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  • Notes and teaching tips: 6 ,8, 17, 19, 20, 28, 32, and 36.
    To view a full-screen figure during a class, click the red “expand” button.
    To return to the previous slide, click the red “shrink” button.
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  • Don’t skip the questions in a rush to get to the economic way of thinking. Open your students’ eyes to economics in the world around them. Ask them to bring a newspaper to class and to identify headlines that deal with stories about What, How, and For Whom. Use Economics in the News Today on your Parkin Web site for a current news item and for an archive of past items (with questions). Pose questions and be sure that the students appreciate that they will have a much better handle on questions like these when they’ve completed their economics course.
  • Talk about Adam Smith and the Wealth of Nations.
    Note that this book was the first systematic attempt to address this big question and that economists have been trying to answer it ever since.
    You might like to mention that several Nobel Prizes have been awarded to economists who have worked on the question including Ken Arrow, John Hicks, and Gerard Debreu, as well as John Nash of “Beautiful Mind” fame.
  • Notes and teaching tips: 5, 6, 17, 21, 37, 38, 41, 57, 58, and 62.
    To view a full-screen figure during a class, click the red “expand” button.
    To return to the previous slide, click the red “shrink” button.
    To advance to the next slide, click anywhere on the full screen figure.
    Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
    (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
    (2) Once or twice a semester, set an assignment, for credit, with the following instructions:
    (a) Find a news article about an economic topic that you find interesting.
    (b) Make a short bullet-list summary of the article.
    (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
    Use the Reading Between the Lines and Economics in the News features in your textbook as models.
  • You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2006, income per person in the United States was about $100 a day. In 1806 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2206 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $20 million!) Encourage a discussion of why scarcity is still present even at these large incomes.
    Be sure to cover the “Standard of Living Tradeoff” idea that the students met in Chapter 1 and that they can now think about with the more powerful tool of the PPF.
    If you wish, connect the discussion of efficiency with that of growth. Ask the students to explain what determines the efficient growth rate (not in text).
  • Classroom activity
    Check out Economics in Action: Hong Kong Catching Up to the United States
  • The gain from trade is a real eye-opener for students. Their first reaction is one of skepticism. Convincing students of the power of trade to raise living standards and the costs of trade restriction is one of the most productive things we will ever do.
    Here are some ideas to drive home the idea of comparative advantage:
    Why didn’t Billy Sunday do his own typing? Billy Sunday, an evangelist in the 1930s, was reputed to be the world’s fastest typist. Nonetheless, he employed a secretary who was a slower typist than he. Why? Because in one hour of preaching, Billy could raise several times the revenue that he could raise by typing for an hour. So Billy plays to his comparative advantage.
    Why doesn’t Martha Stewart bake her own bread? Martha Stewart is probably a better cook than most people, but she is an even better writer and TV performer on the subject of food. So Martha plays to her comparative advantage and writes about baking bread but buys her bread.
    Why doesn’t Vinnie Jones play soccer? Vinnie Jones is one of the world’s best soccer players (although now getting a bit old). But he stopped playing soccer and started making movies some years ago. Why? Because, as he once said, “You go to the bank more often when you’re in movies.” Vinnie’s comparative advantage turned out to be in acting.
    The costs of trade restrictions need to be driven home. The 2002 steel tariff increase and the EU response is a good story to use.
  • Classroom activity
    Check out Economics in the News: Energy Independence
  • The point of this short section is to lay the groundwork for the next chapter on demand and supply. You can cover it quickly or you can use it as a peg on which to hang a discussion of some of the big-picture of the underpinnings of our subject. Some examples follow:
    The “Invisible Hand”: How self-interested individuals promote prosperity for all. Explain that in economics, we take human nature as given (in contrast to political science, philosophy and some other fields) and assume that people are self-interested. Note if you wish that self-interest does not mean selfish.
    If everyone is self-interested, how are people encouraged to specialize and exchange to promote prosperity for all? Building on the Liz and Joe example in the chapter, you can explain how specialization and exchange achieves a higher standard of living that does self sufficiency. So self interest promotes specialization and exchange.
    But for specialization and exchange to work, people must be able to trade. That is why property rights and markets are so crucial.
    Property Rights and Markets: The key to promoting socially beneficial activity. To reap the gains from specialization, people need access to markets in which voluntary exchange can take place. Markets work only if property rights are established and enforced.
  • Notes and teaching tips: 5, 16, 27, 39, 45, 48, 52, 53, 55, and 56.
    To view a full-screen figure during a class, click the red “expand” button.
    To return to the previous slide, click the red “shrink” button.
    To advance to the next slide, click anywhere on the full screen figure.
    Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
    (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
    (2) Once or twice a semester, set an assignment, for credit, with the following instructions:
    (a) Find a news article about an economic topic that you find interesting.
    (b) Make a short bullet-list summary of the article.
    (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
    Use the Reading Between the Lines and Economics in the News features in your textbook as models.
  • The main challenge in teaching this topic is generating interest in it. Many teachers are bored by it and not surprisingly, they bore their students. If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy. It is vital because we use GDP as the basis of measurement of the standard of living, economic welfare, and making international comparisons.
    Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software.
    The BEA began a major revision in 1998 and published the first revisions to reclassify software from intermediate to final good status in 1999. And, when the 1996 GDP was recalculated to include software, it increased by $115 billion, or 1.5 percent of GDP.
  • Government transfer payments, such as Social Security payments, are not part of government expenditure because government expenditure includes only funds used by the government to buy goods and services. Transfer payments are not buying a good or service for the government and so are not included in government expenditures.
  • Little is spent on measuring U.S. GDP. You might like to tell your students that the U.S. government spends very little on the measurement of real GDP. The BEA (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of the nation’s production. For some further perspective, the National Oceanic and Atmospheric Administration (also in the Department of Commerce), whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion!
    Most of the income data used by BEA comes from IRS. Expenditure data comes from a variety of sources.
    You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted.
    First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?
  • Omissions from GDP. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP.
    Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Current Population Survey or the Consumer Expenditure Survey.
    The inclusion of the imputed rental of owner-occupied houses, but not owner-used cars and other durables, is a good example.
    You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?
  • The Importance of the Lucas Wedge It is usually straightforward to interest students in the business cycle. But it is perhaps a bit more difficult to motivate interest in economic growth and the Lucas wedge. Yet economic growth and the Lucas wedge should be of immense importance to young students because they help determine the long-run living standard of their lives. One way to make this point clear is to ask the students whether the difference between, say, 3 percent annual growth in income versus 4 percent annual growth is important.
    This difference probably does not sound important. But, suppose that the initial income was $35,000. After 10 years with growth of 3 percent a year, the income would be $47,037 and with growth of 4 percent a year, the income would be $51,809. This difference of about $4,500 might not seem like much. But point out to the students that this difference is for only ten years and that the annual difference will continue to enlarge: After 30 years with 3 percent growth, the income would be $84,954 and with 4 percent growth the income would be $113,519, a one year difference of about $40,000. And, over a 30-year working career, the total differences in income, which is the analog to the Lucas wedge, is approximately $420,000.
    Over a 40-year working career, the Lucas wedge difference is over $1,000,000! Viewed from this perspective, the seemingly slight 1 percentage point difference in growth rates makes for an incredibly major difference in incomes, which should easily capture your students’ attention.
  • The Business Cycle Students generally are interested in the topic of business cycles, particularly if the economy happens to be in a recession when this chapter is covered. Often it is very difficult to tell the future path of the economy. Stress to the students that it is not stupidity on the part of economists that prevents us from knowing where the economy is heading. Rather it is the fact that forecasting is difficult for at least two reasons.
    First, different sectors of the economy frequently send different signals. For instance, retail sales may be down, signaling a start to a recession, but housing starts may be up, indicating that an expansion will continue for a while.
    Second, the data that must be used always are at least a bit out-of-date. For example, the preliminary estimate of GDP is not made until approximately six weeks after the end of the quarter, and the final revision of GDP doesn’t appear until years later.
    Although economists’ forecasts are much better than those of others, forecasting GDP with complete accuracy is unlikely. Conclude by mentioning that this fact is important in later chapters when we discuss implementation of countercyclical policies.
  • International comparisons and PPP prices. Students sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and students often ask how people can live on such low incomes.
    Point out that the estimate is biased downward in two ways.
    First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people ride a bus or subway and pay a fare, which is counted as part of GDP.
    Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs $20 in New York might cost $1 in Calcutta. (You might get a better haircut in New York, but probably not one that is 20 times better!) Converting Indian GDP into U.S. dollars at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into U.S. dollars avoids this bias.
  • The difference in the two sets of numbers is astonishingly large and makes a dramatic difference to how we view the balance of economic power over the next 25 years.
    At current growth rates and market exchange rates, by 2020, China will have a GDP around a quarter that of the United States.
    At current growth rates and PPP exchange rates, by 2020, China’s real GDP will exceed that of the United States.
    Per person, China in 2020 will still have a long way to go to catch the United States. But China’s economy will be the world’s largest.
  • Omissions from GDP. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP.
    Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Current Population Survey or the Consumer Expenditure Survey.
    The inclusion of the imputed rental of owner-occupied houses, but not owner-used cars and other durables, is a good example.
    You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?
    Classroom activity
    Check out At Issue: Should GNNP Replace GDP?
  • Notes and teaching tips: 5, 9, 10, 27, 34, 40, 44, and 54.
    To view a full-screen figure during a class, click the red “expand” button.
    To return to the previous slide, click the red “shrink” button.
    To advance to the next slide, click anywhere on the full screen figure.
    Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
    (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
    (2) Once or twice a semester, set an assignment, for credit, with the following instructions:
    (a) Find a news article about an economic topic that you find interesting.
    (b) Make a short bullet-list summary of the article.
    (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
    Use the Reading Between the Lines and Economics in the News features in your textbook as models.
  • Positive versus normative. Unemployment is an emotionally charged subject and is a good one for reinforcing the important point that economics is positive in contrast to normative. The economist’s job is to try to explain why unemployment exists, what determines its rate, and assess the efficient amount of unemployment.
    The benefits of unemployment. It comes as a shock to most students that unemployment has benefits as well as costs and that there is an efficient amount of unemployment that is greater than zero. (Note that this statement is positive!) You might like to spend a bit of class time on this topic. If you do, here are some ideas about what to do:
    A good way to introduce the idea that unemployment brings benefits is to think about the unemployment of things rather than people. Look around the campus and notice all the unemployed automobiles in the parking lots/stations. Notice the unemployed class rooms early in the morning and late at night. Notice the unemployed coffee shop seats at peak lecture times. Look around the city and notice all the unemployed automobiles in the car sales lots. Try to make a reservation at any of the hotels in the city and notice that you can almost always get a room—hence, lots of unemployed hotel rooms.
    [Continued on the note for the next slide.]
  • Identifying frictional, structural, and cyclical unemployment. Ask your class if anyone they know has been laid off. Then discuss whether losing a job creates frictional, structural, or cyclical unemployment. Look at your local examples. If you live in a steel-producing area, for example, you can talk about local structural unemployment arising from the closing of a steel manufacturer due to international competition. For cyclical unemployment, ask students how they think the business cycle and cyclical unemployment is related to full-time enrollments at higher education institutions. Students often don’t think there is any relationship. But nationally during a recession, the growth rate of full-time enrollments increases. Ask students if they can explain this relationship. The answer is that during a recession and due to the increase in cyclical unemployment, the opportunity cost of school decreases. This is a great way to keep students thinking about marginal benefits and costs.
  • Classroom activity
    Check out Economics in Action: Cyclical and Structural Unemployment in Michigan
  • The CPI—an average. It is important for students to understand that the CPI is based on the average expenditure basket, not the expenditure pattern of any given household. Displaying the detailed press releases on the BLS Web site helps make this point very forcibly: students often do not realize until they see the numbers that the CPI must include both costs of owning a house and costs of renting one; costs of buying a car and costs of public transportation; and so on.
  • Notes and teaching tips: 12, 18, 20, 34, 45, 46, 47, 48, 50, 51, 52, 56, 63, and 64.
    To view a full-screen figure during a class, click the red “expand” button.
    To return to the previous slide, click the red “shrink” button.
    To advance to the next slide, click anywhere on the full screen figure.
    Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
    (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
    (2) Once or twice a semester, set an assignment, for credit, with the following instructions:
    (a) Find a news article about an economic topic that you find interesting.
    (b) Make a short bullet-list summary of the article.
    (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
    Use the Reading Between the Lines and Economics in the News features in your textbook as models.
  • Compound Interest You can reinforce the importance of economic growth by relating the fact that if real GDP per person had grown just 0.25 percentage points faster between 1960 and the present, every household today, on average, would have almost $12,000 more income (every person would have $4,500 more). If real GDP per person had grown 1 percentage point faster between 1960 and the present, every household today, on average, would have $50,000 more income (every person would have $21,200 more).To make concrete just how much better off we would have been, get the students to list what they would buy with an extra $21,200 a year.
  • Classroom activity
    Check out Economics in Action: Women Are the Better Borrowers
  • Classroom activity
    Check out Economics in Action: Intellectual Property Rights Propel Growth
    Check out Economics in the News: Robots as Skilled Workers
  • Interactions of sources of growth. Most students can see immediately how investment in physical and human capital in the form of education and training contribute to growth. Some have more difficulty getting a clear view of the role of learning by doing and technological change, particularly the small continuous refinement and improvement to existing technology rather than the spectacular breakthroughs. Much growth probably comes from the interaction of the last two, and this source of growth can be illustrated with a discussion of why firms offer incentives to workers to suggest improvements to working methods and procedures.
  • Historical development of theories and an aside. The three growth theories studied in this chapter—classical, neoclassical, and new—are presented in historical order. Point out this fact to the students to emphasize and illustrate how economic theory builds on itself. (An aside for you, not your students: Note that the chapter skips the Keynesian era Harrod-Domar model. The main reason for this omission is that these models were quickly shown to be in error and never formed the basis of a seriously proposed growth theory. Based on fixed coefficients and fixed saving rates, the Harrod-Domar model produces either secular stagnation or secular inflation. Neither phenomenon occurs in real economies. Solow’s neoclassical model was developed, historically, to show the error of the Harrod-Domar model, but the neoclassical model also builds naturally on its classical predecessor, and that is the sequence in the textbook.)
    Classical theory. Start with the classical theory. The classical theory of growth takes technological change as exogenous, essentially ignores the role of capital (as a result of the era in which it was developed), and assumes that population growth increases when income increases (also as a result of the era in which it was developed). As a result, the conclusions from the classical theory are “dismal” indeed! Some students find it interesting to know that Thomas Malthus, most closely associated with the population part of this theory, was a clergyman, but was also the first person in the Anglophone world to hold the title of Professor of Political Economy (at the East India College). Economists came to realize that capital accumulation and technological change were important parts of the growth process. They also came to understand that population growth does not necessarily increase with income. Hence the stage was set for the neoclassical theory.
  • Neoclassical theory. Neoclassical theory follows the classical theory by taking technological growth as exogenous. It differs insofar as it assumes that population growth is also exogenous. The major difference is that neoclassical theory stresses the role played by technological change and how it influences saving and capital accumulation. So of the two differences between neoclassical and classical growth theory, the first—the different assumptions about how population growth is determined—reflects an advance in empirical knowledge of the relationship between population growth and income. The second difference—the importance given to technological change, saving, and capital—shows how the neoclassical theory built on the simpler classical model.
  • New growth theory. Neoclassical theory also is incomplete because the primary engine of economic growth, technology, is exogenous. New growth theory attempts to overcome this weakness. It still uses many of the insights of the neoclassical theory by emphasizing the role of capital accumulation and assuming that population growth is exogenous. But the new growth theory builds on neoclassical theory by examining more closely the role of technology and the factors that influence technological advances.
    Giving the students this type of broad overview before presenting the details of the different models is important because it, along with the text’s outstanding overview, allows the students to see the forest as well as the trees. This knowledge not only helps them understand the particular models, but it also helps them gain an appreciation of how economics progresses. (Of course, progress is hardly as steady as the students might believe; for instance, Pigou and Ramsey presented important papers about growth in the early part of the twentieth century, but, nonetheless, progress has been made.)
  • Achieving faster growth. Policies to promote growth can generate interesting and useful discussion. For example, it is investment that produces growth, and in the previous chapter we showed that investment does not depend on private saving alone. Is it appropriate then to stimulate private saving artificially? Similarly, the arguments for subsidizing research and development and education are both based on public good aspects of those activities, but what form and extent should subsidies take?
    Why the Luddites were wrong. This chapter provides you with a wonderful opportunity to explain to your students why the Luddites were wrong—and why the modern neo-Luddite movement is wrong. You can learn more than you need to know about Luddism and the Luddites, ancient and modern, at http://carbon.cudenver.edu/~mryder/itc_data/luddite.html
    You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces. But it increases the demand for other types of labor—complementary labor. People must acquire more skill—some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on. All of these people are more productive that they were before.
  • New technologies that create new products have even more obvious effects on productivity. The development of the CD in the early 1980s is a good example. Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs. The same type of thing is now happening with the DVD and Blu-ray.
  • Notes and teaching tips: 6, 7, 12, 14, 18, 35, 37, and 50.
    To view a full-screen figure during a class, click the red “expand” button.
    To return to the previous slide, click the red “shrink” button.
    To advance to the next slide, click anywhere on the full screen figure.
    Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
    (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
    (2) Once or twice a semester, set an assignment, for credit, with the following instructions:
    (a) Find a news article about an economic topic that you find interesting.
    (b) Make a short bullet-list summary of the article.
    (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
    Use the Reading Between the Lines and Economics in the News features in your textbook as models.
  • Definitions and the meaning of investment in economics. The student has met the key definitions of investment in this chapter, but to be absolutely sure that they are remembered it is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting these matters clear right from the start.
  • A concrete understanding of stock and flow variables is an important building block to understanding economic principles. You can use “buckets” to convey the relationship between stock and flow variables. Buckets are easy to draw along with a simple faucet and hole in the bucket. You can use this illustration to show how the stock changes over time due to the inflow and outflow of material into the bucket. You can extend the use of buckets to any stock/flow concept like wealth or other resources.
  • Financial Crisis: The fall of 2008 saw the biggest financial crisis since the Great Depression. Essentially securities, such as mortgage-backed securities, lost value and many financial institutions became insolvent. These institutions, such as Fannie Mae, Freddie Mac, Bear Sterns, AIG, and others were considered “too large” to fail. While you cannot fully explain the reasons why failure of a large financial institution might have external costs, your students can readily appreciate the point that if these institutions failed many borrowers would find it significantly more costly to arrange loans. The government acted in most all of these cases by arranging a bailout in one form or another. Some companies were given government loans (AIG received an $85 billion loan from the Fed); others were taken into government oversight (Fannie Mae and Freddie Mac); others were merged into healthier companies, albeit with government assistance (Bear Sterns); a few were allowed to fail (Lehman Brothers).Even beyond these events, most financial institutions were given government assistance in the form of government loans and/or government purchase of stock.
    Classroom activity
    Check out Economics in Action: The Financial Crisis and the Fix
  • It is helpful to show explicitly how the market price of a bond is determined by the current interest rate. Using an example of a government bond will be useful for future chapters on monetary and fiscal policy. Explain that a bond is an “IOU” from the issuer and its basic components are its term, face value and coupon payment. For example, a bond might have a $10,000 face value with a coupon payment of $500 for the next 5 years. Point out to your students that this coupon payment means that the bond is essentially paying an interest rate of 5 percent for the next five years…at least as long as its price is $10,000. Explain how the bond can be traded in the secondary market and ask them what they think the bond’s price would be if the market interest rate rose to 6 percent. Make clear that when the interest rate rises to 6 percent, that means that “new” government bonds with a $10,000 face value will sell for $10,000 and will pay a $600 coupon payment. Your students should be able to see that the “old” bond must be worth less than the new bond because the old bond has a smaller coupon payment. Tell your students that while it is possible to determine the precise price for which the old bond will trade, your key point is that the price has fallen from $10,000 to something less. In other words, an increase in the interest rate has lowered the price of (old) bonds!
  • Real versus nominal interest rate. To drive home the distinction between the nominal interest rate and real interest rate, ask your class if an interest rate of 10 percent is high. Almost assuredly they will respond with a resounding “Yes.” Point out to them that around 1980 a 10 percent interest rate was exceedingly low. At the time a typical interest rate was between 12 percent and 17 percent, depending on the riskiness of the asset and the length of the loan. What accounts for the difference between then and now? The answer is simple: inflation. In 1980 the inflation rate was running at more than 10 percent per year. Given the high inflation rate, the nominal interest rate adjusted so that it, too, was high. Most of the dollars lenders received as (nominal) interest went to keeping their purchasing power intact. But the real interest rate at that time was not much different than the real interest rate nowadays. In other words, the increase in purchasing power received by lenders (the real interest rate) in the 1980s was about the same as the increase in purchasing power received by lenders today.
  • Take advantage of this model to highlight the effect of the deficit. Whether you draw it on the board or use a laser pointer, track the increase in the real interest rate and the decrease moving along the PDLF curve. Mention that crowding out decreases the capital stock because of the decrease in investment.
  • Classroom activity
    Check out Economics in Action: Greenspan’s Interest Rate Puzzle
  • Notes and teaching tips: 5, 8, 9, 14, 18, 22, 24, 30, 35, 47, 48, 68, 70, and 71.
    To view a full-screen figure during a class, click the red “expand” button.
    To return to the previous slide, click the red “shrink” button.
    To advance to the next slide, click anywhere on the full screen figure.
    Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
    (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
    (2) Once or twice a semester, set an assignment, for credit, with the following instructions:
    (a) Find a news article about an economic topic that you find interesting.
    (b) Make a short bullet-list summary of the article.
    (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
    Use the Reading Between the Lines and Economics in the News features in your textbook as models.
  • Fiat money. To get across the idea of money, take a colored piece of paper and cut it to the same size as a $20 bill. Then take the paper into class along with a $20 bill. Ask the students why one piece of paper has value and the other does not. Is there anything intrinsically more valuable about the $20 bill? If not, why won’t someone in class exchange his or her old wrinkled piece of Federal Reserve paper with writing on it for the nice new piece you offer?
    The contrast between money in economics and money in everyday language. It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in every day language. For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why.
    A picky point. The textbook is careful in its use of the terms “quantity of money” and “money supply”. The money supply is the relationship between the quantity of money supplied and the interest rate, other things remaining the same. It parallels the demand for money. Although this point might seem picky, you can help your students by using this same language convention. Everyday usage over uses the term “money supply.”
  • Get the class involved in figuring out what money is. To involve the students in the process of determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards. The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you can poke fun at some of the suggestions. (Point out that students rarely pay for books by giving the bookstore shares of Bombardier stock and asking for change in BCE stock.) By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is.
  • Students usually have bank accounts, but often they have never fully thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice chartered banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students.
  • Classroom activity
    Check out At Issue: The Volcker Rule
  • Classroom activity
    Check out Economics in Action: The Fed’s Balance Sheet Explodes
    Check out Economics in the News: A Massive Open Market Operation
  • Classroom activity
    Check out Economics in Action: The Variable Money Multipliers
  • It is worth reminding students that “money” has a jargon sense in economics; students are often confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public want to hold in the particular form “money.” Students often try to understand ideas in terms of their own lives; few will make a clear connection between interest rates and demand for money from their own introspection. There are two ways to overcome this: one is to ask them to think in terms of extreme situations (get what short-term interest rates are in a high-inflation country); the other is to get them to imagine themselves in the job of treasurer of a corporation with large liquid resources, and to think how their behavior with respect to those funds might differ according to the short-term interest rates available.
  • Velocity of circulation. Emphasize that velocity is defined by the equation V = PY/M, and is not the average number of times a given piece of paper changes hands in a year. Nor is V the transactions velocity because most transactions are not payments for goods and services. (Transactions are twice PY because they also include payments for the services of factors of production, which equals PY, plus all the purely financial transactions such as buying and selling stocks, bonds, foreign currency, and real estate.)
    The quantity theory of money. Given that V is defined as PY/M, the equation of exchange, MV = PY is an identity. The quantity theory is not the equation of exchange but the propositions that (1) V is independent of M and (2) Y equals potential GDP, which is independent of M. Given these assumptions, the inflation rate equals the growth rate of the quantity of money.
    The quantity theory of hyperinflation. A possible exercise is to ask students whether we would expect the correlation between money growth and inflation to remain strong in a hyperinflation. Most will see that in a hyperinflation, velocity will increase. Emphasize that the level of velocity is greater in hyperinflation but if the inflation rate remains constant (and high) velocity also is constant (and high), so the quantity theory still holds. It does not hold in the move from low inflation to high inflation. The inflation rate overshoots the growth rate of the quantity of money.
  • Classroom activity
    Check out Economics in Action: Does the Quantity Theory Work?
  • A money creation experiment. The process through which banks “create money” can be a dark and mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused. The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance.
    Mark Rush (our U.S. study guide author and supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money”). Label this piece of paper a “$100 bill.” In class use one of the students by handing him the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has excess reserves of $90. Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound—coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row. Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will clearly see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.”
  • Notes and teaching tips: 5, 6, 8, 35, 37, 38, 49, 50, 51, 56, and 59.
    To view a full-screen figure during a class, click the red “expand” button.
    To return to the previous slide, click the red “shrink” button.
    To advance to the next slide, click anywhere on the full screen figure.
    Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
    (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
    (2) Once or twice a semester, set an assignment, for credit, with the following instructions:
    (a) Find a news article about an economic topic that you find interesting.
    (b) Make a short bullet-list summary of the article.
    (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
    Use the Reading Between the Lines and Economics in the News features in your textbook as models.
  • Exchange rates: Exchange rates are always somewhat confusing. The problem is that there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S. dollar (120 yen per U.S. dollar) or as U.S. dollars per unit of foreign currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the textbook is consistent in using the exchange rate as the units of foreign currency per U.S. dollar, stick to the “120 yen per dollar” format in your lectures.
  • Classroom activity
    Check out Economics in Action: The Dollar on a Roller Coaster
  • Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity.
    One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans.
    Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person (or organization) that acts as if it can beat the market.
  • Purchasing Power Parity. You can easily get your students to test purchasing power parity. Have them check the prices of some well-known titles at amazon.com, amazon.ca, and amazon.co.uk,. Get the latest exchange rate for the U.S. dollar against the Canadian dollar and the U.K. pound, and see whether it is cheaper to buy a given title in the United States, Canada, or the United Kingdom.
    If one U.S. dollar exchanges for 1.33 Canadian dollars, then purchasing power parity is attained when one U.S. dollar buys the same quantity of goods and services in the United States as 1.33 Canadian dollars buys in Canada.
    If one U.S. dollar buys more goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually appreciate.
    Similarly, if one U.S. dollar buys less goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually depreciate.
    The Economist reports a Big Mac Index that uses the prices of McDonald’s Big Macs and purchasing power parity to make predictions about exchange rate movements. The index is somewhat tongue-in-cheek as it would be hard to arbitrage differences in Big Mac prices by taking a Big Mac on a plane from, say, Japan to the United States. However, it is easier to arbitrage the inputs into Big Macs such as beef. Thus, one might still expect some convergence of Big Mac prices over time. The Economist claims some success in its exchange rate predictions.
  • Classroom activity
    Check out Economics in Action: The People’s Bank of China in the Foreign Exchange Market
  • Classroom activity
    Check out Economics in Action: Three Decades of Deficits
  • The analogy of a country being like an individual in being a borrower or lender is revealing. When Polonius tells Laertes to “neither a lender nor a borrower be” in Hamlet, he is the voice of prudence. But, perhaps, it is too much prudence. Much economic activity and development would be impossible without borrowing and lending. This is true at the individual level and for countries. The United States financed its industrialization and railroads in the nineteenth century by being a debtor nation.
  • Macro

    1. 1. 1 WHAT IS ECONOMICS?
    2. 2. Two Big Economic Questions Two big questions summarize the scope of economics:  How do choices end up determining what, how, and for whom goods and services get produced?  When do choices made in the pursuit of self-interest also promote the social interest? © 2014 Pearson Addison-Wesley
    3. 3. Two Big Economic Questions What, How, and For Whom? Goods and services are the objects that people value and produce to satisfy human wants. What? Agriculture accounts for less than 1 percent of total U.S. production, manufactured goods for 22 percent, and services for 77 percent. In China, agriculture accounts for 11 percent of total production, manufactured goods for 47 percent, and services for 43 percent. © 2014 Pearson Addison-Wesley
    4. 4. Two Big Economic Questions Figure 1.1 shows these numbers for the United States and China. It also shows the numbers for Brazil. What determines these patterns of production? How do choices end up determining the quantity of each item produced in the United States and around the world? © 2014 Pearson Addison-Wesley
    5. 5. Two Big Economic Questions How? Goods and services are produced by using productive resources that economists call factors of production. Factors of production are grouped into four categories:  Land  Labor  Capital  Entrepreneurship © 2014 Pearson Addison-Wesley
    6. 6. Two Big Economic Questions The “gifts of nature” that we use to produce goods and services are land. The work time and work effort that people devote to producing goods and services is labor. The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, on-the-job training, and work experience. The tools, instruments, machines, buildings, and other constructions that businesses use to produce goods and services are capital. The human resource that organizes land, labor, and capital is entrepreneurship. © 2014 Pearson Addison-Wesley
    7. 7. Two Big Economic Questions Self-Interest You make choices that are in your self-interest—choices that you think are best for you. Social Interest Choices that are best for society as a whole are said to be in the social interest. Social interest has two dimensions: Efficiency Equity © 2014 Pearson Addison-Wesley
    8. 8. Two Big Economic Questions Efficiency and Social Interest Resource use is efficient if it is not possible to make someone better off without making someone else worse off. Equity is fairness, but economists have a variety of views about what is fair. Fair Shares and Social Interest The idea that the social interest requires “fair shares” is a deeply held one. But what is fair? © 2014 Pearson Addison-Wesley
    9. 9. Two Big Economic Questions Globalization Globalization means the expansion of international trade, borrowing and lending, and investment. Globalization is in the self-interest of consumers who buy low-cost imported goods and services. Globalization is also in the self-interest of the multinational firms that produce in low-cost regions and sell in high-price regions. But is globalization in the self-interest of low-wage workers in other countries and U.S. firms that can’t compete with low-cost imports? Is globalization in the social interest? © 2014 Pearson Addison-Wesley
    10. 10. Two Big Economic Questions The Information-Age Monopolies The technological change of the past forty years has been called the Information Revolution. The information revolution has clearly served your selfinterest: It has provided your cell-phone, laptop, loads of handy applications, and the Internet. It has also served the self-interest of Bill Gates of Microsoft and Gordon Moore of Intel, both of whom have seen their wealth soar. But did the information revolution serve the social interest? © 2014 Pearson Addison-Wesley
    11. 11. Two Big Economic Questions Climate Change Climate change is a huge political issue today. Every serious political leader is acutely aware of the problem and of the popularity of having proposals that might lower carbon emissions. Burning fossil fuels to generate electricity and to power airplanes, automobiles, and trucks pours a staggering 28 billion tons—4 tons per person—of carbon dioxide into the atmosphere each year. © 2014 Pearson Addison-Wesley
    12. 12. Two Big Economic Questions Every day, when you make self-interested choices to use electricity and gasoline, you contribute to carbon emissions. You leave your carbon footprint. You can lessen your carbon footprint by walking, riding a bike, taking a cold shower, or planting a tree. But can each one of us be relied upon to make decisions that affect the Earth’s carbon-dioxide concentration in the social interest? Can governments change the incentives we face so that our self-interested choices are also in the social interest? © 2014 Pearson Addison-Wesley
    13. 13. Economics: A Social Science and Policy Tool Economist as Social Scientist Economists distinguish between two types of statement:  Positive statements  Normative statements A positive statement can be tested by checking it against facts. A normative statement expresses an opinion and cannot be tested. © 2014 Pearson Addison-Wesley
    14. 14. Economics: A Social Science and Policy Tool A model is tested by comparing its predictions with the facts. But testing an economic model is difficult, so economists also use  Natural experiments  Statistical investigations  Economic experiments © 2014 Pearson Addison-Wesley
    15. 15. © 2014 Pearson Addison-Wesley 2 The Economic Problem
    16. 16. Production Possibilities and Opportunity Cost Any point on the frontier such as E and any point inside the PPF such as Z are attainable. Points outside the PPF are unattainable. © 2014 Pearson Addison-Wesley
    17. 17. Production Possibilities and Opportunity Cost Production Efficiency We achieve production efficiency if we cannot produce more of one good without producing less of some other good. Points on the frontier are efficient. © 2014 Pearson Addison-Wesley
    18. 18. Using Resources Efficiently All the points along the PPF are efficient. To determine which of the alternative efficient quantities to produce, we compare costs and benefits. The PPF and Marginal Cost The PPF determines opportunity cost. The marginal cost of a good or service is the opportunity cost of producing one more unit of it. © 2014 Pearson Addison-Wesley
    19. 19. Using Resources Efficiently Figure 2.2 illustrates the marginal cost of a pizza. As we move along the PPF, the opportunity cost of a pizza increases. The opportunity cost of producing one more pizza is the marginal cost of a pizza. © 2014 Pearson Addison-Wesley
    20. 20. Economic Growth The expansion of production possibilities—an increase in the standard of living—is called economic growth. Two key factors influence economic growth:  Technological change  Capital accumulation Technological change is the development of new goods and of better ways of producing goods and services. Capital accumulation is the growth of capital resources, which includes human capital. © 2014 Pearson Addison-Wesley
    21. 21. Economic Growth The Cost of Economic Growth To use resources in research and development and to produce new capital, we must decrease our production of consumption goods and services. So economic growth is not free. The opportunity cost of economic growth is less current consumption. © 2014 Pearson Addison-Wesley
    22. 22. Economic Growth Figure 2.5 illustrates the tradeoff we face. We can produce pizzas or pizza ovens along PPF0. By using some resources to produce pizza ovens today, the PPF shifts outward in the future. © 2014 Pearson Addison-Wesley
    23. 23. Gains from Trade Comparative Advantage and Absolute Advantage A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. A person has an absolute advantage if that person is more productive than others. Absolute advantage involves comparing productivities while comparative advantage involves comparing opportunity costs. Let’s look at Liz and Joe who operate smoothie bars. © 2014 Pearson Addison-Wesley
    24. 24. Gains from Trade Liz's Smoothie Bar In an hour, Liz can produce 30 smoothies or 30 salads. Liz's opportunity cost of producing 1 smoothie is 1 salad. Liz's opportunity cost of producing 1 salad is 1 smoothie. Liz’s customers buy salads and smoothies in equal number, so she produces 15 smoothies and 15 salads an hour. © 2014 Pearson Addison-Wesley
    25. 25. Gains from Trade Joe's Smoothie Bar In an hour, Joe can produce 6 smoothies or 30 salads. Joe's opportunity cost of producing 1 smoothie is 5 salads. Joe's opportunity cost of producing 1 salad is 1/5 smoothie. Joe spends 10 minutes making salads and 50 minutes making smoothies, so he produces 5 smoothies and 5 salads an hour. © 2014 Pearson Addison-Wesley
    26. 26. Gains from Trade Liz’s Comparative Advantage Liz’s opportunity cost of a smoothie is 1 salad. Joe’s opportunity cost of a smoothie is 5 salads. Liz’s opportunity cost of a smoothie is less than Joe’s. So Liz has a comparative advantage in producing smoothies. © 2014 Pearson Addison-Wesley
    27. 27. Gains from Trade Joe’s Comparative Advantage Joe’s opportunity cost of a salad is 1/5 smoothie. Liz’s opportunity cost of a salad is 1 smoothie. Joe’s opportunity cost of a salad is less than Liz’s. So Joe has a comparative advantage in producing salads. © 2014 Pearson Addison-Wesley
    28. 28. Gains from Trade Achieving the Gains from Trade Liz and Joe produce the good in which they have a comparative advantage:  Liz produces 30 smoothies and 0 salads.  Joe produces 30 salads and 0 smoothies. © 2014 Pearson Addison-Wesley
    29. 29. Gains from Trade Liz and Joe trade:  Liz sells Joe 10 smoothies and buys 20 salads.  Joe sells Liz 20 salads and buys 10 smoothies. After trade: Liz has 20 smoothies and 20 salads. Joe has 10 smoothies and 10 salads. © 2014 Pearson Addison-Wesley
    30. 30. Gains from Trade Gains from trade:  Liz gains 5 smoothies and 5 salads an hour  Joe gains 5 smoothies and 5 salads an hour © 2014 Pearson Addison-Wesley
    31. 31. Gains from Trade Figure 2.6 shows the gains from trade. Joe initially produces at point A on his PPF. Liz initially produces at point A on her PPF. © 2014 Pearson Addison-Wesley
    32. 32. Gains from Trade Joe’s opportunity cost of producing a salad is less than Liz’s. So Joe has a comparative advantage in producing salad. © 2014 Pearson Addison-Wesley
    33. 33. Gains from Trade Liz’s opportunity cost of producing a smoothie is less than Joe’s. So Liz has a comparative advantage in producing smoothies. © 2014 Pearson Addison-Wesley
    34. 34. Gains from Trade Joe specializes in producing salad and he produces 30 salads an hour at point B on his PPF. © 2014 Pearson Addison-Wesley
    35. 35. Gains from Trade Liz specializes in producing smoothies and produces 30 smoothies an hour at point B on her PPF. © 2014 Pearson Addison-Wesley
    36. 36. Gains from Trade They trade salads for smoothies along the red “Trade line.” The price of a salad is 2 smoothies or the price of a smoothie is ½ of a salad. © 2014 Pearson Addison-Wesley
    37. 37. Gains from Trade Joe buys smoothies from Liz and moves to point C—a point outside his PPF. Liz buys salads from Joe and moves to point C—a point outside her PPF. © 2014 Pearson Addison-Wesley
    38. 38. Economic Coordination To reap the gains from trade, the choices of individuals must be coordinated. To make coordination work, four complimentary social institutions have evolved over the centuries:  Firms  Markets  Property rights  Money © 2014 Pearson Addison-Wesley
    39. 39. Economic Coordination A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services. A market is any arrangement that enables buyers and sellers to get information and do business with each other. Property rights are the social arrangements that govern ownership, use, and disposal of resources, goods or services. Money is any commodity or token that is generally acceptable as a means of payment. © 2014 Pearson Addison-Wesley
    40. 40. 4 © 2014 Pearson Addison-Wesley MEASURING GDP AND
    41. 41. Gross Domestic Product GDP Defined GDP or gross domestic product is the market value of all final goods and services produced in a country in a given time period. This definition has four parts: Market value Final goods and services Produced within a country In a given time period © 2014 Pearson Addison-Wesley
    42. 42. Gross Domestic Product GDP and the Circular Flow of Expenditure and Income GDP measures the value of production, which also equals total expenditure on final goods and total income. The equality of income and value of production shows the link between productivity and living standards. The circular flow diagram in Figure 4.1 illustrates the equality of income and expenditure. © 2014 Pearson Addison-Wesley
    43. 43. Gross Domestic Product Households and Firms Households sell and firms buy the services of labor, capital, and land in factor markets. For these factor services, firms pay income to households: wages for labor services, interest for the use of capital, and rent for the use of land. A fourth factor of production, entrepreneurship, receives profit. In the figure, the blue flow, Y, shows total income paid by firms to households. © 2014 Pearson Addison-Wesley
    44. 44. Gross Domestic Product © 2014 Pearson Addison-Wesley
    45. 45. Gross Domestic Product Firms sell and households buy consumer goods and services in the goods market. Consumption expenditure is the total payment for consumer goods and services, shown by the red flow labeled C . Firms buy and sell new capital equipment in the goods market and put unsold output into inventory. The purchase of new plant, equipment, and buildings and the additions to inventories are investment, shown by the red flow labeled I. © 2014 Pearson Addison-Wesley
    46. 46. Gross Domestic Product © 2014 Pearson Addison-Wesley
    47. 47. Gross Domestic Product Governments Governments buy goods and services from firms and their expenditure on goods and services is called government expenditure. Government expenditure is shown as the red flow G. Governments finance their expenditure with taxes and pay financial transfers to households, such as unemployment benefits, and pay subsidies to firms. These financial transfers are not part of the circular flow of expenditure and income. © 2014 Pearson Addison-Wesley
    48. 48. Gross Domestic Product © 2014 Pearson Addison-Wesley
    49. 49. Gross Domestic Product Rest of the World Firms in the United States sell goods and services to the rest of the world—exports—and buy goods and services from the rest of the world—imports. The value of exports (X ) minus the value of imports (M) is called net exports, the red flow (X – M). If net exports are positive, the net flow of goods and services is from U.S. firms to the rest of the world. If net exports are negative, the net flow of goods and services is from the rest of the world to U.S. firms. © 2014 Pearson Addison-Wesley
    50. 50. Gross Domestic Product © 2014 Pearson Addison-Wesley
    51. 51. Gross Domestic Product The circular flow shows two ways of measuring GDP. GDP Equals Expenditure Equals Income Total expenditure on final goods and services equals GDP. GDP = C + I + G + X – M. Aggregate income equals the total amount paid for the use of factors of production: wages, interest, rent, and profit. Firms pay out all their receipts from the sale of final goods, so income equals expenditure, Y = C + I + G + (X – M). © 2014 Pearson Addison-Wesley
    52. 52. Gross Domestic Product Why “Domestic” and Why “Gross”? Domestic Domestic product is production within a country. It contrasts with national product, which is the value of goods and services produced anywhere in the world by the residents of a nation. Gross Gross means before deducting the depreciation of capital. The opposite of gross is net, which means after deducting the depreciation of capital. © 2014 Pearson Addison-Wesley
    53. 53. Gross Domestic Product Depreciation is the decrease in the value of a firm’s capital that results from wear and tear and obsolescence. Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital. Net investment is the increase in the value of the firm’s capital. Net investment = Gross investment − Depreciation. © 2014 Pearson Addison-Wesley
    54. 54. Gross Domestic Product Gross investment is one of the expenditures included in the expenditure approach to measuring GDP. So total product is a gross measure. Gross profit, which is a firm’s profit before subtracting depreciation, is one of the incomes included in the income approach to measuring GDP. So total product is a gross measure. © 2014 Pearson Addison-Wesley
    55. 55. Measuring U.S. GDP The Bureau of Economic Analysis uses two approaches to measure GDP:  The expenditure approach  The income approach © 2014 Pearson Addison-Wesley
    56. 56. Measuring U.S. GDP The Expenditure Approach The expenditure approach measures GDP as the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. GDP = C + I + G + (X − M) Table 4.1 on the next slide shows the expenditure approach with data (in billions) for 2012. GDP = $11,007 + $2,032 + $3,055 − $616 = $15,478 billion © 2014 Pearson Addison-Wesley
    57. 57. © 2014 Pearson Addison-Wesley
    58. 58. Measuring U.S. GDP The Income Approach The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire—wages for labor, interest for capital, rent for land, and profit for entrepreneurship. © 2014 Pearson Addison-Wesley
    59. 59. Measuring U.S. GDP The National Income and Expenditure Accounts divide incomes into two broad categories: 1. Compensation of employees 2. Net operating surplus Compensation of employees is the payments for labor services. It is the sum of net wages plus taxes withheld plus social security and pension fund contributions. WAT Net operating surplus is the sum of other factor incomes. It includes net interest, rental income, corporate profits, and proprietor’s income. © 2014 Pearson Addison-Wesley
    60. 60. Measuring U.S. GDP The sum of all factor incomes is net domestic income at factor cost. Two adjustments must be made to get GDP: 1. Indirect taxes less subsidies are added to get from factor cost to market prices. 2. Depreciation is added to get from net domestic income to gross domestic income. Table 4.2 on the next slide shows the income approach with data for 2012. © 2014 Pearson Addison-Wesley
    61. 61. © 2014 Pearson Addison-Wesley
    62. 62. Measuring U.S. GDP Nominal GDP and Real GDP Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. Currently, the reference base year is 2005 and we describe real GDP as measured in 2005 dollars. Nominal GDP is the value of goods and services produced during a given year valued at the prices that prevailed in that same year. Nominal GDP is just a more precise name for GDP. © 2014 Pearson Addison-Wesley
    63. 63. Measuring U.S. GDP Calculating Real GDP Table 4.3(a) shows the quantities produced and the prices in 2005 (the base year). Nominal GDP in 2005 is $100 million. Because 2005 is the base year, real GDP equals nominal GDP and is $100 million. © 2014 Pearson Addison-Wesley
    64. 64. Measuring U.S. GDP Table 4.3(b) shows the quantities produced and the prices in 2012. Nominal GDP in 2012 is $300 million. Nominal GDP in 2012 is three times its value in 2005. © 2014 Pearson Addison-Wesley
    65. 65. The Uses and Limitations of Real GDP Economists use estimates of real GDP for two main purposes: To compare the standard of living over time To compare the standard of living across countries © 2014 Pearson Addison-Wesley
    66. 66. The Uses and Limitations of Real GDP The Standard of Living Over Time Real GDP per person is real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy. By using real GDP, we remove any influence that rising prices and a rising cost of living might have had on our comparison. © 2014 Pearson Addison-Wesley
    67. 67. The Uses and Limitations of Real GDP Long-Term Trend A handy way of comparing real GDP per person over time is to express it as a ratio of some reference year. For example, in 1960, real GDP per person was $15,850 and in 2012, it was $43,182. So real GDP per person in 2012 was 2.7 times its 1960 level—that is, $43,182 ÷ $15,850 = 2.7. © 2014 Pearson Addison-Wesley
    68. 68. The Uses and Limitations of Real GDP Two features of our expanding living standard are  The growth of potential GDP per person  Fluctuations of real GDP around potential GDP The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed is called potential GDP. © 2014 Pearson Addison-Wesley
    69. 69. The Uses and Limitations of Real GDP Figure 4.2 shows U.S. real GDP per person. Potential GDP grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace. Real GDP fluctuates around potential GDP. © 2014 Pearson Addison-Wesley
    70. 70. The Uses and Limitations of Real GDP Productivity Growth Slowdown The growth rate of real GDP per person slowed after 1970. How costly was that slowdown? The answer is provided by a number that we’ll call the Lucas wedge. The Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the 1960s growth rate had persisted and what real GDP per person turned out to be. © 2014 Pearson Addison-Wesley
    71. 71. The Uses and Limitations of Real GDP Figure 4.3 illustrates the Lucas wedge. The red line is actual real GDP per person. The thin black line is the trend that real GDP per person would have followed if the 1960s growth rate of potential GDP had persisted. The shaded area is the Lucas wedge. © 2014 Pearson Addison-Wesley
    72. 72. The Uses and Limitations of Real GDP Real GDP Fluctuations— The Business Cycle A business cycle is a periodic but irregular up-and-down movement of total production and other measures of economic activity. Every cycle has two phases: 1. Expansion 2. Recession and two turning points: 1. Peak 2. Trough © 2014 Pearson Addison-Wesley
    73. 73. The Uses and Limitations of Real GDP Figure 4.4 illustrates the business cycle. An expansion is a period during which real GDP increases—from a trough to a peak. Recession is a period during which real GDP decreases—its growth rate is negative for at least two successive quarters. © 2014 Pearson Addison-Wesley
    74. 74. The Uses and Limitations of Real GDP The Standard of Living Across Countries Two problems arise in using real GDP to compare living standards across countries: 1. The real GDP of one country must be converted into the same currency units as the real GDP of the other country. 2. The goods and services in both countries must be valued at the same prices. © 2014 Pearson Addison-Wesley
    75. 75. The Uses and Limitations of Real GDP Using the exchange rate to compare GDP in one country with GDP in another country is problematic because … prices of particular products in one country may be much less or much more than in the other country. For example, using the market exchange rate to value China’s GDP in U.S. dollars leads to an estimate that in 2012, GDP per person in the United States was 8.4 times GDP per person in China. © 2014 Pearson Addison-Wesley
    76. 76. The Uses and Limitations of Real GDP Figure 4.5 illustrates the problem. Using the market exchange rate and domestic prices makes China look like a poor developing country. But when GDP is valued at purchasing power parity prices, U.S. income per person is only 5.6 times that in China. © 2014 Pearson Addison-Wesley
    77. 77. The Uses and Limitations of Real GDP Limitations of Real GDP Real GDP measures the value of goods and services that are bought in markets. Some of the factors that influence the standard of living and that are not part of GDP are  Household production  Underground economic activity  Leisure time  Environmental quality © 2014 Pearson Addison-Wesley
    78. 78. 5 © 2014 Pearson Addison-Wesley MONITORING JOBS AND INFLATION
    79. 79. Employment and Unemployment Why Unemployment Is a Problem Unemployment results in Lost incomes and production Lost human capital The loss of income is devastating for those who bear it. Employment benefits create a safety net but don’t fully replace lost wages, and not everyone receives benefits. Prolonged unemployment permanently damages a person’s job prospects by destroying human capital. © 2014 Pearson Addison-Wesley
    80. 80. Employment and Unemployment To be counted as unemployed, a person must be in one of the following three categories: 1. Without work but has made specific efforts to find a job within the previous four weeks 2. Waiting to be called back to a job from which he or she has been laid off 3. Waiting to start a new job within 30 days © 2014 Pearson Addison-Wesley
    81. 81. Employment and Unemployment Three Labor Market Indicators  The unemployment rate  The employment-to-population ratio  The labor force participation rate © 2014 Pearson Addison-Wesley
    82. 82. Employment and Unemployment The Unemployment Rate The unemployment rate is the percentage of the labor force that is unemployed. The unemployment rate is (Number of people unemployed ÷ labor force) × 100. In June 2012, the labor force was 155 million and 12.8 million were unemployed, so the unemployment rate was 8.2 percent. The unemployment rate increases in a recession and reaches its peak value after the recession ends. © 2014 Pearson Addison-Wesley
    83. 83. Employment and Unemployment Figure 5.2 shows the unemployment rate: 1980–2012. The unemployment rate increases in a recession. © 2014 Pearson Addison-Wesley
    84. 84. Employment and Unemployment The Employment-to-Population Ratio The employment-to-population ratio is the percentage of the working-age population who have jobs. The employment-to-population ratio is (Employment ÷ Working-age population) × 100. In June 2012, the employment was 142.2 million and the working-age population was 243.4 million. The employment-to-population ratio was 58.45 percent. © 2014 Pearson Addison-Wesley
    85. 85. Employment and Unemployment The Labor Force Participation Rate The labor force participation rate is the percentage of the working-age population who are members of the labor force. The labor force participation rate is (Labor force ÷ Working-age population) × 100. In June 2012, the labor force was 155 million and the working-age population was 243.4 million. The labor force participation rate was 63.7 percent. © 2014 Pearson Addison-Wesley
    86. 86. Employment and Unemployment Marginally Attached Workers A marginally attached worker is a person who currently is neither working nor looking for work but has indicated that he or she wants and is available for a job and has looked for work sometime in the recent past. A discouraged worker is a marginally attached worker who has stopped looking for a job because of repeated failure to find one. © 2014 Pearson Addison-Wesley
    87. 87. Employment and Unemployment Part-Time Workers Who Want Full-Time Jobs Many part-time workers want to work part time, but some part-time workers would like full-time jobs and can’t find them. In the official statistics, these workers are called economic part-time workers and they are partly unemployed. Most Costly Unemployment All unemployment is costly, but the most costly is longterm unemployment that results from job loss. © 2014 Pearson Addison-Wesley
    88. 88. Unemployment and Full Employment Unemployment can be classified into three types:  Frictional unemployment  Structural unemployment  Cyclical unemployment © 2014 Pearson Addison-Wesley
    89. 89. Unemployment and Full Employment Frictional Unemployment Frictional unemployment is unemployment that arises from normal labor market turnover. The creation and destruction of jobs requires that unemployed workers search for new jobs. Increases in the number of people entering and reentering the labor force and increases in unemployment benefits raise frictional unemployment. Frictional unemployment is a permanent and healthy phenomenon of a growing economy. © 2014 Pearson Addison-Wesley
    90. 90. Unemployment and Full Employment Structural Unemployment Structural unemployment is unemployment created by changes in technology and foreign competition that change the skills needed to perform jobs or the locations of jobs. Structural unemployment lasts longer than frictional unemployment. © 2014 Pearson Addison-Wesley
    91. 91. Unemployment and Full Employment Cyclical Unemployment Cyclical unemployment is the higher than normal unemployment at a business cycle trough and lower than normal unemployment at a business cycle peak. A worker who is laid off because the economy is in a recession and is then rehired when the expansion begins experiences cyclical unemployment. © 2014 Pearson Addison-Wesley
    92. 92. Unemployment and Full Employment “Natural” Unemployment Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment. Natural unemployment is all frictional and structural unemployment. The natural unemployment rate is natural unemployment as a percentage of the labor force. © 2014 Pearson Addison-Wesley
    93. 93. Unemployment and Full Employment Full employment is defined as the situation in which the unemployment rate equals the natural unemployment rate. When the economy is at full employment, there is no cyclical unemployment or, equivalently, all unemployment is frictional and structural. © 2014 Pearson Addison-Wesley
    94. 94. Unemployment and Full Employment The natural unemployment rate changes over time and is influenced by many factors. Key factors are The age distribution of the population The scale of structural change The real wage rate Unemployment benefits © 2014 Pearson Addison-Wesley
    95. 95. Unemployment and Full Employment Real GDP and Unemployment Over the Cycle Potential GDP is the quantity of real GDP produced at full employment. Potential GDP corresponds to the capacity of the economy to produce output on a sustained basis. Real GDP minus potential GDP is the output gap. Over the business cycle, the output gap fluctuates and the unemployment rate fluctuates around the natural unemployment rate. © 2014 Pearson Addison-Wesley
    96. 96. Price Level, Inflation, and Deflation The price level is the average level of prices and the value of money. A persistently rising price level is called inflation. A persistently falling price level is called deflation. We are interested in the price level because we want to 1. Measure the inflation rate or the deflation rate 2. Distinguish between money values and real values of economic variables. © 2014 Pearson Addison-Wesley
    97. 97. Price Level, Inflation, and Deflation Why Inflation and Deflation Are Problems Low, steady, and anticipated inflation or deflation is not a problem. Unpredictable inflation or deflation is a problem because it Redistributes income and wealth  Lowers real GDP and employment  Diverts resources from production © 2014 Pearson Addison-Wesley
    98. 98. Price Level, Inflation, and Deflation Unpredictable changes in the inflation rate redistribute income in arbitrary ways between employers and workers and between borrowers and lenders. A high inflation rate is a problem because it diverts resources from productive activities to inflation forecasting. From a social perspective, this waste of resources is a cost of inflation. At its worst, inflation becomes hyperinflation—an inflation rate that is so rapid that workers are paid twice a day because money loses its value so quickly. © 2014 Pearson Addison-Wesley
    99. 99. Price Level, Inflation, and Deflation The Consumer Price Index The Consumer Price Index, or CPI, measures the average of the prices paid by urban consumers for a “fixed” basket of consumer goods and services. © 2014 Pearson Addison-Wesley
    100. 100. Price Level, Inflation, and Deflation Reading the CPI Numbers The CPI is defined to equal 100 for the reference base period. Currently, the reference base period is 1982−1984. That is, for the average of the 36 months from January 1982 through December 1984, the CPI equals 100. In June 2012, the CPI was 228.8. This number tells us that the average of the prices paid by urban consumers for a fixed basket of goods was 128.8 percent higher in June 2012 than it was during 1982−1984. © 2014 Pearson Addison-Wesley
    101. 101. Price Level, Inflation, and Deflation The Monthly Price Survey Every month, BLS employees check the prices of the 80,000 goods in the CPI basket in 30 metropolitan areas. Calculating the CPI 1. Find the cost of the CPI basket at base-period prices. 2. Find the cost of the CPI basket at current-period prices. 3. Calculate the CPI for the current period. © 2014 Pearson Addison-Wesley
    102. 102. Price Level, Inflation, and Deflation Table 5.1(b) shows the fixed CPI basket of goods. It also shows the prices in the current period. The cost of the CPI basket at current-period prices is $70. © 2014 Pearson Addison-Wesley
    103. 103. Price Level, Inflation, and Deflation The CPI is calculated using the formula: CPI = (Cost of basket at current-period prices ÷ Cost of basket at base-period prices)  100. Using the numbers for the simple example, CPI = ($70 ÷ $50)  100 = 140. The CPI is 40 percent higher in the current period than it was in the base period. © 2014 Pearson Addison-Wesley
    104. 104. Price Level, Inflation, and Deflation Measuring the Inflation Rate The major purpose of the CPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. The inflation formula is: Inflation rate = [(CPI this year – CPI last year) ÷ CPI last year] × 100. © 2014 Pearson Addison-Wesley
    105. 105. Price Level, Inflation, and Deflation Figure 5.7 shows the relationship between the price level and the inflation rate. The inflation rate is High when the price level is rising rapidly and Low when the price level is rising slowly. Negative when the price level is falling © 2014 Pearson Addison-Wesley
    106. 106. Price Level, Inflation, and Deflation New Goods Bias New goods that were not available in the base year appear and, if they are more expensive than the goods they replace, they put an upward bias into the CPI. Quality Change Bias Quality improvements occur every year. Part of the rise in the price is payment for improved quality and is not inflation. The CPI counts all the price rise as inflation. © 2014 Pearson Addison-Wesley
    107. 107. Price Level, Inflation, and Deflation Commodity Substitution Bias The market basket of goods used in calculating the CPI is fixed and does not take into account consumers’ substitutions away from goods whose relative prices increase. Outlet Substitution Bias As the structure of retailing changes, people switch to buying from cheaper sources, but the CPI, as measured, does not take account of this outlet substitution. © 2014 Pearson Addison-Wesley
    108. 108. Price Level, Inflation, and Deflation The Magnitude of the Bias Estimates say that the CPI overstates inflation by 1.1 percentage points a year. Some Consequences of the Bias  Distorts private contracts.  Increases government outlays (close to a third of federal government outlays are linked to the CPI). A bias of 1 percent is small, but over a decade adds up to almost $1 trillion of additional expenditure. © 2014 Pearson Addison-Wesley
    109. 109. Price Level, Inflation, and Deflation Alternative Price Indexes Alternative measures of the price level are  PPI  GDP deflator  Create your own price index (why not?) © 2014 Pearson Addison-Wesley
    110. 110. Price Level, Inflation, and Deflation Core Inflation The figure shows the CPI inflation rate. The core inflation rate is the CPI inflation rate excluding the volatile elements (of food and fuel). The core inflation rate attempts to reveal the underlying inflation trend. © 2014 Pearson Addison-Wesley
    111. 111. Price Level, Inflation, and Deflation The Real Variables in Macroeconomics We can use the deflator to deflate nominal variables to find their real values. For example, Real wage rate = (Nominal wage rate ÷ GDP deflator)  100 But not the real interest rate! It is different. © 2014 Pearson Addison-Wesley
    112. 112. 6 © 2014 Pearson Addison-Wesley ECONOMIC GROWTH
    113. 113. The Basics of Economic Growth Economic growth is the sustained expansion of production possibilities measured as the increase in real GDP over a given period. Calculating Growth Rates The economic growth rate is the annual percentage change of real GDP. The economic growth rate tells us how rapidly the total economy is expanding. © 2014 Pearson Addison-Wesley
    114. 114. The Basics of Economic Growth The standard of living depends on real GDP per person. Real GDP per person is real GDP divided by the population. Real GDP per person grows only if real GDP grows faster than the population grows. © 2014 Pearson Addison-Wesley
    115. 115. The Basics of Economic Growth Economic Growth Versus Business Cycle Expansion Real GDP can increase for two distinct reasons: 1.The economy might be returning to full employment in an expansion phase of the business cycle. 2.Potential GDP might be increasing. The return to full employment in an expansion phase of the business cycle isn’t economic growth. The expansion of potential GDP is economic growth. © 2014 Pearson Addison-Wesley
    116. 116. The Basics of Economic Growth Figure 6.1 illustrates the distinction. A return to full employment in a business cycle expansion is a movement from inside the PPF (point A) to a point on the PPF (point B). Economic growth is the outward shift of the PPF from PPF0 to PPF1 and the movement from point B on PPF0 to point C on PPF1. © 2014 Pearson Addison-Wesley
    117. 117. The Basics of Economic Growth The Magic of Sustained Growth The Rule of 70 states that the number of years it takes for the level of a variable to double is approximately 70 divided by the annual percentage growth rate of the variable. © 2014 Pearson Addison-Wesley
    118. 118. The Basics of Economic Growth Applying the Rule of 70 Figure 6.3 shows the doubling time for growth rates. A variable that grows at 7 percent a year doubles in 10 years. A variable that grows at 2 percent a year doubles in 35 years. A variable that grows at 1 percent a year doubles in 70 years. © 2014 Pearson Addison-Wesley
    119. 119. How Potential GDP Grows What Determines Potential GDP? Potential GDP is the quantity of real GDP produced when the quantity of labor employed is the full-employment quantity. To determine potential GDP we use a model with two components:  An aggregate production function  An aggregate labor market © 2014 Pearson Addison-Wesley
    120. 120. How Potential GDP Grows Aggregate Production Function The aggregate production function tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same. An increase in labor increases real GDP. © 2014 Pearson Addison-Wesley
    121. 121. How Potential GDP Grows Aggregate Labor Market The demand for labor shows the quantity of labor demanded and the real wage rate. The real wage rate is the money wage rate divided by the price level. The supply of labor shows the quantity of labor supplied and the real wage rate. The labor market is in equilibrium at the real wage rate at which the quantity of labor demanded equals the quantity of labor supplied. © 2014 Pearson Addison-Wesley
    122. 122. How Potential GDP Grows Figure 6.7 illustrates labor market equilibrium. Labor market equilibrium occurs at a real wage rate of $35 an hour and 200 billion hours employed. At a real wage rate above $35 an hour, there is a surplus of labor and the real wage rate falls. © 2014 Pearson Addison-Wesley
    123. 123. How Potential GDP Grows Potential GDP The quantity of real GDP produced when the economy is at full employment is potential GDP. The economy is at fullemployment when 200 billion hours of labor are employed. Potential GDP is $13 trillion. © 2014 Pearson Addison-Wesley
    124. 124. How Potential GDP Grows What Makes Potential GDP Grow? We begin by dividing real GDP growth into the forces that increase:  Growth in the supply of labor  Growth in labor productivity © 2014 Pearson Addison-Wesley
    125. 125. How Potential GDP Grows Growth in the Supply of Labor Aggregate hours, the total number of hours worked by all the people employed, change as a result of changes in: 1. Average hours per worker 2. Employment-to-population ratio 3. The working-age population growth Population growth increases aggregate hours and real GDP, but to increase real GDP per person, labor must become more productive. © 2014 Pearson Addison-Wesley
    126. 126. How Potential GDP Grows Figure 6.9(a) illustrates the effects of population growth in the labor market. The labor supply curve shifts rightward. The real wage rate falls and aggregate hours increase. © 2014 Pearson Addison-Wesley
    127. 127. How Potential GDP Grows The increase in aggregate hours increases potential GDP. Because of the diminishing returns, the increased population … increases real GDP, but decreases real GDP per hour of labor. © 2014 Pearson Addison-Wesley
    128. 128. How Potential GDP Grows Growth of Labor Productivity Labor productivity is the quantity of real GDP produced by an hour of labor. Labor productivity equals real GDP divided by aggregate labor hours. If labor becomes more productive, firms are willing to pay more for a given number of hours so the demand for labor increases. © 2014 Pearson Addison-Wesley
    129. 129. How Potential GDP Grows Figure 6.10 shows the effect of an increase in labor productivity. The increase in labor productivity shifts the production function upward. © 2014 Pearson Addison-Wesley
    130. 130. How Potential GDP Grows In the labor market: An increase in labor productivity increases the demand for labor. With no change in the supply of labor, the real wage rate rises and aggregate hours increase. © 2014 Pearson Addison-Wesley
    131. 131. How Potential GDP Grows And with the increase in aggregate hours, potential GDP increases. © 2014 Pearson Addison-Wesley
    132. 132. Why Labor Productivity Grows Physical Capital Growth The accumulation of new capital increases capital per worker and increases labor productivity. Human Capital Growth Human capital acquired through education, on-the-job training, and learning-by-doing is the most fundamental source of labor productivity growth. © 2014 Pearson Addison-Wesley
    133. 133. Why Labor Productivity Grows Technological Advances Technological change—the discovery and the application of new technologies and new goods—has contributed immensely to increasing labor productivity. Figure 6.11 on the next slide summarizes the process of growth. It also shows that the growth of real GDP per person depends on real GDP growth and the population growth rate. © 2014 Pearson Addison-Wesley
    134. 134. Why Labor Productivity Grows © 2014 Pearson Addison-Wesley
    135. 135. Growth Theories, Evidence, and Policies We study three growth theories:  Classical growth theory  Neoclassical growth theory  New growth theory Classical Growth Theory Classical growth theory is the view that the growth of real GDP per person is temporary and that when it rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level. © 2014 Pearson Addison-Wesley
    136. 136. Growth Theories, Evidence, and Policies Neoclassical Growth Theory Neoclassical growth theory is the proposition that real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow. Growth ends only if technological change stops because of diminishing marginal returns to both labor and capital. WAT © 2014 Pearson Addison-Wesley
    137. 137. Growth Theories, Evidence, and Policies The Neoclassical Theory of Population Growth The neoclassical view is that the population growth rate is independent of real GDP and the real GDP growth rate. Technological Change and Diminishing Returns In the neoclassical theory, the rate of technological change influences the economic growth rate but economic growth does not influence the pace of technological change. It is assumed that technological change results from chance. © 2014 Pearson Addison-Wesley
    138. 138. Growth Theories, Evidence, and Policies Technology begins to advance at a more rapid pace. New profit opportunities arise and investment and saving increase. As technology advances and the capital stock grows, real GDP per person increases. Diminishing returns to capital lower the real interest rate and eventually economic growth slows and just keeps up with population growth. Capital per worker remains constant. © 2014 Pearson Addison-Wesley
    139. 139. Growth Theories, Evidence, and Policies A Problem with Neoclassical Growth Theory All economies have access to the same technologies and capital is free to roam the globe, seeking the highest available real interest rate. These facts imply that economic growth rates and real GDP per person across economies will converge. Figure 6.5 shows some convergence among rich countries, but convergence doesn’t appear imminent for all countries. © 2014 Pearson Addison-Wesley
    140. 140. Growth Theories, Evidence, and Policies New Growth Theory New growth theory holds that real GDP per person grows because of choices that people make in the pursuit of profit and that growth can persist indefinitely. The theory begins with two facts about market economies:  Discoveries result from choices.  Discoveries bring profit and competition destroys profit. © 2014 Pearson Addison-Wesley
    141. 141. Growth Theories, Evidence, and Policies Two further facts play a key role in the new growth theory:  Discoveries are a public capital good.  Knowledge is not subject to diminishing returns. Increasing the stock of knowledge makes capital and labor more productive. The central proposition of new growth theory is that knowledge capital does not experience diminishing returns. © 2014 Pearson Addison-Wesley
    142. 142. Growth Theories, Evidence, and Policies Sorting Out the Theories Each theory teaches us something of value but not the whole story. Classical theory reminds us that our physical resources are limited and we need technological advances to grow. Neoclassical theory’s emphasis of diminishing returns to capital means we need technological advances to grow. New theory emphasizes the capacity of human resources to innovate at a pace that offsets diminishing returns. © 2014 Pearson Addison-Wesley
    143. 143. Growth Theories, Evidence, and Policies Policies for Achieving Faster Growth Growth accounting tells us that to achieve faster economic growth we must either increase the growth rate of capital per hour of labor or increase the pace of technological change. The main suggestions for achieving these objectives are: Stimulate Saving Saving finances investment. So higher saving rates might increase physical capital growth. Tax incentives might be provided to boost saving. © 2014 Pearson Addison-Wesley
    144. 144. Growth Theories, Evidence, and Policies Stimulate Research and Development Because the fruits of basic research and development efforts can be used by everyone, not all the benefit of a discovery falls to the initial discoverer. So the market might allocate too few resources to research and development. Government subsidies and direct funding might stimulate basic research and development. © 2014 Pearson Addison-Wesley
    145. 145. Growth Theories, Evidence, and Policies Improve the Quality of Education The benefits from education spread beyond the person being educated, so there is a tendency to under invest in education. Provide International Aid to Developing Nations If rich countries give financial aid to developing countries, investment and growth will increase. But data on the effect of aid shows that it has had zero or a negative effect. © 2014 Pearson Addison-Wesley
    146. 146. Growth Theories, Evidence, and Policies Encourage International Trade Free international trade stimulates growth by extracting all the available gains from specialization and trade. The fastest growing nations are the ones with the fastest growing exports and imports. © 2014 Pearson Addison-Wesley
    147. 147. 7 © 2014 Pearson Addison-Wesley FINANCE, SAVING, AND INVESTMENT
    148. 148. Financial Institutions and Financial Markets Physical Capital and Financial Capital Physical capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used today to produce goods and services. The funds that firms use to buy physical capital are called financial capital. © 2014 Pearson Addison-Wesley
    149. 149. Financial Institutions and Financial Markets Capital and Investment Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital. Depreciation is the decrease in the quantity of capital that results from wear and tear and obsolescence. Net investment is the change in the quantity of capital. Net investment = Gross investment − Depreciation. © 2014 Pearson Addison-Wesley
    150. 150. Financial Institutions and Financial Markets Wealth and Saving Wealth is the value of all the things that people own. Saving is the amount of income that is not paid in taxes or spent on consumption goods and services. Saving increases wealth. Wealth also increases when the market value of assets rises—called capital gains—and decreases when the market value of assets falls—called capital losses. © 2014 Pearson Addison-Wesley
    151. 151. Financial Institutions and Financial Markets Financial Capital Markets Saving is the source of funds used to finance investment. These funds are supplied and demanded in three types of financial markets:  Loan markets  Bond markets  Stock markets © 2014 Pearson Addison-Wesley
    152. 152. Financial Institutions and Financial Markets Financial Institutions A financial institution is a firm that operates on both sides of the markets for financial capital. It is a borrower in one market and a lender in another. Key financial institutions are Commercial banks  Government-sponsored mortgage lenders  Pension funds  Insurance companies © 2014 Pearson Addison-Wesley
    153. 153. Financial Institutions and Financial Markets Insolvency and Illiquidity A financial institution’s net worth is the total market value of what it has lent minus the market value of what it has borrowed. If net worth is positive, the institution is solvent and can remain in business. But if net worth is negative, the institution is insolvent and will go out of business. © 2014 Pearson Addison-Wesley
    154. 154. Financial Institutions and Financial Markets Interest Rates and Asset Prices The interest rate on a financial asset is the interest received expressed as a percentage of the price of the asset. For example, if the price of the asset is $50 and the interest is $5, then the interest rate is 10 percent. If the asset price rises (say to $200), other things remaining the same, the interest rate falls (2.5 percent). If the asset price falls (say to $20), other things remaining the same, the interest rate rises (to 25 percent). © 2014 Pearson Addison-Wesley
    155. 155. The Loanable Funds Market The market for loanable funds is the aggregate of all the individual financial markets. Funds that Finance Investment Funds come from three sources: 1. Household saving S 2. Government budget surplus (T – G) 3. Borrowing from the rest of the world (M – X) Figure 7.2 on the next slide illustrates the flows of funds that finance investment. © 2014 Pearson Addison-Wesley
    156. 156. The Loanable Funds Market The Real Interest Rate The nominal interest rate is the number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed and lent. For example, if the annual interest paid on a $500 loan is $25, the nominal interest rate is 5 percent per year. © 2014 Pearson Addison-Wesley
    157. 157. The Loanable Funds Market The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. For example, if the nominal interest rate is 5 percent a year and the inflation rate is 2 percent a year, the real interest rate is 3 percent a year. The real interest rate is the opportunity coast of borrowing. © 2014 Pearson Addison-Wesley
    158. 158. The Loanable Funds Market The market for loanable funds determines the real interest rate, the quantity of funds loaned, saving, and investment. We’ll start by ignoring the government and the rest of the world. The Demand for Loanable Funds The quantity of loanable funds demanded depends on 1. The real interest rate 2. Expected profit © 2014 Pearson Addison-Wesley
    159. 159. The Loanable Funds Market The Demand for Loanable Funds Curve The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same. Business investment is the main item that makes up the demand for loanable funds. © 2014 Pearson Addison-Wesley
    160. 160. The Loanable Funds Market Changes in the Demand for Loanable Funds When the expected profit changes, the demand for loanable funds changes. Other things remaining the same, the greater the expected profit from new capital, the greater is the amount of investment and the greater the demand for loanable funds. © 2014 Pearson Addison-Wesley
    161. 161. The Loanable Funds Market The Supply of Loanable Funds The quantity of loanable funds supplied depends on 1. The real interest rate 2. Disposable income 3. Expected future income 4. Wealth 5. Default risk © 2014 Pearson Addison-Wesley
    162. 162. The Loanable Funds Market The Supply of Loanable Funds Curve The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same. Saving is the main item that makes up the supply of loanable funds. © 2014 Pearson Addison-Wesley
    163. 163. The Loanable Funds Market Changes in the Supply of Loanable Funds A change in disposable income, expected future income, wealth, or default risk changes the supply of loanable funds. An increase in disposable income, a decrease in expected future income, a decrease in wealth, or a fall in default risk increases saving and increases the supply of loanable funds. © 2014 Pearson Addison-Wesley
    164. 164. The Loanable Funds Market Equilibrium in the Loanable Funds Market The loanable funds market is in equilibrium at the real interest rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied. © 2014 Pearson Addison-Wesley
    165. 165. The Loanable Funds Market Changes in Demand and Supply Financial markets are highly volatile in the short run but remarkably stable in the long run. Volatility comes from fluctuations in either the demand for loanable funds or the supply of loanable funds. These fluctuations bring fluctuations in the real interest rate and in the equilibrium quantity of funds lent and borrowed. They also bring fluctuations in asset prices. © 2014 Pearson Addison-Wesley
    166. 166. Government in the Loanable Funds Market Government enters the loanable funds market when it has a budget surplus or deficit.  A government budget surplus increases the supply of funds.  A government budget deficit increases the demand for funds. © 2014 Pearson Addison-Wesley
    167. 167. The Global Loanable Funds Market The loanable funds market is global, not national. Lenders want to earn the highest possible real interest rate and they will seek it by looking around the world. Borrowers want to pay the lowest possible real interest rate and they will seek it by looking around the world. Financial capital is mobile: It moves to the best advantage of lenders and borrowers. © 2014 Pearson Addison-Wesley
    168. 168. The Global Loanable Funds Market International Capital Mobility Because lenders are free to seek the highest real interest rate and borrowers are free to seek the lowest real interest rate, the loanable funds market is a single, integrated, global market. Funds flow into the country in which the real interest rate is highest and out of the country in which the real interest rate is lowest. © 2014 Pearson Addison-Wesley
    169. 169. The Global Loanable Funds Market International Borrowing and Lending A country’s loanable funds market connects with the global market through net exports. If a country’s net exports are negative, the rest of the world supplies funds to that country and the quantity of loanable funds in that country is greater than national saving. If a country’s net exports are positive, the country is a net supplier of funds to the rest of the world and the quantity of loanable funds in that country is less than national saving. © 2014 Pearson Addison-Wesley
    170. 170. The Global Loanable Funds Market In part (b), at the world real interest rate, borrowers want more funds than the quantity supplied by domestic lenders. The shortage of funds is made up by international borrowing. © 2014 Pearson Addison-Wesley
    171. 171. The Global Loanable Funds Market In part (c), at the world real interest rate, the quantity supplied by domestic lenders exceeds what domestic borrowers want. The excess quantity supplied goes to foreign borrowers. © 2014 Pearson Addison-Wesley
    172. 172. 8 © 2014 Pearson Addison-Wesley MONEY, THE PRICE LEVEL, AND INFLATION
    173. 173. What is Money? Medium of Exchange A medium of exchange is an object that is generally accepted in exchange for goods and services. In the absence of money, people would need to exchange goods and services directly, which is called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly. © 2014 Pearson Addison-Wesley
    174. 174. What is Money? Unit of Account A unit of account is an agreed measure for stating the prices of goods and services. Table 8.1 illustrates how money simplifies comparisons. Store of Value As a store of value, money can be held for a time and later exchanged for goods and services. © 2014 Pearson Addison-Wesley
    175. 175. What is Money? Money in the United States Today Money in the United States consists of  Currency  Deposits at banks and other depository institutions Currency is the notes and coins held by households and firms. © 2014 Pearson Addison-Wesley
    176. 176. What is Money? Official Measures of Money The two main official measures of money in the United States are M1 and M2. M1 consists of currency and traveler’s checks and checking deposits owned by individuals and businesses. M2 consists of M1 plus time, saving deposits, money market mutual funds, and other deposits. © 2014 Pearson Addison-Wesley
    177. 177. What is Money? Are M1 and M2 Really Money? All the items in M1 are means of payment. They are money. Some saving deposits in M2 are not means of payments— they are called liquid assets. Liquidity is the property of being instantly convertible into a means of payment with little loss of value. © 2014 Pearson Addison-Wesley
    178. 178. What is Money Deposits are Money but Checks Are Not In defining money, we include, along with currency, deposits at banks and other depository institutions. But we do not count the checks that people write as money. A check is an instruction to a bank to transfer money. Credit Cards Are Not Money Credit cards are not money. A credit card enables the holder to obtain a loan, but it must be repaid with money. © 2014 Pearson Addison-Wesley
    179. 179. Depository Institutions A depository institution is a firm that takes deposits from households and firms and makes loans to other households and firms. Types of Depository Institutions Deposits at three institutions make up the nation’s money. They are  Commercial banks  Thrift institutions  Money market mutual funds © 2014 Pearson Addison-Wesley
    180. 180. Depository Institutions Commercial Banks A commercial bank is a private firm that is licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans. Thrift Institutions Savings and loan associations, savings banks, and credit unions are called thrift institutions. Money Market Mutual Funds A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds assets such as U.S. Treasury bills. © 2014 Pearson Addison-Wesley
    181. 181. Depository Institutions What Depository Institutions Do The goal of any bank is to maximize the wealth of its owners. To achieve this objective, the interest rate at which it lends exceeds the interest rate it pays on deposits. But the banks must balance profit and prudence:  Loans generate profit.  Depositors must be able to obtain their funds when they want them. © 2014 Pearson Addison-Wesley
    182. 182. Depository Institutions A commercial bank puts the depositors’ funds into four types of assets: 1. Reserves—notes and coins in its vault or its deposit at the Federal Reserve 2. Liquid assets—U.S. government Treasury bills and commercial bills 3. Securities—longer-term U.S. government bonds and other bonds such as mortgage-backed securities 4. Loans—commitments of fixed amounts of money for agreed-upon periods of time © 2014 Pearson Addison-Wesley
    183. 183. Depository Institutions Economic Benefits Provided by Depository Institutions Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans. Depository institutions provide four benefits:  Create liquidity  Pool risk  Lower the cost of borrowing  Lower the cost of monitoring borrowers © 2014 Pearson Addison-Wesley
    184. 184. Depository Institutions How Depository Institutions Are Regulated Depository institutions engage in risky business. To make the risk of failure small, depository institutions are required to hold levels of reserves and owners’ capital equal to or that surpass the ratios laid down by regulation. If a depository institution fails, deposits are guaranteed up to $250,000 per depositor per bank by the FDIC—Federal Deposit Insurance Corporation. © 2014 Pearson Addison-Wesley
    185. 185. Depository Institutions Financial Innovation The aim of financial innovation—the development of new financial products—is to lower the cost of deposits or to increase the return from lending. Two influences on financial innovation are 1.Economic environment 2.Technology © 2014 Pearson Addison-Wesley
    186. 186. The Federal Reserve System The Federal Reserve System (the Fed) is the central bank of the United States. A central bank is the public authority that regulates a nation’s depository institutions and controls the quantity of money. The Fed’s goals are to keep inflation in check, maintain full employment, moderate the business cycle, and contribute toward achieving long-term growth. In pursuit of its goals, the Fed pays close attention to the federal funds rate—the interest rate that banks charge each other on overnight loans of reserves. © 2014 Pearson Addison-Wesley
    187. 187. The Federal Reserve System The Fed’s Policy Tools To achieve its objectives, the Fed uses three main policy tools:  Open market operations  Last resort loans  Required reserve ratios © 2014 Pearson Addison-Wesley
    188. 188. The Conduct of Monetary Policy Open Market Operations An open market operation is the purchase or sale of government securities by the Fed from or to a commercial bank or the public. When the Fed buys securities, it pays for them with newly created reserves held by the banks. When the Fed sells securities, they are paid for with reserves held by banks. So open market operations influence banks’ reserves. © 2014 Pearson Addison-Wesley
    189. 189. The Conduct of Monetary Policy An Open Market Purchase Figure 8.2 shows the effects of an open market purchase on the balance sheets of the Fed and the Bank of America. The open market purchase increases bank reserves. © 2014 Pearson Addison-Wesley
    190. 190. The Conduct of Monetary Policy An Open Market Sale This figure shows the effects of an open market sale on the balance sheets of the Fed and Bank of America. The open market sale decreases bank reserves. © 2014 Pearson Addison-Wesley
    191. 191. The Federal Reserve System Last Resort Loans The Fed is the lender of last resort, which means the Fed stands ready to lend reserves to depository institutions that are short of reserves. Required Reserve Ratio The Fed sets the required reserve ratio, which is the minimum percentage of deposits that a depository institution must hold as reserves. The Fed rarely changes the required reserve ratio. © 2014 Pearson Addison-Wesley
    192. 192. How Banks Create Money Creating Deposits by Making Loans Banks create deposits when they make loans and the new deposits created are new money. The quantity of deposits that banks can create is limited by three factors:  The monetary base  Desired reserves  Desired currency holding © 2014 Pearson Addison-Wesley
    193. 193. How Banks Create Money The Monetary Base The monetary base is the sum of Federal Reserve notes, coins, and banks’ deposits at the Fed. The size of the monetary base limits the total quantity of money that the banking system can create because 1. Banks have desired reserves 2. Households and firms have desired currency holdings And both these desired holdings of monetary base depend on the quantity of money. © 2014 Pearson Addison-Wesley
    194. 194. How Banks Create Money Desired Reserves A bank’s actual reserves consists of notes and coins in its vault and its deposit at the Fed. The desired reserve ratio is the ratio of the bank’s reserves to total deposits that a bank plans to hold. The desired reserve ratio exceeds the required reserve ratio by the amount that the bank determines to be prudent for its daily business. © 2014 Pearson Addison-Wesley
    195. 195. How Banks Create Money Desired Currency Holding People hold some fraction of their money as currency. So when the total quantity of money increases, so does the quantity of currency that people plan to hold. Because desired currency holding increases when deposits increase, currency leaves the banks when they make loans and increase deposits. This leakage of reserves into currency is called the currency drain. The ratio of currency to deposits is the currency drain ratio. © 2014 Pearson Addison-Wesley
    196. 196. How Banks Create Money The Money Creation Process The money creation process begins with an increase in the monetary base. The Fed conducts an open market operation in which it buys securities from banks. The Fed pays for the securities with newly created bank reserves. Banks now have more reserves but the same amount of deposits, so they have excess reserves. Excess reserves = Actual reserves – desired reserves. © 2014 Pearson Addison-Wesley
    197. 197. How Banks Create Money Figure 8.3 illustrates one round in how the banking system creates money by making loans. © 2014 Pearson Addison-Wesley
    198. 198. How Banks Create Money The Money Multiplier The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base. For example, if the Fed increases the monetary base by $100,000 and the quantity of money increases by $250,000, the money multiplier is 2.5. The quantity of money created depends on the desired reserve ratio and the currency drain ratio. The smaller these ratios, the larger is the money multiplier. © 2014 Pearson Addison-Wesley
    199. 199. The Money Market How much money do people want to hold? The Influences on Money Holding The quantity of money that people plan to hold depends on four main factors: The price level The nominal interest rate Real GDP Financial innovation © 2014 Pearson Addison-Wesley
    200. 200. The Money Market The Price Level A rise in the price level increases the quantity of nominal money but doesn’t change the quantity of real money that people plan to hold. Nominal money is the amount of money measured in dollars. Real money equals nominal money ÷ price level. The quantity of nominal money demanded is proportional to the price level—a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent. © 2014 Pearson Addison-Wesley
    201. 201. The Money Market The Nominal Interest Rate The nominal interest rate is the opportunity cost of holding wealth in the form of money rather than an interestbearing asset. A rise in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold. Real GDP An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold. © 2014 Pearson Addison-Wesley
    202. 202. The Money Market Financial Innovation Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold. The Demand for Money The demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same. © 2014 Pearson Addison-Wesley
    203. 203. The Money Market Figure 8.4 illustrates the demand for money curve. A rise in the interest rate brings a decrease in the quantity of real money demanded. A fall in the interest rate brings an increase in the quantity of real money demanded. © 2014 Pearson Addison-Wesley
    204. 204. The Money Market Shifts in the Demand for Money Curve Figure 8.5 shows that a decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward. An increase in real GDP increases the demand for money and shifts the demand curve rightward. © 2014 Pearson Addison-Wesley
    205. 205. The Money Market Money Market Equilibrium Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied. Adjustments that occur to bring about money market equilibrium are fundamentally different in the short run and the long run. © 2014 Pearson Addison-Wesley
    206. 206. The Money Market If the interest rate is 4 percent a year, … the quantity of money that people plan to hold exceeds the quantity supplied. People try to get more money by selling bonds. This action raises the interest rate. © 2014 Pearson Addison-Wesley
    207. 207. The Money Market The Short-Run Effect of a Change in the Supply of Money Initially, the interest rate is 5 percent a year. If the Fed increases the quantity of money, people will be holding more money than the quantity demanded. They buy bonds. The increased demand for bonds raises the bond price and lowers the interest rate. © 2014 Pearson Addison-Wesley
    208. 208. The Money Market Initially, the interest rate is 5 percent a year. If the Fed decreases the quantity of money, people will be holding less money than the quantity demanded. They sell bonds. The increased supply of bonds lowers the bond price and raises the interest rate. © 2014 Pearson Addison-Wesley
    209. 209. The Money Market Long-Run Equilibrium In the long run, the loanable funds market determines the real interest rate. The nominal interest rate equals the equilibrium real interest rate plus the expected inflation rate. In the long run, real GDP equals potential GDP, so the only variable left to adjust in the long run is the price level. © 2014 Pearson Addison-Wesley
    210. 210. The Money Market The price level adjusts to make the quantity of real money supplied equal to the quantity demanded. If in long-run equilibrium, the Fed increases the quantity of money, the price level changes to move the money market to a new long-run equilibrium. In the long run, nothing real has changed. Real GDP, employment, quantity of real money, and the real interest rate are unchanged. In the long run, the price level rises by the same percentage as the increase in the quantity of money. © 2014 Pearson Addison-Wesley
    211. 211. The Money Market The Transition from the Short Run to the Long Run Start in full-employment equilibrium: If the Fed increases the quantity of money by 10 percent, the nominal interest rate falls. As people buy bonds, the real interest rate falls. As the real interest rate falls, consumption expenditure and investment increase. Aggregate demand increases. With the economy at full employment, the price level rises. © 2014 Pearson Addison-Wesley
    212. 212. The Money Market As the price level rises, the quantity of real money decreases. The nominal interest rate and the real interest rate rise. As the real interest rate rises, expenditure plans are cut back and eventually the original full-employment equilibrium is restored. In the new long-run equilibrium, the price level has risen 10 percent but nothing real has changed. © 2014 Pearson Addison-Wesley
    213. 213. The Quantity Theory of Money The quantity theory of money is the proposition that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. The quantity theory of money is based on the velocity of circulation and the equation of exchange. The velocity of circulation is the average number of times in a year a dollar is used to purchase goods and services in GDP. © 2014 Pearson Addison-Wesley
    214. 214. The Quantity Theory of Money Calling the velocity of circulation V, the price level P, real GDP Y, and the quantity of money M: V = PY ÷ M. The equation of exchange states that MV = PY. The equation of exchange becomes the quantity theory of money if M does not influence V or Y. So in the long run, the change in P is proportional to the change in M. © 2014 Pearson Addison-Wesley
    215. 215. The Quantity Theory of Money Expressing the equation of exchange in growth rates: Money growth rate + Rate of velocity change = Inflation rate + Real GDP growth Rearranging: Inflation rate = Money growth rate + Rate of velocity change − Real GDP growth In the long run, velocity does not change, so Inflation rate = Money growth rate − Real GDP growth © 2014 Pearson Addison-Wesley
    216. 216. Mathematical Note: The Money Multiplier To see how the process of money creation works, suppose that the desired reserve ratio is 10 percent of deposits and the currency drain ratio is 50 percent of deposits. The process starts when all banks have zero excess reserves and the Fed increases the monetary base by $100,000. The figure in the next slide illustrates the process and keeps track of the numbers. © 2014 Pearson Addison-Wesley
    217. 217. Mathematical Note: The Money Multiplier The bank with excess reserves of $100,000 loans them. Of the amount loaned, $33,333 drains from the bank as currency and $66,667 remains on deposit. Currency drain is 50 percent of deposits. © 2014 Pearson Addison-Wesley
    218. 218. Mathematical Note: The Money Multiplier The bank’s reserves and deposits have increased by $66,667, so the bank keeps $6,667 (10 percent of deposits) as reserves and loans out $60,000. © 2014 Pearson Addison-Wesley
    219. 219. Mathematical Note: The Money Multiplier $20,000 drains off as currency and $40,000 remains on deposit. Again, the currency drain is 50 percent of deposits. © 2014 Pearson Addison-Wesley
    220. 220. Mathematical Note: The Money Multiplier The process repeats until the banks have created enough deposits to eliminate the excess reserves. The $100,000 increase in monetary base has created $250,000 of money. © 2014 Pearson Addison-Wesley
    221. 221. Mathematical Note: The Money Multiplier The size of the money multiplier depends on  The currency drain ratio (C/D)  The desired reserve ratio (R/D) Money multiplier = (1 + C/D)/(R/D + C/D) In our example, C/D is 0.5 and R/D is 0.1, so Money multiplier = (1 + 0.5)/(0.1 + 0.5) = (1.5)/(0.6) = 2.5 © 2014 Pearson Addison-Wesley
    222. 222. 9 © 2014 Pearson Addison-Wesley THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS
    223. 223. The Foreign Exchange Market To buy goods and services produced in another country we need money of that country. Foreign bank notes, coins, and bank deposits are called foreign currency. We get foreign currency in the foreign exchange market. © 2014 Pearson Addison-Wesley
    224. 224. The Foreign Exchange Market Exchange Rates The price at which one currency exchanges for another is called a foreign exchange rate. A fall in the value of one currency in terms of another currency is called currency depreciation. A rise in value of one currency in terms of another currency is called currency appreciation. © 2014 Pearson Addison-Wesley
    225. 225. The Foreign Exchange Market The Demand for One Money Is the Supply of Another Money When people who are holding one money want to exchange it for U.S. dollars, they demand U.S. dollars and they supply that other country’s money. So the factors that influence the demand for U.S. dollars also influence the supply of Canadian dollars, E.U. euros, U.K. pounds, and Japanese yen. And the factors that influence the demand for another country’s money also influence the supply of U.S. dollars. © 2014 Pearson Addison-Wesley
    226. 226. The Foreign Exchange Market Demand in the Foreign Exchange Market The quantity of U.S. dollars that traders plan to buy in the foreign exchange market during a given period depends on 1. The exchange rate 2. World demand for U.S. exports 3. Interest rates in the United States and other countries 4. The expected future exchange rate © 2014 Pearson Addison-Wesley
    227. 227. The Foreign Exchange Market The Law of Demand for Foreign Exchange The demand for dollars is a derived demand. People buy U.S. dollars so that they can buy U.S.-produced goods and services or U.S. assets. Other things remaining the same, the higher the exchange rate, the smaller is the quantity of U.S. dollars demanded in the foreign exchange market. © 2014 Pearson Addison-Wesley
    228. 228. The Foreign Exchange Market The exchange rate influences the quantity of U.S. dollars demanded for two reasons: Exports effect Expected profit effect Exports Effect The larger the value of U.S. exports, the greater is the quantity of U.S. dollars demanded on the foreign exchange market. The lower the exchange rate, the greater is the value of U.S. exports, so the greater is the quantity of U.S. dollars demanded. © 2014 Pearson Addison-Wesley
    229. 229. The Foreign Exchange Market Expected Profit Effect The larger the expected profit from holding U.S. dollars, the greater is the quantity of U.S. dollars demanded today. But expected profit depends on the exchange rate. The lower today’s exchange rate, other things remaining the same, the larger is the expected profit from buying U.S. dollars and the greater is the quantity of U.S. dollars demanded today. © 2014 Pearson Addison-Wesley
    230. 230. The Foreign Exchange Market The Demand Curve for U.S. Dollars Figure 9.1 illustrates the demand curve for U.S. dollars on the foreign exchange market. © 2014 Pearson Addison-Wesley
    231. 231. The Foreign Exchange Market Supply in the Foreign Exchange Market The quantity of U.S. dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate. This quantity depends on many factors but the main ones are 1. The exchange rate 2. U.S. demand for imports 3. Interest rates in the United States and other countries 4. The expected future exchange rate © 2014 Pearson Addison-Wesley
    232. 232. The Foreign Exchange Market The Law of Supply of Foreign Exchange Other things remaining the same, the higher the exchange rate, the greater is the quantity of U.S. dollars supplied in the foreign exchange market. The exchange rate influences the quantity of U.S. dollars supplied for two reasons:  Imports effect  Expected profit effect © 2014 Pearson Addison-Wesley
    233. 233. The Foreign Exchange Market Imports Effect The larger the value of U.S. imports, the larger is the quantity of U.S. dollars supplied on the foreign exchange market. The higher the exchange rate, the greater is the value of U.S. imports, so the greater is the quantity of U.S. dollars supplied. © 2014 Pearson Addison-Wesley
    234. 234. The Foreign Exchange Market Expected Profit Effect For a given expected future U.S. dollar exchange rate, the lower the current exchange rate, the greater is the expected profit from holding U.S. dollars, and the smaller is the quantity of U.S. dollars supplied on the foreign exchange market. © 2014 Pearson Addison-Wesley
    235. 235. The Foreign Exchange Market Supply Curve for U.S. Dollars Figure 9.2 illustrates the supply curve of U.S. dollars in the foreign exchange market. © 2014 Pearson Addison-Wesley
    236. 236. Exchange Rate Fluctuations Changes in the Demand for U.S. Dollars A change in any influence on the quantity of U.S. dollars that people plan to buy, other than the exchange rate, brings a change in the demand for U.S. dollars. These other influences are World demand for U.S. exports U.S. interest rate relative to the foreign interest rate The expected future exchange rate © 2014 Pearson Addison-Wesley
    237. 237. Exchange Rate Fluctuations World Demand for U.S. Exports At a given exchange rate, if world demand for U.S. exports increases, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward. U.S. Interest Rate Relative to the Foreign Interest Rate The U.S. interest rate minus the foreign interest rate is called the U.S. interest rate differential. If the U.S. interest differential rises, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward. © 2014 Pearson Addison-Wesley
    238. 238. Exchange Rate Fluctuations The Expected Future Exchange Rate At a given current exchange rate, if the expected future exchange rate for U.S. dollars rises, the demand for U.S. dollars increases and the demand curve for dollars shifts rightward. © 2014 Pearson Addison-Wesley
    239. 239. Exchange Rate Fluctuations Changes in the Supply of Dollars A change in any influence on the quantity of U.S. dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars. These other influences are  U.S. demand for imports  U.S. interest rates relative to the foreign interest rate  The expected future exchange rate © 2014 Pearson Addison-Wesley
    240. 240. Exchange Rate Fluctuations U.S. Demand for Imports At a given exchange rate, if the U.S. demand for imports increases, the supply of U.S. dollars on the foreign exchange market increases and the supply curve of U.S. dollars shifts rightward. U.S. Interest Rate Relative to the Foreign Interest Rate If the U.S. interest differential rises, the supply of U.S. dollars decreases and the supply curve of U.S. dollars shifts leftward. © 2014 Pearson Addison-Wesley
    241. 241. Exchange Rate Fluctuations The Expected Future Exchange Rate At a given current exchange rate, if the expected future exchange rate for U.S. dollars rises, … the supply of U.S. dollars decreases and the supply curve of U.S. dollars shifts leftward. © 2014 Pearson Addison-Wesley
    242. 242. Exchange Rate Fluctuations Changes in the Exchange Rate If demand for U.S. dollars increases and supply does not change, the exchange rate rises.  If demand for U.S. dollars decreases and supply does not change, the exchange rate falls.   If supply of U.S. dollars increases and demand does not change, the exchange rate falls. If supply of U.S. dollars decreases and demand does not change, the exchange rate rises.  © 2014 Pearson Addison-Wesley
    243. 243. Exchange Rate Fluctuations Fundamentals, Expectations, and Arbitrage The exchange rate changes when it is expected to change. But expectations about the exchange rate are driven by deeper forces. Two such forces are  Interest rate parity  Purchasing power parity © 2014 Pearson Addison-Wesley
    244. 244. Exchange Rate Fluctuations Interest Rate Parity A currency is worth what it can earn. The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. When the rates of returns on two currencies are equal, interest rate parity prevails. Interest rate parity means equal interest rates when exchange rate changes are taken into account. Market forces achieve interest rate parity very quickly. © 2014 Pearson Addison-Wesley
    245. 245. Exchange Rate Fluctuations Purchasing Power Parity A currency is worth the value of goods and services that it will buy. The quantity of goods and services that one unit of a particular currency will buy differs from the quantity of goods and services that one unit of another currency will buy. When two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity, which means equal value of money. © 2014 Pearson Addison-Wesley
    246. 246. Exchange Rate Fluctuations Instant Exchange Rate Response The exchange rate responds instantly to news about changes in the variables that influence demand and supply in the foreign exchange market. Suppose that the Bank of Japan is considering raising the interest rate next week. With this news, currency traders expect the demand for yen to increase and the demand for dollars to decrease— they expect the U.S. dollar to depreciate. © 2014 Pearson Addison-Wesley
    247. 247. Exchange Rate Fluctuations But to benefit from a yen appreciation, yen must be bought and dollars must be sold before the exchange rate changes. Each trader knows that all the other traders share the same information and have similar expectations. Each trader knows that when people begin to sell dollars and buy yen, the exchange rate will change. To transact before the exchange rate changes means transacting right away, as soon as the news is received. © 2014 Pearson Addison-Wesley
    248. 248. Exchange Rate Fluctuations The Real Exchange Rate The real exchange rate is the relative price of U.S.-produced goods and services to foreign-produced goods and services. It measures the quantity of real GDP of other countries that a unit of U.S. real GDP buys. The equation that links the nominal exchange rate (E) and real exchange rate (RER) is RER = (E x P)/P* where P is the U.S. price level and P* is the Japanese price level. © 2014 Pearson Addison-Wesley
    249. 249. Exchange Rate Fluctuations The Short Run In the short run, the equation determines RER. RER = (E x P)/P* In the short run, if the nominal exchange rate changes, P and P* do not change and the change in E brings an equivalent change in RER. © 2014 Pearson Addison-Wesley
    250. 250. Exchange Rate Fluctuations The Long Run In the long run, RER is determined by the real forces of demand and supply in the markets for goods and services. So in the long run, E is determined by RER and the price levels. That is, E = RER x (P*/P) A rise in the Japanese price level P* brings an appreciation of the U.S. dollar in the long run. A rise in the U.S. price level P brings a depreciation of the U.S. dollar in the long run. © 2014 Pearson Addison-Wesley
    251. 251. Exchange Rate Policy Three possible exchange rate policies are  Flexible exchange rate  Fixed exchange rate  Crawling peg Flexible Exchange Rate A flexible exchange rate policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. © 2014 Pearson Addison-Wesley
    252. 252. Exchange Rate Policy Fixed Exchange Rate A fixed exchange rate policy is one that pegs the exchange rate at a value decided by the government or central bank and is achieved by direct intervention in the foreign exchange market to block unregulated forces of demand and supply. A fixed exchange rate requires active intervention in the foreign exchange market. © 2014 Pearson Addison-Wesley
    253. 253. Exchange Rate Policy Figure 9.6 shows how the Fed can intervene in the foreign exchange market to keep the exchange rate close to a target rate. Suppose that the target is 100 yen per U.S. dollar. If the demand for U.S. dollars increases, the Fed sells U.S. dollars to increase supply. © 2014 Pearson Addison-Wesley
    254. 254. Exchange Rate Policy Crawling Peg A crawling peg is an exchange rate that follows a path determined by a decision of the government or the central bank and is achieved by active intervention in the market. China is a country that operates a crawling peg. A crawling peg works like a fixed exchange rate except that the target value changes. The idea behind a crawling peg is to avoid wild swings in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate. © 2014 Pearson Addison-Wesley
    255. 255. Financing International Trade Balance of Payments Accounts A country’s balance of payments accounts records its international trading, borrowing, and lending. There are three balance of payments accounts: 1. Current account 2. Capital and financial account 3. Official settlements account © 2014 Pearson Addison-Wesley
    256. 256. Financing International Trade The current account records  receipts from exports of goods and services sold abroad,  payments for imports of goods and services from abroad,  net interest paid abroad, and  net transfers (such as foreign aid payments). The current accounts balance = exports - imports + net interest income + net transfers. © 2014 Pearson Addison-Wesley
    257. 257. Financing International Trade The capital and financial account records foreign investment in the United States minus U.S. investment abroad. The official settlements account records the change in U.S. official reserves. U.S. official reserves are the government’s holdings of foreign currency. If U.S. official reserves increase, the official settlements account is negative. The sum of the balances of the three accounts always equals zero. © 2014 Pearson Addison-Wesley
    258. 258. Financing International Trade Borrowers and Lenders A country that is borrowing more from the rest of the world than it is lending to it is called a net borrower. A country that is lending more to the rest of the world than it is borrowing from it is called a net lender. Since the early 1980s, except for 1991, the United States has been a net borrower from the rest of the world. In 2010, the United States borrowed more than $400 billion from the rest of the world, mostly from China. © 2014 Pearson Addison-Wesley
    259. 259. Financing International Trade Debtors and Creditors A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. Since 1986, the United States has been a debtor nation. A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it. The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital. © 2014 Pearson Addison-Wesley
    260. 260. Financing International Trade Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption. © 2014 Pearson Addison-Wesley
    261. 261. Financing International Trade Current Account Balance The current account balance (CAB) is CAB = NX + Net interest income + Net transfers The main item in the current account balance is net exports (NX). The other two items are much smaller and don’t fluctuate much. © 2014 Pearson Addison-Wesley
    262. 262. Financing International Trade The government sector surplus or deficit is equal to net taxes, T, minus government expenditure on goods and services G. The private sector surplus or deficit is saving, S, minus investment, I. Net exports is equal to the sum of government sector balance and private sector balance: NX = (T – G) + (S – I) © 2014 Pearson Addison-Wesley
    263. 263. Financing International Trade Where is the Exchange Rate? In the short run, a fall in the nominal exchange rate lowers the real exchange rate, which makes our imports more costly and our exports more competitive. So in the short run, a fall in the nominal exchange rate decreases the current account deficit. But in the long run, a change in the nominal exchange rate leaves the real exchange rate unchanged. So in the long run, the nominal exchange rate plays no role in influencing the current account balance. © 2014 Pearson Addison-Wesley

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