ,
I 1 1 I 11
1- -
1 I I 1 1 11 ( I I I I I I 7 I I 1 1 1 •
B
Pz
M ,D M
D
Z
Q
money
I .
As economy grows , money demand shifts
right
2. The Fed expands the money supply over time → shift
right
in money supply
3. The price level T ( P ,
to Pz ) { the value of money t
Inflation G Government Spending
.gov
'
+
traditionally finance activity through taxes or
borrowing
.
at times , gov't prints money to finance activity
.
implicitly , printing of money is a tax of all holders of
money in a
Society
-
Can lead to
hyperinflation
Inflation E Interest Rates :
Fisher Effect
.
Nominal interest rate =
real interest rate + inflation rate
'
Interpretation :
nominal interest rates ( quoted rates )
equals real interest rate ( determined in savings -
investment model ) plus the inflation rate ( determined
by monetary authorities )
.
inflation rate considered is
"
expected inflation
"
.
growth in
money affects nominal interest rates but
not real interest rates , growth in Money affects inflation
( long run )

Costs of Inflation
.
inflation can
generate inefficiencies
-
costs to
Society.
inflation fallacy : If one doubles price level →
double nominal value → neutral
1. shoe leather Costs :
high transaction costs ; resources
wasted When inflation
encourages people to reduce
money holdings
2. menu costs : costs of
altering prices
ex :
in an
inflationary environment ,
restaurant must
reprint menu more
frequently
3. tax distortions :
when inflation alters real after tax returns
4. redistribution of wealth :
unexpected inflation can
reallocate resources from creditors to debtors
5. relative price distortions due to differential costs 4
timing of price changes across goods
Deflation
.
thought Of as damaging
.
experience some of same costs as inflation
.
If
agents expect deflation ,
they may delay activity
-
purchases ,
investment ,
etc .
They want to purchase
goods 1 assets When prices are lower . In short term ,
this may weaken economy
-
Fed aims for 21 .
inflation to keep buffer from
inflation

Unemployment
Measuring unemployment
.
US :
current population survey
-
60,000 households
-
goal :
to determine labor force status of all Civilians
( nonmilitary ) 16 +
, not living in institutional setting
-
broad set of information on
demographics ,
income ,
education
-
produces national level stats on a number of
labor Market indicators at a
monthly frequency.
census bureau places individual into 3
groups
1.
employed
2.
Unemployed
:
searching for job wl in last 4 Weeks ,
Wants G is available to work
3. not in labor force ( N ) :
all other individuals
-
retired ,
disabled ,
Students . stay
-
at -
home
.
marginally attached :
wants job ,
has searched
in last 12 Months ,
not in labor force
Labor Market Indicators
Population =
E + U i N
Labor force = Et U
.
Labor force participation rate =
Top × 100 't
.
unemployment rate =
¥ ×
100%
.
employment to pop .
ratio =
¥op ×
1001

Labor Market Indicators
.
monthly release of labor market data
.
household survey
.
establishment survey
-
survey of business establishments on
employment , payroll ,
E hours
-
# of new jobs
-
wage gains by workers
US Unemployment Rate
'
cyclical pattern
.
takes time for
unemployment rate to decrease
.
current
unemployment rate is low ~ 4%
US Labor Force Participation Rate
.
1960 -
1990 women enter labor force more frequently
.
baby boomers exit labor force -
retirement
Alternative Measures of Labor Market Utilization
-
standard unemployment is referred to as U -3
.
US :
adds marginally attached into Calculation of
unemployment rate
U + M A
US = -
L +
MA
.
U6 :
US + adds in workers that
identify themselves
as
working part -
time for economic reasons
U + M A + PTER
UG = -
Lt MA
Duration of Unemployment
.
unemployment differs across individuals by length of
time in unemployment
.
most unemployment spells are of short duration but most
unemployment at a
given point in time is due to
individuals that have been
unemployed for a long time

Ml MZ M3 M4 MS
Ind I X
2 X
) unemployed for a 1
3 ×
month spell
4 X
5 X
6 X X X X ×
7 × X × × ×
} Unemployed for a
8 × X X × ×
6 Month spell
LOOK down a column
Individual -
1 in short spell
}
Within a month ,
most
individuals are in
long unemployment3 in long spell
spells
5 are in short spells
8 Individuals
= } most spells are
3 are in
long spells
short in
duration
Unemployment Rate
.
sources of unemployment
-
frictional unemployment ; job
Search process
-
structural unemployment t of jobs available is less than
the # of jobs available at Current
wage-
cyclical Unemployment :
unemployment that occurs
in the economy due to the business Cycle ,
in
particular ,
recessions

Natural Rate of unemployment
-
normal rate of unemployment at which the economy
fluctuates around ( includes frictional structural
unemployment )
.
cyclical unemployment : deviation of the actual
rate of unemployment from the natural rate
.
Why does the natural rate
vary over time ?
-
changes in labor force characteristics :
age
E
experience Of workforce
-
changes in labor market institutions :
technology ,
changes in unionization
-
changes in government policies :
unemployment
benefits
Frictional Unemployment :
job search process
'
US economy characterized by relative
large
Unemploymentflows .
Large #s of jobs are being
Created G destroyed in a
typical month
takestime for workers 4 firms to find good employment
matches
thetime searching in unemployment is frictional unemployment
.
Institutions that affect job search frictions
-
unemployment insurance
-
employment agencies ,
temporary help firms
-
tech platforms :
monster ,
linked in , etc .
.
Unemployment Insurance Programs-
goals
:
provide financial resources to workers that
Suffer job loss ( income insurance ) ,
{
improve
efficiency Of Match process
-
unemployment insurance programs in the Us replace
a portion of a worker 's lost income for a set amount
Of time
-
generosity of systems Vary across States E countries

Structural Unemployment
:
excess supply of workers E
wage rigidity
-
normally wages face downward rigidity
.
reasons :
-
minimum wage
-
labor unions
-
efficiency Wages
wage rate
'
aborted labor
supply
wage
floor 11 I I 1 I 1
• E
labor demand
Q labor
:
Minimum
wage policy sets
wage
floor ,
if associated w/
Unemployment likely to affect younger E. less skilled
workers
-
standard view :
raising minimum
Wages likely reduced
Unemployment for less skilled 4
younger workers but
not
by much
-
less than 2% of workers in the US
get paid the
minimum wage
.
labor unions
may bargain for wages above market
equilibrium → create rigid wages

.
efficiency wages are when firms choose to
pay above
market equilibrium wages to increase worker effort or
to reduce turnover
-
reduce turnover
-
raise worker effort
-
increase worker
quality
-
increase worker health ( developing economies )

Midterm 2 Review
.
Chapter 6 .
2C , Chapter 8 , Chapter 10 , Chapter 11 , Chapter
12 .
Chapter 13 .
I ,
Deaton Ch .
6
6 .
ZC
Interestrates :
nominal vs. real interest rates
-
nominal interest rate :
the interest rate as
usually
reported Without a correction for the effects of
inflation
.
real interest rate :
the interest rate corrected for the
effects Of inflation
great
interest rate =
nominal interest rate -
inflation rate
Direct Finance :
Stocks E bonds
.
bond :
a certificate of indebtedness
-
debt finance
.
stock :
a claim to partial ownership in a firm
-
equity finance
-
higher risk ,
but
potentially higher return
Bonds : Term ,
Credit Risk ,
Tax Treatment
.
longer term , higher credit risk ,
taxable →
higher interest
Indirect Finance : Banks G Mutual Funds
.
financial intermediaries :
financial institutions through
Which Savers can indirectly provide funds to borrowers
.
mutual fund : an institution that sells shares to the
public 4 Uses the proceeds to buy a portfolio of Stocks
G bonds
Savings 4 Investment identities
.
Y =
C + 1 + G +
NX
.
S = 1 =
( Y -
T -
C) + ( T -
G)
T private saving public
national
saving
saving

Budget Deficit E Budget Surplus
.
deficit :
T < G
.
surplus
: T > G
Saving :
Supply of loanable funds
.
all income that people have chosen to save
and lend Out , rather than use for Consumption
Investment :
Demand for Kanable funds
Saving 4 Investment Graphical Analysis
Factor Shift
.
tax laws that encourage s→
greater saving rt qtr
.
tax laws that
encourage D →
greater investment rln qt
:
budget deficit S ←
,
rtqt.
budget surplus S →
,
rtQT
r
S , Sz
r
S
→
•
→
• •
•
D D ,
Dz
q q
tax laws that
encourage tax laws that encourage
greater saving greater investment
r
SzS ,
r
S,
Sz•
←
→
• •
•
D D
q q
budget deficit budget surplus

Crowding Out
.
a decrease in investment that results from
government borrowing
10
Current Population Survey
.
employed : those who worked as paid employees.
unemployed :
those who were not
employed ,
Were available for work , & tried to find employment
in last 4 weeks
.
not in labor force :
fit in neither of the first 2
categories L student ,
homemaker ,
retired )
Unemployment Rate :
Cyclical G Natural Rate
.
natural rate of
unemployment
:
amount of
Unemployment that the economy normally
experiences
.
cyclical unemployment
:
year
to
year fluctuations
in employment around its natural rate
Labor Force Participation Rate
.
labor force =
employed
+
unemployed
.
labor force participation rate =
labor force
× 100%
adult population
Alternative Measures of Unemployment
.
U3 :
standard
U + M A
.
US = -
L +
MA
.
u6 =
UtMA_PER * PTER :
part time
L + MA for economic reasons

Unemployment Duration
.
most unemployment spells are short term ,
but
most unemployment at a
given time are
long
term spells
Frictional vs .
.
frictional :
due to
job search process
.
Structural :
too few jobs available
-
due to minimum wage , unions ,
G efficiency
wages
Unemployment Insurance Programs.
increases frictional unemployment
.
a
government program that partially protects
workers
'
incomes when they become Unemployed
Efficiency Wages.
reduce turnover
.
increase effort
.
improve worker quality.
improve worker health
Henry Ford example
jefficienoy
wage aimed at reducing turnover
Money :
medium of exchange ,
Store of value ,
Unit of account
.
medium of
exchange
:
an item that buyers give
to sellers when they want to purchase something
.
store of value :
an item that people can use to
transferpurchasing power from present to future
.
unit of account :
yardstick for prices

Monetary Systems :
Commodity 4 Fiat
.
Commodity money
:
money that takes the form
of a
Commodity With intrinsic value
.
fiat money
:
money Wo intrinsic value that is
Used as
Money bk of government decree
Money Aggregates : MI da MZ
.
MI :
demand deposits ,
traveler 's checks ,
currency.
MZ :
M 1 +
savings deposits ,
time deposits , money
market Mutual funds ,
etc .
-
less
liquidity
Brief Monetary History of US ( week 8 ,
slide 14 )
'
American Revolution :
Continental dollar C fiat money )
-
1789 New Republic
:
dollar coins of
gold Or silver
.
First & Second banks of the US 4791 -
1836 )
.
Free banking era 4837 -
1863 )
.
Civil War :
greenbacks Lfiat money )
.
classical gold Standard ( 18705 -
1913 )
.
Federal Reserve Act ( 1913 )
.
1934 amended FRA
.
1971 -
Off gold standard -
fiat
money
The Federal Reserve System
.
Federal reserve board ,
12 regional federal
reserve banks ,
G federal open market Committee
.
board includes 7 members appointed by
President
-
supervision Of Member banks , support of
monetary policy , oversight of RBS ,
monitoring
lending in
mortgage markets

.
Federal Open Market Committee
-
12 voting members :
7 board of governors ,
NY Fed Pres ,
4 RB presidents
-
sets monetary policy
Money Multiplier
4D =
I
.
M = -
•
B
4D +
R
/ D
-
money monetary
multiplier base
Leverage
-
Leverage ratio =
Assets
Capital
.
bank is solvent if capital > 0
Monetary Policy Tools Of the Fed
.
Open Market Operations :
buying bonds increases
money Supply 4 selling bonds decreases money
SUPPLY
.
reserves :
higher interest on reserves decreases
money supply
.
lending :
discount window 4 discount rate
-
discount rate :
interest rate on the loans that
the Fed makes to banks
-
higher discount rate discourages borrowing
Fameof Money & Price Level
.
If p is the price of goods services measured in
terms of money ,
'
/ p is the value of Money
measured in terms of
goods services
.
when price level rises ,
value of money
falls

Money Supply 4 Demand Analysis 4 the Value
of Money.
demand for
money reflects how much wealth
people Want to hold in liquid form
.
as price level increases ( value of money
decreases ) , quantity of money demanded
increases
.
supply curve is vertical bk Fed has fixed the
quantity of money available
Shifts in the Money Supply G Demand 4 the
Value of
Money
value
M ? M {
Of
money →
YP
¥ -
j -
•
M
D
of ,
oh q
Quantity Theory of Money :
Neutrality of Money
E Classical Dichotomy
quantity theory of money
:
the quantity of
money available determines the price level ; the
growth rate of quantity of money determines
inflation rate
.
changes in money supply affect nominal Variables
but not real ones
-
only in long run
velocity
p ×
v.
:
Velocity =
-M

Quantity Theory of Money
.
% 0 M + t.LV = % 0 P +
t.LY
Hyperinflations
.
inflation that exceeds 501 per month
.
Usually due to governments printing money
Inflation Tax
.
the revenue the government raises by printing money
.
like a tax on
everyone who holds money
Fisher Effect
.
the one -
for -
one adjustment of the nominal
Interest rate to the inflation rate
.
when the Fed increases the rate of money
growth ,
the long -
run result is both a
higher
inflation rate E a
higher nominal interest rate
.
nominal interest rate adjusts to expected inflation
.
real interest rate =
nominal interest rate
-
inflation rate
Inflation Fallacy
.
inflation itself does not in itself reduce people 's
real purchasing power
Costs of Inflation
.
shoe leather costs :
resources wasted when inflation
encourages people to reduce their money holdings
.
Menu costs :
the costs of changing prices
.
confusion
.
inflation -
induced tax distortions

Deflation
-
reduces Overall demand for
goods 4 services
in the
economy
.
similar costs as inflation
13 .
1
International Flow of Goods 4 Services
.
exports :
goods 4 services that are produced
domestically 4 sold abroad
.
imports :
g{ s that are produced abroad E sold
domestically
.
net exports =
exports
-
imports
Trade Balance
.
same as net exports
.
trade surplus :
excess of exports Over imports
'
trade deficit :
excess of imports over exports
Capital Flows
.
Net Capital outflow =
purchase of foreign assets
by domestic residents -
purchase of domestic assets
by foreign residents
.
NCO =
Nx
-
positive → Outflow
-
negative
→
inflow
.
NX = NCO = S -
1
Deaton Ch 6
Global Growth E Catch Up Effect
.
poor countries have
opportunity to adopt knowledge
of rich countries
.
growth has been
unequally distributed

Global Poverty :
Measurement Challenges
.
differences in price level
.
differences in what people in each
country
will typically buy
tension blw collecting prices on items that are
availableinternationally a items that are comparable
Global Inequality
.
richer countries have
grown rapidly 4 closer
together
.
international income inequality is not falling over
time
.
average person lived in a
country that was
growing at 3% a
year
-
China E India have
grown rapidly da have a
large population
.
global inequality is Stable Or slowly falling ( 262 )

Aggregate Demand E Supply
.
Volatile Components of GDP :
I { NX
-
C E G are less volatile
-
NX is a relatively small share of GDP ( -31 .
)
-
I is about 171 .
Of GDP
Chicago Fed 's Dual Mandate Bulls
eye
.
target unemployment
:
natural rate of unemployment
( 4. St .
)
.
target inflation :
2%
.
low unemployment
→
competition to
get workers →
higher wages
→
higher prices
Fed 's Balance Sheet
.
Think about the Fed as a bank for Commercial banks
A L
Treasury Securities Reserves of Member Banks
trillion L akin to deposits )
} ttfnfn
+3.5
{ Mortgage Securities
currencyMisc .
Short run macro model
.
develop a macro model to explain short -
run fluctuations
in Output 4 prices over the business cycle
.
relax assumption of
monetary neutrality
-
allows role for monetary { fiscal policy to influence
Output
.
Aggregate Demand -
Aggregate Supply model

Aggregate Demand ( AD )
Aggregate Supply LAS )
links spending to price level links production to price level
In to L T
monetary E interaction of AD G AS long run VS .
fiscal policy determine an economy 's GDP short run AS
effects { price level ( P ) { shape of AS
Aggregate Demand
.
Spending by households ,
firms ,
L governments
.
shows the quantity of
goods services ( real GDP ) that
people want to buy at each price level
.
AD Curve is plotted W1 price level ( P ) on the
y
-
axis 2
real GDP ( Y ) on ×
-
axis
.
This is where classical dichotomy starts to break down . . .
AD :
Y =
C
-
l t
G + NX
Why does AD Curve slope downward ?
I . wealth effect on consumption ( C )
2. interest rate on investment ( i )
3. exchange rate on net exports ( NX )
The Wealth Effect
.
Consumers hold money as asset
.
suppose price level declines
-
define real money holdings as ( ¥ )
.
As Pt ,
( MFIT , purchasing power T ,
Consumers use this
T in purchasing power
4
spending
:
1 1 1 1
_•Ap
-
•
B
2 1
11 1=11
=
Y , Yz Y

Interest Rate Effect
.
tp
,
t interest rate ,
In investment
:
I I 1 1
•_
A
p
-
•
B
2 I 11 I -1I
- =
Y , Yz Y
ExchangeRate Effect
t interest rate ,
demand by foreigners for US assets t ,
demand for US dollars t ,
dollar depreciates ,
stimulates NX ,
quantityof demanded goods G Services T
Shifters of AD Curve
.
changes in consumption
-
stock market
* young people might devote more income to savings
-
demographics :
aging of
Society
than consumption
-
tax increases / decreases
-
Consumer Confidence (
changes )
changes in investment
-
interest rates changes unrelated to price
-
level
change
story discussed above
-
business expectations
-
tax incentives
-
monetary policy
.
C
'
-
f ( Wealth , demographics ,
taxes ,
Confidence )
↳ specific story to
figure out
shift in AD
p p
→ to wealth ← -
o wealth
p
,
-0 taxes to taxes
1 1 11 -
l l l
-
to confidence
Pi l l l '
-
l 1 1
-
-
D confidence
= =
-
=
- .
.
=
I AD .
ADZ
= I ADZ AD ,
Y , Yz Y Yz Y
, Y

Nominal Exchange Rate
.
rate at which one Country 's currency trades for another
.
expressed as foreign currency per unit of domestic currency
.
determined by supply 1 demand for domestic
Currency
relative to foreign currency
.
a currency appreciates relative to another
currency
-
increases in value relative to the other
currency
ex :
10 > =
107 Japanese
Yen → , 10 =
110 Japanese yen
1
US dollar 1 US dollar
-
dollar is
appreciating versus
yen
.
A
Currency that depreciates relative to another currency
-
decreases in value to other
currency
e
¥ -
dollar supply of dollars in
exchange for
yen
exchange
rate
E* t I I I l '
I= demand for dollars
q* q
Real
Exchange Rate
'
rate at which goods 's services of one
country trade
for goods E. services of another
country
Real Exchange Rate =
e. Domestic Price Level
Foreign Price Level
Ex :
ton of steel costs $1000 in US
,
120,000 Yen in Japan
e= 110 Yen per dollar
1101¥1$
.
$1000
per ton
Real Exchange Rate =
120,000¥per ton
=
110000
120000
=
.
917

Suppose the nominal exchange rate (e)
goes from 110¥ 1$ to
120 ¥ 1$
=
120 .
1000
= 1
120000
Real Exchange Rate
.
the real exchange rate increases if :
I .
e appreciates
2. price of domestic
goods increases
3. the price of foreign goods decreases
'
If real
exchange rate increases ,
NX decreases
.
domestically priced goods become more expensive
.
reduce domestic exports and increase domestic imports
P
Start at Point A :
A
p ,
1,1 ,; t P
,
t interest rate ,
t
exchange rates ,
P 1
11=11•
B T NX
2
= = Recall :
A D= Y + C + It G +
NX
=
-
AD movement
along AD curve due to TNX
Y .
Yz Y

p -
0 interest Investment related snifters of AD
←
rates .
t interest rate
,
41 ,
AD→
→
+ D bus .
+ winter .
confidence
.
t taxes ,
T 1
,
AD →
rate
-0 bus . conf .
-
0 taxes
.
T BUS .
C Ohf .
,
41 ,
AD →
to taxes
y
p
→
+ OG
÷G
y
p
+ OGDP
,→ang
Shifters Associated With NX
→ partners
-
growth in
trading partners
←
-
oe
-
T economic growth in Europe ,
wGDP+p
T demand Of US exports ,
TNX
+
oe
.
te ,
TNX ,
AD →
y

Aggregate Supply
.
production of goods & Services by firms
.
long run ( LRAS ) :
Solow model ,
not affected by price level
.
short run LSRAS ) :
*
Long Run
aggregate Supply
.
not affected by price level
.
vertical at natural 1 full employment level of output
'
Shifters ts of Solow model
( k ).
amount
:
otoiireisineaeuapita
'
}Yrn→→
-
amount Of labor
-
amount of human capital ( Hl
-
technology L Al
-
natural resources ( N )
P LRASO LRAS
,
Po
1 11 11
P , 111
:Yo
Y
p LRASOLRAS
, YT from Yo → Y .
→
Fed increases money supply over
P
, 1111 • A • B time
,
shifts AD to
right Over time
AD ,
Y increases over time
, ,
ADO P is rising overtime
Yo Y ,
Y

]
Suppose the central bank T
money supply
AD →
In long run ,
T in price level
Y

Short Run Aggregate Supply
.
links output to price level
.
As PT
,
YT
.
quantity of output supplied deviates from the natural rate of
output when the actual price level deviates from the expected level
-
Why the expected price level ? In this model firms make production
plans based on expectations of what prices will be
-
if prices turn out
different than expectations ,
firms alter their production plans in the short run
.
3 stories that economists tell here :
sticky wages , sticky prices , price
misperceptions
.
each story indicates that if the price level rises above the
expected price level .
Firms will produce more in the short run
.
If price level falls below expectations ,
firms will produce less in the
Shrgnrt
1.
Sticky wage Theory
.
nominal wages ( w ) are fixed in short run
.
real
wages ( wlp ) Will change if p Changes ( purchasing power )
.
an increase in P
,
reduces the real wage ( wlp )
-
With lower real
wages ,
firms hire more labor { expand
production
¥ .
Price level T Po to P , ,
Wo fixed
wee
.
As ¥1 ,
firms hire more workers
po
1 1 119A Q A
→
QB
We 1 I 1
1=-1i•
B
p -
-
i
- -
QA Q B
Q
2.
Sticky Price Theory
.
prices fixed in short run
.
firms originally set price based on expected level
.
relative price Of product falls
.
this increases demand for their product E they expand production
.
price level exceeded firm 's expectations

3. Misconception Theory
.
firms have
difficulty distinguishing the source of the price
Changes for their products
-
the price of their product may
rise due to a shift in demand
for their
good . In this Case , they should expand production
-
the price of their product may rise due to an increase in price
level . In this case ,
this is just inflation 's they shouldn't expand production
.
In this theory ,
some firms misinterpret the price rise as a
signal of strengthening demand and increase production
this
occurs when actual price level exceeds expected price level
what the 3 theories have in common
.
Y deviates from Ycras when P deviates from PE
Y =
Yuaas +
a ( P -
PE )
Output natural rate a > 0 actual expected
of output measures price price level
how much Y level
responds to
unexpected
Changes in PP
LRAS
SRAS
P , 1 1 11
-
•
B Y =
YLR As
+
A ( Pactua,
-
Pexpected )
Po I i i i i i • A
I
At Pt .
A , Pactual =P expected
p
.
"
÷c
=
.
§u¥¥I¥E¥e¥
ay,oa±yq.
# expected
to
-
And1 i ,
v v
Y .
✓
1
2 I
LRAS )
At Pt .
B :
P is at P ,
and Y is at Y
,
Y =
Yugas +
X ( Pactua ,
-
Pexpected )
P ,
> Pexpected ( Po )
Y > Yuras > 0
T
this is at Y ,
At Pt .
C ,
Pz < Pexpected ( Po )
SO Yz =
Yugas
+
X ( Pactuai
-
Pexpected )
( < 0 )
Yz < YLRAS

.
Movements along the SRAS Curve occur when Pactuai
deviates from P
expected
.
Shifters Of SRAS
-
things that shift both long run and short run
aggregate
supply
-
all the pieces in the Solow that shift LRAS also Shift
SRAS → K ,
L , technology LrasosRASOLRAS,
SRAS
,
LRAS
SRAS ,
P
,
1 1 1 1 •
B
SRASO Yo Y ,
Po 1
I 1 ' •
A
.
At Pt .
A ( For SRAS )
expected price level =
actual price
Yo level =
Po
.
At Pt . B ,
the expected E actual
Price level are
higher & are at P ,
.
Cost / Supply shock will shift SRAS
T Costs are
' '
supply shocks
' '
,
shift On the SRAS curve
left Or up
-
wages are a
key cost variable
.
SRAS Curve With Supply shocks :
Y =
YLRAS +
a ( Pactuai -
P
expected
) -
SUPPLY Shocks
.
A Supply shock increases costs G reduces Y ( negative sign ) -
leftward shift
in the SRAS Curve
.
wage adjustments shift the SRAS :
-
When unemployment is above the natural rate ( Y < Yeras ) ,
the
wage rate
Will decline as high unemployment reflects an excess supply of workers ,
Which Will put downward pressure on
wages ( SRAS →
)
-
When unemployment is below natural rate ( Y > Kras ) ,
the wage rate
Will increase ,
as low unemployment reflects an excess demand for
Workers ,
which will put upward pressure On
wages ( SRAS ← )

Short run
Aggregate Supply Curve :
Demand shift
.
Case I :
an increase in
aggregate demand
P LRAS
SRASO
How does this economy adjust in
i,
'
,
'
,
i •
'
a•=B
the short run ?
•
-
1. AD →
-
2. Pt .
A →
Pt .
B
.
-
ADO AD , 3 .
At B ,
P
,
> Pexpected ( at Po)YOY,
Y 4. At B. agents start to increase their
p LRAS
SRAS '
expectation of prices , driving up the
←
SRASO
C •
expected price level
,
'
,
'
,
'
,
! •
'
a•=B
This Closes the ( Pactuai
-
Pexpected ) gap•
- 5. SRAS shifts left ( Up ) to SRAS ,
E
-
economy returns to LRAS curve }.
.
ADO AD , vYOY,
y
I o
.
Case 2 :
supply Shock
SRAS , 1. Cost Shock Or supply shock ( EX :
LRAS SRASO
Oil price 4 of the 19705 )
B
P ,
ni i •
2. T input costs ,
SRAS ←
Po 11
if
' • A
SRASO to SRAS ,
= 3. Move to a short run equilibrium B
=
Also P
,
> Po and Y ,
> Yo
Y Yo At B ,
the
economy is in recession
Y ,
< Yo ( LRAS -
level )
In recession ,
T in unemployment which
puts downward pressure on Wages
twages yields a decrease in input cost
SRAS →
return to A

LRAS
SRAS
,
p SRASZ
SRAS 3 Scenario :
Cost Shock
SRASO
T oil prices shifts SRAS
P,
B
left or Up
Pz 111111111 •
€
13
1 l ' 1 1 1 11 ,
g.y••£
poll
11111×1ID
• A
ADO
Y
Economy : Actual Price level :
Expected Price level :
SRAS :
Pt .
A Po Po SRASO
Pt .
B P
,
Po SRAS ,
Pt .C Pz P , SRASZ
Pt .
D Pz Pz SRAS }
: : :
:
.
. ,
.
Pt .
A Po Po SRASO
LRAS
SRAS ,
SRASO
1. At Pt .
B
, economy is in
→
B recession ( Y ,
< Yo )
?
2.
unemployment is high
= •
A
.
3. high unemployment ,
excess
=
supply of workers ,
to
wages
.
=
AD 4. AS
Wages fall , SRAS shifts
Y , Yo
right or down

Monetary Policy : Pre -
Financial Crisis
.
Federal funds rate
.
federal funds :
market where a select group of banks make Overnight
loans to one another
'
reflects the interaction between supply and demand for bank money
interest
rate Federal funds interest rate :
federal
funds
'
short term interest rate
fate Tffl 11 -
.
Fed targets this rate
rffz ,
# MD :
money demanded inversely
-
-
related to the interest rate bk
= -
MD as the interest rate T
, Opp . cost
Qin Qri Qof
money Of holding money T G quantity
Of money demanded declines in
response to T in interest rate
Money Supply controlled by Fed :
interest Ms
'
ME
rate
vertical supply curve -
.
Fed is
targeting a level of federal
stuufpdosserfteearleratuta
'starget ratio
r**¥fff
* *
rff** 1 11 11 1 1 | •
B
HOW :
Carry out OMO ( purchase
MD
T .
Securities ) Qin Qin QM
interest Ms
'
M } p
LRAS
rate MD is affected
→
by 0 's in price
aai@aYnYttsArsigPnImDiIiiiii.EB
M
D
-
rff** 1 1 1
11 1 1 , a
B
1 -
MDO-
ADO
AD ,
Qin Qin QM Yo Y ,
Y

Aggregate Demand Effect
'
Changing the federal funds rate -
the Fed influences spending in the
economy
.
lowering the Fed .
funds rate will encourage increases in investment
Spending E perhaps the purchase of consumer durables .
It
may also
have effects on NX through exchange rate effects .
A
lowering of rates
can lead to a depreciation in the dollar ,
increasing exports and
decreasing imports ( NXT )
.
the result is that
expansionary monetary policy shifts the AD curve right .
This
results in a movement up along the SRAS curve ,
with increases in Y E P
.
money neutrality does not hold in the short run
-
a contraction
any monetary policy results in the opposite effects . Increase in interest
rates ,
a shift left in AD ,
a movement down along SRAS Curve ,
wl decreasesin Y E P
LR AS
SRA So
1
.
Pt .
A
2. Great Recession
.
'
AI due to loss in Consumer
>
0 • A Confidence
P ,
•
B
.
wealth effects
= 2 options :
take no action ( allows AD
= AD , ADO to shift right over time ) or
carry out
Y , Yo
expansionary monetary policy ( shift
AD curve right )
Monetary Policy :
Pre -
Financial Crisis
.
Prior to Great Recession ,
the federal funds rate was the
key policy tool of the Fed
Aggregate Demand Effect
-
raising of federal funds target
-
by a quarter point ( 2. ZS to 2. S )
.
contraction of reserves ,
decrease in
money supply
.
tend to shift AD curve to the left ,
or slow movement to right
.
W/ interest rates at 2.5% ,
the Fed was still very accommodative

Monetary Policy
.
By altering interest rates ,
the Fed is
trying to influence
spending by agents in the economy
-
Cannot increase AD directly
-
only encourage 1
discourage spending
-
FOMC meets 8 times a year in scheduled meetings .
These meetings announce the
current status of
Monetary policy G the Fed 's outlook on the
economy
-
Sometimes ,
the Fed holds unnanounced Conference Call meetings in Case of
emergencies E can
change policy then
.
the Fed has the ability to change policy immediately ,
but the spending changes
that Occur as a result of the policy take a long time
.
Monetary policy is said to have a short inside lag
-
can alter policy quickly
-
but has a
long outside lag since it may take a long time for businesses G
households to change spending in response to Fed policy
.
Review :
Fed can lend bank reserves at the Discount Window
-
the Fed charges a bank an interest rate for such a loan
-
the interest rate is called the discount rate
-
the Discount rate G Federal Funds Rate move
together
.
Fed also sets required reserve ratio -
but rarely changes this → not short -
run tool
Financial Crisis :
Housing Issues
-
a series of inter -
related events
-
housing price boom -
bust cycle
-
housing prices peaked in 2006 and
Started to fall
-
fall in house prices was relatively wide -
spread -
hadn't happened since
Great Depression
-
mortgage and debt markets hadn't priced in the likelihood of such
correlated falls in price . Wiped out collateral underlying many loans .
Loans were much riskier than
originally thought
-
subprime lending also contributed to the problem -
riskier loans
were being made
I Securitization also proved problematic
-
originate to distribute model of lending
Problems in
housing { mortgage markets
quickly spread to financial sector

Financial Crisis :
Bank Runs
1.
August 2007 :
Ben Bernanke ,
Chair of Fed ,
said problems in
mortgage
finance market were well contained
2. Fall 2007 :
Fed starts to cut interest rates
3.
Economy starts to noticeably weaken in late Fall G several
mortgage lenders go
Under -
Fed starts cutting the Fed Funds rate 1
Aug 2007 @ 5.251 .
→ Dec @ 4.251 . )
4 .
Bear Stearns fails in March 2008 ,
lots of confidence -
Counterparties
( Other banks ) unwilling to lend .
Bear Stearns has a bunch of assets related to
mortgage finance market . People question the Value → bank run
5 . Fed arranges a partial bailout of Bear Stearns and JP Morgan buys
Bear Stearns
6. Would the Fed 's willingness to bail -
out a financial firm cause other firms
to take more risk -
an issue referred to as Moral hazard
Bank Runs continued into Fall 2008
1
.
more
mortgage lenders E some banks become
"
troubled
"
.
Solution is to
find buyers for the troubled financial institutions
2. Fannie Mae E Freddie Mac (
mortgage finance entities ) are put under
government control
3. Lehman Brothers had a
large real -
estate portfolio that experienced losses
4 .
The financial model that Lehman used was to hold long
-
term assets
but finance these assets w/ short -
term loans G debt .
Wiggins et al
report that on some
days Lehman might borrow $200 billion dollars
5. Counterparties lost Confidence in Lehman E cut off funding
6. resulted in bankruptcy as the gov't decided not to bail out Lehman
Financial Crisis :
Lehman Brothers Bankruptcy
Government response :
1.
government had bailed out Bear Stearns & Freddie Mac 1 Fannie Mae
2.
government believed further bailouts would
encourage banks to take
risks ( in the long term ) and exacerbate
"
moral hazard
"
problems

3 .
gov 't tried to
arrange a private bailout of Lehman
-
wl no
government
help in financing
4 .
All likely buyers of Lehman declined the deal wlo the
gov't help
5. the potential buyers did not Want to own the troubled assets of Lehman
6. On Monday Sept .
15 ,
2008 ,
Lehman filed for bankruptcy bk it Could not
get the short -
term funding to open up for business
Financial Crisis : Bank runs
I . Lehman accelerated the financial crisis that was
bubbling up worldwide
2. Fire sale on certain types of assets .
Lehman was a
global investment
bank SO had Counterparties around the World .
Lots of firms started to
try to sell
"
troubled
"
assets ,
at the same time .
Driving down price
G
exacerbating problems
3. Financial firms became less -
confident in firms they transacted with -
hoarded highly liquid assets G reduced lending
4. spread to non -
financial firms through commercial paper market 4 through
general reductions in business E consumer lending
5. result was global recession
After Lehman in Fall 2008
1. Bank runs continued in Fall 2008
2. capital markets -
borrowing { lending
-
seized up
3. Stock market falls in next month by almost 301 .
and dollar rose
sharply
4.
gov't decides that bailing Out banks better than allowing them to fail
5 .
by Dec . 2008 ,
FOMC sets federal funds rate at zero -
reaching
zero lower bound
.
It ,
N X d → FD by a lot
.
Ct due to Wealth effect

Financial Crisis :
Zero Lower Bound
Fed and Treasury response :
1
.
During crisis , Treasury LTARP ) G Fed ( TALF ,
Term Auction , . . .
) set up a
range of lending and financing facilities to inject liquidity into banking
system .
2. Treasury injects liquidity into banks through TARP programs
3 .
Fed expands lending
-
taking a broader set of collateral from banks da
lending into Commercial -
paper market .
Providing funds to non -
bank lenders
4. Term auction facility CTAF ) was one way the Fed expanded lending but
many others .
5. At the zero -
lower bound interest on rates ,
what other actions could
Fed take ?
Fed Response
I . At zero -
lower bound on interest rates ,
What actions could Fed take ?
2. Expand balance sheet :
quantitative easing
3.
goal
:
lower long
-
term interest rates
4. Fed controls short -
term rates using standard open market operations in
federal funds market but long term rates aren't controlled by Fed
5. Quantitative easing was an attempt by Fed to lower interest rates on
5 -
year ,
10 -
year ,
E 30 -
year loans , pivoting the
yield curve down
interest
Yield Curve rate
Length in time Interest in
yield curve
pre Great Recession
of the Loan Rate
30 Days I. 5% a
yield curve
start of 2009
1
Year 2. Oil .
5 Year 3.0%
T yield curve
10 Year 3 .
51 .
Post QE
length of loan

in an Cia I Crisis : Quantitative Easing
A series of inter -
related events
I .
Yield curve is a chart that shows the interest rates on bonds for various
maturities at a
given point in time
2. Quantitative easing in 3 steps :
-
Q E I :
end Of 2008 ( IS months )
.
Q E 2 :
end Of 2010 ( 8 months )
.
Q E 3 :
end of 2012 ( IS months )
3. Purchase :
longer term treasuries E mortgage
-
backed securities -
quadrupling
size of Fed Balance Sheet
4. resulted in some decline in
longer
-
term interest rates but under debate
Financial Crisis : Interest on Reserves
.
The expansion of the balance sheet resulted in large expansion of reserves .
This was due to the fact that in 2008 the Fed began paying interest On
reserves
1
.
Banks began to hold excess reserves as they were compensated for the
reserves they held in accounts at the Fed
2. The Fed sets the Interest on Reserves ( IORK targets a Federal Funds Rate
range .
The IOR helps the Fed hit its target in the Federal Funds market
3. The IOR rate lies above the Fed . Funds Target rate ,
SO banks have little incentive
to lend in this market .
( in Pre -
crisis ,
Fed didn't
pay IOR )
4 .
Why do any transactions occur in the Fed Funds market today ? There are
some financial institutions that participate in the Fed Funds market but do
not hold reserves at the Fed
5 .
The Fed still carries out open market operations to help Keep the Fed Funds
rate close to the target rate which is still announced
Intereston Reserves :
1.75%
.
Federal Funds Market : 1
.
SO -
1.751 .

Financial Crisis : Forward Guidance
.
Forward Guidance is the practice by central banks to communicate to
the public about the path of future monetary policy
1. Forward guidance was emphasized during the Financial Crisis as a
key
aspect of
monetary policy
2. For ex ,
the post FOMC meeting statement issued in Dec 2008 noted
that the Committee anticipated that weak economic conditions were likely
to warrant really low levels of the fed funds rate for some time
3.The Fed provides guidance through its policy statement G projections
4 .
Every other meeting ,
all 19 participants in FOMC
meeting provide a
projection of the path of the Fed Funds Rate ,
Which Will imply the
path of IOR
Post Financial Crisis :
Monetary Policy
1. Fed continues to
target a fed funds rate -
now a
target range
2. Fed sets I OR at top of Fed Funds Rate
3. Started to shrink balance sheet -
very slowly ( about $10 Billion a month )
4. Continue to employ forward guidance as a tool of monetary policy
5. Introduction of a set of micro G macro Prudential tools to assess the
financial stress in the
system
-
Stress test individual banks ( Dodd Frank Act )
-
Create indices of macro stress G uncertainty and use to supplement
policy
6. Financial crisis has had a
large impact on how Central Banks carry
Out policy
-
in the US , Europe ,
da Asia

Deaton :
Escaping Death in the Tropics ( Ch .
3)
.
general improvement in life expectancy in rich G poor countries over the
last 60 years
-
Still work remains to be done in Africa { some parts of South Africa
1
. Documents What people die from around the globe
2 .
High income countries :
people die from chronic disease ( old age ) :
Cancer {
Cardiovascular disease ; very low infant
mortality ( table I )
3. LOW income Countries :
mortality rates much higher , people die of some
tropical diseases I malaria ) but preventable diseases dominate
4. LOW income countries :
mortality rates of children are
very high Compared to
high income countries
.
Asks :
-
Why should children die in poor countries when
they would not die
if they had been born in rich countries ?
-
What is it that prevents the
knowledge that is freely available and effective
from saving the lives of millions of people who die in the poor World ?
.
the facts from table I
suggest income poverty may be cause root ( untrue )
-
Figure 2 on China { India suggest growth might be a factor but patterns
are Complicated ( not direct correlation in short term )
.
Deaton argues income poverty 1 growth are not
key parts of
story
.
In figure 3 ,
shows a
relatively weak link blw decline in infant mortality
rates 4 economic growth in the long run
.
Certainly , poorer countries have less infrastructure that help reduce the
prevalence of certain types of diseases : sanitation ,
water ,
G pest control -
public health investments ( related to income )
.
Poorer countries spend very little on health -
Care systems
.
Deaton thinks a significant portion of poor performance on infant
mortality E other health systems
-
is poor management of public G private
health care systems in these countries
.
These stories he tells are ones of inefficiencies .
Still he acknowledges
that lack of resources is a problem
.
But his overall
message suggests that these inefficiencies need to be
resolved before additional health spending resources can be most
effectively used

Monetary Policy in Crisis :
countercyclical or stabilization policy
-
economy enters deep recession IAI ) ,
the Fed responds :
1. Policy 1 : lower federal funds rate to zero
lower
long term
2. Policy 2 :
expand balance sheet , buy longer
-
term debt securities → interest rates
3. Policy 3 :
forward guidance : Fed announce that Will keep interest rates low for a
long time
4. Fed reasoning :3
policy actions are very accomodative →
reducing interest rates will :
-
encourage increases in investment spending ( l )
-
encourage increases in consumption spending that is sensitive to interest rates ( C )
-
counteract the strengthening of the dollar
5. AS -
AD :
shift AD curve to the right
-
introduce alternative SRAS curve here
LRAS
P SRA So I .
Great Recession
5.
I
'
as
1111 ,
.•
' ' 1 ' • A Do to AD ,
B
=
Reason :
housing bust 1 stock market bust 1 loss in
= business confidence
= AD ,
A Do Cd ,
It ,
NXT ( dollar strengthens )
Y . Yo Y
Fed 's Action :
attempt to shift AD back to the
right
An aside in the shape of the SRAS
→
tentative shape of the SRAS → reflects the fact that
1
. Can add more labor when
economy is in recession →
big increase in Y ,
small
increase in P
2 .
When the economy is
ina boom ,
there are capacity limits to the production
→
big increase in P ,
smaller increase in Y
Fiscal Policy :
Countercyclical 1 stabilization Policy
AG →
government spending Pg Gp } shift AD
{ AT =
taxes and tax rates
right Affect AD

Multiplier G Crowding Out Effect
Exl :
AG by $1
See the impact on AD
[ Y +
I ] =
C + 1 + [6+1] +
NX
TG of $1 ,
T Y
by $1
Government multiplier → I
AS In G of 1
,
an TY of 1
AG = AY ( I for 1)
Ex 2 :
Multiplier > I
Y +
2 =
[ Ct 1 ] + I + [6+1] + NX
AG of $1 ,
YT by $2
AG < AY
Ex 3 :
Crowding Out ( complete )
Y =
( + [ I .
1
] +
[6+1] +
NX
In G by I ,
TI by 1 due to crowding out
LIGT $1 ,
a Y=O
government multiplier =
O
p
+ ag
Fiscal Policy
- TG ,
+ a G
→
.
If multiplier > I ,
then final AD is to the
right of AD ,
dulmutffiplier
.
AD
3
effect
ADZ
AD }
is the Case where
Crowding out is
strong
ADO AD ,
( government multiplier is less than 1 )
Y
P
LRAS
At Pt . A :
GT spending
)
RAS
P
,
B
+
AG
p
:
'
ii
'
ii.
'
•
' '
9
• c AD shifts right0
A =
.
Economy from A to B
=-
Gap blw A E C represents the AG
-
ADO AD
,
Yo Yi Y Economy goes to point B
Increase in price level →
increase in interest
rates
t investment
[ Y + .
S ] = ( + [ I -
.
S ] +
[ G + I ] + NX

Fiscal Policy :
Countercyclical or Stabilization Policy
.
fiscal policy involves the government changing spending (G) or taxes ( T ) in
response to current economic conditions
→
.
Changes in G or T affect AD : increase in G or a decrease in T shifts AD
.
Countercyclical fiscal
policy
:
changes in G or T that government takes to
shift AD in response to a recession
.
debate about whether actions generate multiplier effect

Fiscal da
Monetary Policy
Fiscal
Policy
:
Fiscal Multipliers Vs .
Crowding Out
P LRAS
SRASO
qg -7 Case I :
Start analysis in recession
÷
( left of LRAS )
A
'
B
A 's
A Do to AD ,
due to TG ; AD ,
to ADZ due
•
• AD 4
A Ab
to multiplier effect
Ado AD ,
Ah

Case 2 :
Start analysis in a boom'
ay
'
his
Y
period ( right Of LRAS )
start at A
'
:
AD } to ADA but note the Ll is
relatively small compared to
1.a fiscal multiplier above I implies that the fiscal expansion ( GT ) will increase GDP
by greater than the initial increase in fiscal expansion
.
the multiplier effect reflects a positive feedback blw the fiscal expansion →
increase in GDP ( Y ) → increase in household incomes → increase in consumption
.
size of the fiscal multiplier will vary depending on whether the
economy is in a
recession or boom ; also
vary whether the fiscal expansion is due to spending
or tax cuts
.
in a recession ,
firms can easily expand production
.
in a boom ,
it is harder for firms to raise production so increased gov't
spending is more likely to crowd out private spending
Fiscal Policy :
Crowding Out
P LRAS SRAS , 0
÷ Short Run
µras•
TG , economy goes from A to B ( already some
•
crowding out )
A
AD ,
long Run
ADO SRAS ← from 13 to C
Yo Y
Y = ( + 1 + G + NX
t T
as PT ,
interest rates T
In long run , crowding out is present

Fiscal Policy :
Crowding Out
.
2 ways to view this framework
.
Short run :
I .
GT ,
AT ,
MT ,
interest rates T
2 . As interest rates increase ,
It ,
so the increase in AD will not be as
large
The interest rate increase mutes the effect of the initial rise in G ( smaller
shift in A D)
.
long run :
I .
GT ,
AT ,
SRAT due to increases in nominal
wages and expected price levels
2. Y returns to LRAS level ,
but G is higher ,
so some other component of GDP
must be lower . Investment will be lower bk the
higher price level Will
result in higher interest rates .

Fiscal Policy :
Financial Crisis
.
During the financial crisis ( Feb 2009 ) , government passed a stimulus
package to
try to boost economic activity
.
American Recovery E Reinvestment Act CARRA ) :
increased G by $500 bit .
Cut taxes by $280 bit .
but increased G in 2009 by $120 bit .
Cut T in 2009 by $65 bit
.
Question : What Was the estimated effect of ARRA on GDP in 2009
-
2009 :
GDP grew at -2.8%
-
the gov't spending multiplier -
use a relatively large value of 1.5 ( bk similar to
Case 1)
-
tax multiplier -
use 1.0 -
upper
-
middle of usual
range
total effect of increased G in 2009 : 1.5 × $120 bit =
$180 bit Or 1.3% of GDP
-
total effect of cut in T in 2009 :
1.0 ×
$65 bit = $65 bit . or 0.5% of GDP
-
total effect of ARRA in 2009 :
increase GDP by 1 . 8 it
-
SO if no ARBA ,
GDP would have fallen by 4 . 6% as Opposed to the fall of
2. 8% that was observed
-
economists don't
agree on this number
Fiscal Policy :
Countercyclical
:
tax cuts vs .
gov't spending as fiscal stimulus
.
Once enacted ,
tax Cuts can have an immediate effect on spending
-
just
mailing checks -
but no guarantee individuals that receive tax cut will spend
.
government spending takes more time . Need to pick projects and assemble
needed resources
.
inefficiencies happen when gov its try to increase
spending quickly
-
Worry
about wasteful spending

LRAS
C
°
Pt A :
US economy at Start of 2018
µ
RAS
To
:B
fiscal policy g
t T ( tax cuts E jobs Act ( Dec 2017 ))
A -
TG (
spending bill :
ARRA
program )
I =
AD ,
↳ AD shift right
= =
Also Unemployment 1 in 201822019
Yo Y ,
Yz
interest Ms
rate
f
,
1 1 1 1 1
to 1 1 1 1
M ?
M to
q of money
Tax Reform Motivation
t corporate taxes
}
In incentives to make
t tax on work long term investments
p LRA So LRAS ,
→
If shift Out LRAS faster ,
this reflects an 9 economic growth
Overall economic pie T
Y
Monetary { Fiscal Policy :
Countercyclical Stabilization Policies
.
both types of policies are
trying to reduce problems associated wl the
business Cycle
-
especially unemployment during recessions
.
policy transmission varies across 2 types
:
-
Monetary policy can be implemented by Fed ( short inside lag ) but the effects
may take a
long time to impact economy ( long outside lag )
-
fiscal policy takes a
longer time to enact (
long inside lag ) but the effect can
be immediate , especially tax cuts ( short outside lag )

.
Stabilization is the idea that in recessions ,
fiscal & monetary policy
Should boost AD G in expansions ,
fiscal E monetary policy should constrain
Output growth ( try to keep the SR equilibriums close to LRAS curve )
WIO stabilization wl Stabilization
LRAS
§ if
.
a
key problem is that given the implementation lags in policy that occur E
the fact that economic models aren't great at forecasting ,
it is hard to
adopt policies that fine tune or stabilize the
economy
.
Critics of Stabilization policy
-
argue gov't should worry about long -
run policy
Creating a good environment for long term growth
.
short term policy is too difficult in practice .
Rather ,
allow the economy 's
natural equilibrating process to bring economy back toward equilibrium
.
In model speak : let SRAS curve adjust on its Own
.
automatic Stabilizers are fiscal policies that do not require legislative action
to
kick in when the
economy fluctuates
unemployment insurance -
if
unemployment increases then gov't
spending on
unemployment insurance payments will increase .
This will
help maintain spending of unemployed workers
2. tax code -
if the economy goes into recession ,
tax collections are Cut
-
acts as a tax cut
3 . Overall impact of such automatic stabilizers is not enough to stabilize the
economy
4. a role for
"
discretionary
"
fiscal G monetary policy is still in play

Inflation 4 Unemployment
.
Our model approach so far has focused on the relationship blw
Output E the price level
in reality , policymakers care more about inflation than price level
develop a model that links inflation to econ .
activity directly
.
Phillips Curve
Short Run View :
Relationship blw Inflation 4 Unemployment
P o
inflation
)sBAS rate
P,
1 11 1 1 11 ' • B ( IT ) B
P 1 1 1 1 1
•
= T
,
1 1 1 1 •
0
A
-
- =
A-
AD ,
-
To 1 1 1 1 1 1 s •
= I
ADO
-
-
PC L Phillip 's Curve )
1 1
YO Y ,
Y u ,
uo Unemploynfafnet
*
illustrating the potential tradeoffs blw inflation { unemployment

Phillips Curve : Inflation 4 Unemployment
.
The PC shows the short run tradeoff blw inflation { unemployment for
an economy
.
Along the PC ,
there is an inverse relationship blw inflation E
unemployment
.
a low unemployment economy experiences more inflation compared to a
high
Unemployment economy
.
the idea that low unemployment is linked directly to high AD .
High AD puts
upward pressure on
wages / prices
.
implication of PC was that policymakers could pick what type of economy
they wanted to be in -
high inflation low unemployment or low inflation
high unemployment
.
vertical LR PC bk neutrality of
money
inflation SR -
PC :
reflects the short run tradeoff
rate
it 1 1 11 , , •
A between
Unemployment G inflation
0
=
IT ,
I I 1 I 1 ,
T
| , • B
= -
÷ Uz Unemployment
Rate ( u )
LRPC
P LRAS IT
Uo -
natural rate of
>
•
B IT
,
-
• B'
Unemployment
Po 1 11 11 • A AD , to -
••
A
LRPC Is a Vertical 5 reflects
the fact that in the LR
ADO
, there is no tradeoff blw
Yo Y U ° U
U { IT
Shifts in SRPC
'
Shifts reflect how the model adjusts blw the short E long run
Two Main Shifters of SRPC
'
inflation expectations
.
cost 1
supply Shocks

Principles of Macroeconomics Notes

Principles of Macroeconomics Notes

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