1. AP/ Honors Macroeconomics Unit 4 Notes and Terms Fiscal and Monetary Policy

2. 1. Public Good- G or S provided by the government. Examples: Education, Military, Police, Fire, Jails, S.S., Welfare, Agriculture Subsidies

3. 2. Private Good- G or S provided by private individuals or private companies. Examples: Shirt from Old Navy, Gas from ARCO, Car from Sanderson Ford, Education from Brophy

4. 2 Reasons for Public Goods 3. Non-exclusion rule- difficult to exclude(keep out) individuals who are unwilling to pay. Examples: Education, Parks, Library, Street lights, system of money, weights and measure. 4. Shared Consumption rule- everyone can share in the use of a G or S. One person using a G or S does not lessen the benefit another person gets from it. Examples: Parks, Police/Military/Fire Protection, Roads, Courts, Dams/ Flood Control

5. Free Rider- someone who receives the benefits of a good or service without having to contribute to its costs. Examples: bumming a cigarette, copying homework, borrowing yard tools Dam example- 2 people (A & B) living in a flood plain, both would benefit from a dam, only A wants to pay for it, B does not.

6. 6. Taxes- Required payments of money to governments that are used to provide public goods and services.

7. 7. Types of taxes A. Personal Income- on earnings B. Corporate Income- on profit C. Excise- tax on specific item (tobacco, alcohol, gas, tires, marijuana D. Tariffs- on imports E. Inheritance- >$1 mil F. Property- on land G. Sales- on purchases H. Luxury- excise tax on expensive jewelry, planes, boats, cars, china, crystal I. Social Security- on wages/salaries/tips J. Licenses and Fees- Driver’s, hunting, business, toll road/bridge

8. 8. Federal Spending Federal Taxes/ Revenue 1. Defense 2. Social Security 3. Net interest 4. Social Programs 1. Personal Income 2. Social Security 3. Borrowing 4. Corporate Income

9. Government Purchases vs. Government Transfers 35 30 25 20 15 10 5 0 Percentage of U.S. Output 19602005 Government Purchases Government Transfer Payments 22% 5% 19% 12% 27% 31%

10. GLOBAL PERSPECTIVE Total Tax Revenue – Selected Nations Percent of Total Output-2004 Sweden Denmark Norway Finland France Italy United Kingdom Germany Canada Australia United States Japan South Korea 1020304050 Source: Organization for Economic Cooperation and Development 50.7 49.6 44.9 44.3 43.7 42.2 36.1 34.6 33.0 31.6 25.4 25.3 24.6

11. Federal Expenditures-2005 01020304050 Pensions & Income Security National Defense Health Interest on the Public Debt Source: U. S. Office of Management and Budget 35% 20% 17% 7% Four Stand-Out Areas of Spending

13. Income Tax Characteristics Progressive Tax Rates Brackets of Income Marginal Tax Rate Average Tax Rate

14. 10% for the first $8,350 earned, 15% between $8,250 to $33,950, 25% between $33,950 and $82,250, 28% between $82,250 to $171,550, 33% between $171,550 and $372,950, and 35% above $372,950. Marginal Income Tax Rates (2009) Taxable Income Progressive Tax rates with brackets of income and marginal rates.

15. Average rates AFTER you take tax deductions and tax credits

17. Federal Tax Revenues-2005 01020304050 Personal Income Tax Payroll Taxes Corporate Income Taxes Excise Taxes Source: U. S. Office of Management and Budget 43% 37% 3% 4% All Other 13% Basic Revenue Sources

18. State & Local Spending State & Local Taxes 1. Education 2. Health/ Welfare 3. Public Safety 4. Transportation 1. Sales 2. Property 3. Excise 4. Federal Grants

19. State Government Finances Primary Revenues Sales & Excise Taxes - 48% Personal Income Taxes - 34% Corporate Income Taxes & License Fees – Most of Balance Primary Expenditures Education – 35% Public Welfare – 28% Health & Hospitals – 7% Highways – 7% Public Safety – 4% Other – 19%

20. Local Government Finances Primary Revenues Property Taxes – 73% Sales & Excise Taxes – 17% Primary Expenditures Education – 44% Welfare, Health & Hospitals – 12% Public Safety – 11% Housing, Parks, & Sewers – 8% Streets & Highways – 5%

21. U.S. is actually a “low tax” country when compared to other developed countries.

22. Progressive tax- a tax that takes a larger percentage of higher incomes than of lower incomes. Examples: Income, Inheritance, Luxury, Property 0 % of Income Income ($) 10% $1,000 $10,000 $100,000 20% 50% Impact of Taxes on Income

23. Regressive tax- A tax that takes a larger percentage of lower incomes than of higher incomes. Examples: Sales, Licenses and Fees, Excise, Social Security 0 % of Income Income ($) 5% $1,000 $10,000 $100,000 20% 40% Impact of Taxes on Income

24. Proportional Tax- A tax that takes the same percentage of income from all workers. Examples: Flat tax proposal for the income tax 0 % of Income Income ($) $1,000 $10,000 $100,000 20% Impact of Taxes on Income

25. 13. Benefits Received Principle- The people who pay the tax are the ones who directly receive the benefits. Examples: Licenses and Fees, Most Excise Taxes, Social Security

26. 14. Ability to Pay Principle- The amount of tax a person pays is based on how much they can afford to pay. Two types: 1. Based on Wealth- Value of your assets(what you own). Examples: Property, Inheritance 2. Based on Income- How much money you earn now. Examples: Personal Income, Luxury

27. Good  1-3% Inflation  Bad Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Bad  3-4% Growth (RGDP)  Good Good  4-6% Unemployment  Bad

28. 3% CPI Increase/ Inflation Rate Economic Statistics- Expansionary Policy -2% Growth in RGDP 10% Unemployment Rate What is the problem with the economy? Recession! How do you know this? Unemployment is at a very high rate, higher than it’s normal range of 3-5%. The economy is also shrinking, since the RGDP is negative.

29. 3% CPI Increase/ Inflation Rate Economic Statistics- Expansionary Policy -2% Growth in RGDP 10% Unemployment Rate What can the Congress and the President do to solve/ help this situation? Increase the amount of income for people! This will put more money into the economy and get it expanding again.

30. “Murphy's Law of Economic Policy” ''Economists have the least influence on policy where they know the most and are most agreed; they have the most influence on policy where they know the least and disagree most vehemently.'' Economist Alan Blinder, former vice chair of the Federal Reserve

31. 15. Fiscal Policy- Using Taxes and Government Spending to achieve specific economic goals. 16. Expansionary Fiscal Policy- Efforts by Congress and the President to stimulate the economy and get it expanding. Used during a recession. Tries to increase aggregate demand. 3 “Tools” of Fiscal Policy: 1. Taxes- Decrease 2. Government Spending- Increase 3. Transfer Payments- Increase

32. Expansionary Fiscal Policy pushes AD from AD 0 to AD 1 ; PL ↑ from PL 0 to PL 1, RGDP ↑ from Y 0 to Y 1. U ↓ because economy has risen to FE. But…Demand-Pull Inflation! AD 1 SRAS 0 0 PL RGDP=Y PL 1 LRAS Y1Y1 FE PL 0 Y0Y0 AD 0 The economy is below FE at an output of Y 0. Congress and the President can: AD/AS Graph- Expansionary Fiscal Policy 1. ↑ G 2. ↑ TP 3. ↓ T AD/ AS Graph John Maynard Keynes

35. Real Domestic Output, GDP Price Level AD 2 Recessions Decrease Aggregate Demand AD 1 $5 Billion Additional Spending Full $20 Billion Increase in Aggregate Demand AS $490$510 P1P1 Expansionary Fiscal Policy

36. Good  1-3% Inflation  Bad Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Bad  3-4% Growth (RGDP)  Good Good  4-6% Unemployment  Bad

37. 15% CPI Increase/ Inflation Rate Economic Statistics- Contractionary Policy 5% Growth in RGDP 4% Unemployment Rate What is the problem with the economy? Inflation! How do you know this? CPI is going up at a very high rate. Higher than it’s normal range of 2-3%.

38. 15% CPI Increase/ Inflation Rate Economic Statistics- Contractionary Policy 5% Growth in RGDP 4% Unemployment Rate What can the Congress and the President do to solve/ help this situation? Decrease the amount of income for people! This will put less money into the economy and get it to slow down or contract.

39. 17. Contractionary Fiscal Policy- Efforts by Congress and the President to constrict the economy and get it contracting. Used during an expansion with high inflation. Tries to decrease aggregate demand. 3 “Tools” of Fiscal Policy: 1. Taxes- Increase 2. Government Spending- Decrease 3. Transfer Payments- Decrease

40. Contractionary Fiscal Policy pushes AD from AD 0 to AD 1 ; PL ↓ from PL 0 to PL 1, RGDP ↓ from Y 0 to Y 1. U ↑ because economy has decreased to FE. AD 1 SRAS 0 0 PL RGDP=Y PL 1 LRAS Y1Y1 FE PL 0 Y0Y0 AD 0 The economy is above FE at an output of Y 0. Congress and the President can: AD/AS Graph- Contractionary/ Restrictive Fiscal Policy 1. ↓ G 2. ↓TP 3. ↑ T AD/ AS Graph

41. Real Domestic Output, GDP Price Level AD 3 Recessions Decrease Aggregate Demand AD 4 $5 Billion Initial Decrease In Spending Full $20 Billion Decrease in Aggregate Demand AS $510$522 P1P1 Contractionary Fiscal Policy

42. 18. Discretionary Stabilizers- Fiscal policy tools that require Congress and the President to take some action. Examples- increase or decrease taxes, create or eliminate a tax break, Spend more on infrastructure, weapons, education, NASA, FBI, National Parks

43. 19. Automatic Stabilizers- Fiscal policy tools that do not require Congress and the President to take some action. Examples- Welfare, food stamps, AHCCS, section 8 housing vouchers, other programs based on income, unemployment compensation.

44. U.S. Income-Maintenance System Entitlement Programs Social Security Earned-Income Tax Credit (EITC) Medicare and Medicaid Unemployment Compensation Public Assistance “Welfare” Supplemental Security Income (SSI) Program Temporary Assistance for Needy Families (TANF) Food-Stamp Program Section 8 Housing Vouchers

45. 2009 Stimulus Package by category- Link to larger graphicLink

46. Problems of Timing Recognition Lag Administrative Lag Operational Lag Political Considerations Political Business Cycle Future Policy Reversals Offsetting State and Local Finance Crowding-Out Effect Current Thinking on Fiscal Policy Problems, Criticisms, and Complications of Fiscal Policy O 11.2

47. 2009 Stimulus Package by year in which money is spent- Link to larger graphic.Link

48. 20. Barter- Trading of goods and services without the use of money. Not very efficient! It lacks a “coincidence of wants”. Pogs! Marbles! Trueques (barter markets) of Argentina Baseball cards!

49. Sources of Money’s Value Commodity Money- The item used as money has value of it’s own. Ex: Silver, Gold, Gems, Salt, tobacco, furs, shells

50. Sources of Money’s Value Representative Money- The item used as money has value because it can be exchanged for something valuable. Gold and Silver Certificates

51. Sources of Money’s Value Fiat Money- The item used as money has value because the government says it is money AND the citizens accept it is money. Almost all coins and currency today

52. 21. Functions of money- 1. Medium of exchange- Accepted in trade for G & S 2. Store of value- Can be saved for use at a later date

53. 21. Functions of money- 3. Unit of Account/ Measure of value- Easy to judge the worth of different products 4. Standard of Deferred Payment Used as a standard benchmark for specifying future payments for current purchases, that is, buying now and paying later.

54. 22. Characteristics of money- Why do we use certain items as money? 1. Divisibility- Easy to break into smaller units 2. Portability- Easy to carry or transport 3. Durability- Lasts a long time 4. Stability in value- Holds its value over time (no/ low inflation!)

55. 23. M1- Measure of the supply of money in circulation. Used by the Federal Reserve and others to measure the growth of money in circulation. Includes the following: 2. Demand Deposits/ Checking Accounts 3. Traveler’s Checks 1. Coins and Currency

56. 24. M2- Another measure of the supply of money. Used for the same reason as M1. Many economists feel it more accurately reflects the "readily available" supply of money(the money that can relatively quickly be turned into cash). M2 includes everything in M1 plus the following major components : 1. Savings Accounts 2. Money Market Accounts (MMA’s) 3. Certificates of Deposit (CD’s) 4. Eurodollars (U.S. $ in Euro banks) 25. M3 = M2 + Large Time Deposits Broadest definition of the money supply

57. M1M1M2M2 54% 46% M1M1 20% Savings Deposits Including Money Market Deposit Accounts (MMDA) Small Time Deposits Money Market Mutual Funds Held By Individuals (MMMF) Currency Checkable Deposits 15% 11% 54% $1,375 Billion $6,758 Billion February 2006 Totals + + + + +

58. The Global Greenback U.S. Currency Circulating Abroad Russians $40 Billion Argentineans $7 Billion Polish $6 Billion U.S. Profits from Dollars Leaving Black Markets and Illegal Activities Seeking Stable Purchasing Power Soviet Union Collapse Brazil Inflation Issues Asian Market Exchanges

59. 26.The Monetary Equation of Exchange M x V = P x Q Money X Velocity = Price Level X Quantity M = M1 Velocity = The number of times a dollar is spent Price Level = The rate of inflation (GDP Price Deflator) Quantity = Real GDP Real GDP (Q) x Price Level (P) = Nominal GDP

60. 27. Money Multiplier = 1/ Reserve Requirement X Initial Deposit Example: If the Fed has a Reserve Requirement of 20% this means 1 ÷.2 = 5 5 is the money multiplier $1000 initial deposit  $800 (80%) in excess reserves and $200 (20%) in required reserves $1000 x 5 = $5000 of money in circulation $800 x 5 = $4000 new money created by the banking SYSTEM (not by 1 bank) $1000 initial deposit + $4000 new money = $5000 in circulation Refer to Money Creation Simulation for more examples

61. Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks Bank (1) Acquired Reserves and Deposits (2) Required Reserves (Reserve Ratio =.2) (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) $100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00

62. Monetary Multiplier or Checkable-Deposit Multiplier Monetary Multiplier = 1 Required Reserve Ratio or in Symbols… m = 1 R New Reserves $100 $20 Required Reserves $80 Excess Reserves $100 Initial Deposit $400 Bank System Lending Money Created Graphic Example

63. The Monetary Multiplier Reversibility Making Loans Creates Money Loan Repayment Destroys Money Multiple Step Money Expansion Multiple Step Destruction of Money W 13.2

64. An injection of $100 of new money to the system when the reserve requirement is 10% will change the money supply by $1000. BUT the banking system increases the money supply by $900 (the $100 difference being the action of the depositor). Students have to be very careful to read the question carefully and understand the two possible answers for the change in the money supply. A third possibility to the $100 of new deposits to the system is "how much can this previously fully loaned out bank immediately increase their loans?" Well now, I might not have the wording that the College Board would use after a two year period crafting the question, but a $100 deposit with a reserve requirement of 10% allows the bank to make a loan of $90. AP Macro Exam Tip

65. 28. The Federal Reserve(The Fed)- Central bank of the U.S. Privately owned and financed by member banks in the U.S. Very important and powerful. The Fed is given power by law to conduct the following major functions: 1. Check clearing- Clears checks written under one bank and then deposited in another bank. 2. Bank Regulation- Keeps banks honest and depositors' money safe from banks misuse. 3. Providing Currency- Issues, but does not print, new money when banks turn in old, worn out currency. 4. Regulating the money supply(using the 3 tools)- Increase or decrease the money supply to fight inflation and / or prevent the economy from entering a recession.

66. 29. Structure of the Fed (Major parts)- 1. Regional Banks- 12 regional banks; AZ in the 12th district; San Francisco HQ of 12th district; New York most important district. Regional banks are in charge of the 1st 3 functions listed above.

67. 29. Structure of the Fed (Major parts)- 2. Board of Governors- 7 members, appointed to 14 year terms by the President and confirmed by the Senate. Oversee all operations of the Fed. Chairman-Benjamin Bernanke, appointed in 2005 by G. W. Bush, confirmed by Senate 1/31/2006 B of G Building

68. 29. Structure of the Fed (Major parts)- 3. Federal Open Market Committee (FOMC)- 12 members (7 BofG's and 5 district bank presidents) Decides monetary policy (see below).

69. 12 regional bank presidents 7 members, appointed by president, confirmed by the Senate 5 of the branch presidents serve on the FOMC too, 1 of 5 is always from NY branch All 7 of B of G serve on FOMC

70. Framework of the Federal Reserve System and the Relationship to the Public Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses) 12 Federal Reserve Banks Board of Governors Federal Open Market Committee

71. Reserve Bank of Australia (RBA) Bank of Canada Central Bank of Europe (CBE) Bank of Japan (BOJ) Banco de Mexico (Mex Bank) Central Bank of Russia Sveriges Riksbank Bank of England Federal Reserve System (the “Fed”) (12 Regional Federal Reserve Banks) Australia: Canada: Euro Zone: Japan: Mexico: Russia Sweden: United Kingdom: United States: Central Banks, Selected Nations GLOBAL PERSPECTIVE

72. Fed Salary Facts Fed Chairman Makes $191,300 All other members make $172,200. Salaries are not very high when compared to what a private banker could make These numbers are as of January 2008.

73. 30.Monetary Policy- The control of the supply of money by the Fed to achieve specific economic goals. Changing the money supply will cause the aggregate demand curve to shift! 31. The Three (3) Tools of Monetary Policy- 1. Open Market Operations (OMO)- Sets the Federal Funds Rate = IR Banks charge Banks Buying and Selling Government Bonds (Securities) Fed Buys bonds  Decrease in Fed Funds Rate  Increase in $ supply Fed Sells bonds  Increase in Fed Funds Rate  Decrease in $ supply Buy Bigger, Sell Smaller

74. Tools of Monetary Policy New Reserves $1000 $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) Fed Buys $1,000 Bond from a Commercial Bank $1000 Excess Reserves

75. Tools of Monetary Policy Check is Deposited New Reserves $1000 Total Increase in the Money Supply, ($5000) Fed Buys $1,000 Bond from the Public $200 Required Reserves $800 Excess Reserves $1000 Initial Checkable Deposit $4000 Bank System Lending

76. Federal Funds Rate, Percent 3.5 Quantity of Reserves DfDf S f3 4.0 4.5 S f1 S f2 Q f3 Q f1 Q f2 Using Open Market Operations To Set The Federal Funds Rate

77. How the Fed’s actions affect all of the participants in the economy

78. 2. Discount Rate (DR)- IR Fed charges Banks Fed decreases DR  Banks borrow more $  Banks lend out more $  Increase in $ Supply Fed increases DR  Banks borrow less $  Banks lend out less $  decrease in $ Supply Many days, there is less than $100 million in discount- window loans outstanding. That leapt to almost $46 billion after the Sept. 11, 2001, terrorist attacks on the U.S. disrupted the money markets. LinkLink to change in FFR and DR rates

79. 3. Reserve Requirements (RR)- Fed decreases RR  Banks Lend out more $  Increase in $ Supply Fed increases RR  Banks Lend out less $  Decrease in $ Supply LinkLink to use of technology to reduce required reserves

80. Money Market Graph- Money Demand Curve MD 0 Nominal Interest Rate (i) Quantity of Money (QM) The nominal interest rate is the opportunity cost of holding money. As i ↓  ↑ Quantity of MD, ∆ Q MD As i ↑  ↓ Quantity of MD, ∆ Q MD i0i0 QM 0 i1i1 QM 1 ∆ QMD Money Market Money Market- The market for short term lending.

81. Money Market Graph Money demand (MD) slopes downward for 4 reasons: Transaction Demand- Need to keep money for daily purchases Asset Demand- Need to hold money as an asset, for its liquidity and low risk Precautionary Demand- Need to keep $ to pay for emergencies MD 0 Nominal Interest Rate (i) Quantity of Money MS i0i0 QM 0 The supply of money (MS) is determined by the Fed so it is a fixed amount (perfectly inelastic) Speculative Demand- Change the amount of money you hold because you think interest rates will change Money Market

82. Demand for Money and the Money Market Rate of Interest, I percent 10 7.5 5 2.5 0 501001502005010015020050100150200250300 Amount of Money Demanded (Billions of Dollars) Amount of Money Demanded (Billions of Dollars) Amount of Money Demanded and Supplied (Billions of Dollars) = + (a) Transactions Demand for Money, D t (b) Asset Demand for Money, D a (c) Total Demand for Money, D m And Supply DtDt DaDa DmDm SmSm 5

83. Interest Rates Equilibrium Interest Rate Interest Rates and Bond Prices Bond Prices Fall When Interest Rates Rise Bond Prices Rise When Interest Rates Fall Inverse Relationship Between Interest Rates and Bond Prices W 14.2 G 14.1

84. Money Market Graph- ∆ MS (shift in MS) An ↑ in MS from MS 0 to MS 1 → ↓ i from i 0 to i 1 ; ↑ QM from QM 0 to QM 1 A ↓ in MS from MS 0 to MS 2 → ↑ i from i 0 to i 2 ↓ QM from QM 0 to QM 2 MD 0 Nominal Interest Rate (i) Quantity of Money (QM) MS 0 i0i0 QM 0 MS 1 i1i1 QM 1 MS 2 i2i2 QM 2 Money Market

85. Money Market Graph- ∆ MD (shift in MD) An ↑ money demand from MD 0 to MD 1 → ↑ i from i 0 to i 1 A ↓ money demand from MD 0 to MD 2 → ↓ i from i 0 to i 2 MD 0 0 Nominal Interest Rate (i) Quantity of Money (QM) MS 0 i0i0 QM 0 i2i2 i1i1 MD 1 MD 2 What happens to Quantity of Money? Money Market

86. Money Market Graph Country A has a relatively elastic MD. MD- Country A 0 Nominal Interest Rate (i) Quantity of Money MS 0 i0i0 QM 0 Different elasticities of MD Country B (USA)- An ↑in MS from MS 0 to MS 1 will cause a relatively large ↓ in i from i 0 to i 2. Country B’s MD is relatively sensitive to ∆ in i. Countries with more developed countries/ economies (MDC’s). MD- Country B Country B has a relatively inelastic MD. Country A (Bolivia)- An ↑ in MS from MS 0 to MS 1 will cause a relatively small ↓ in i from i 0 to i 1. Country A’s MD is relatively insensitive to ∆ in i. Countries with less developed countries/ economies (LDC’s). MS 1 i1i1 QM 1 i2i2 Money Market

87. Different Elasticities of Investment Demand ID I Nominal Interest Rate (i) Quantity of Investment QI E QI 0 The ↓ in i from i 0 to i 1 ↑ investment a little in the country A but a lot in country B. A country would rather have an elastic investment D curve, sensitive to changes in i. These would tend to be more developed countries/ economies (MDC’s). MD 0 Nominal Interest Rate (i) Quantity of Money MS 0 i0i0 QM 0 i1i1 ID E MS 1 QM 1 QI I Country B Country A Money MarketInvestment Demand

88. Different Elasticities of Money Demand and Investment Demand Nominal Interest Rate (i) Quantity of Investment QI 0 A country would rather have an inelastic (insensitive) money demand curve and an elastic (sensitive) investment demand curve. These would tend to be more developed countries/ economies (MDC’s) MD I 0 Nominal Interest Rate (i) Quantity of Money MS 0 i0i0 QM 0 i1i1 ID E MS 1 QM 1 QI E Money Market Investment Demand

89. Good  1-3% Inflation  Bad Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Bad  3-4% Growth (RGDP)  Good Good  4-6% Unemployment  Bad

90. 3% CPI Increase/ Inflation Rate Economic Statistics- Expansionary Policy -2% Growth in RGDP 10% Unemployment Rate What is the problem with the economy? Recession! How do you know this? Unemployment is at a very high rate, higher than it’s normal range of 4-6%. The economy is also shrinking, since the RGDP is negative.

91. 3% Inflation Economic Statistics- Expansionary Policy -2% Growth (RGDP) 10% Unemployment What can the Federal Reserve do to solve/ help this situation? Increase the money supply! This will put more money into the economy and get it expanding again.

92. 32. Expansionary Monetary Policy (Easy money) - Efforts by the Fed to stimulate the economy and get it expanding. Used during a recession. Tries to increase aggregate demand. 3 “Tools” of Monetary Policy: 1. Open Market Operations (OMO)- Fed Buys bonds/ Decreases Fed Funds Rate 2. Discount Rate (DR)- Fed decreases DR 3. Reserve Requirements (RR)- Fed decreases RR

93. Expansionary Monetary Policy Problem: Unemployment and Recession Fed Buys Bonds, Lowers Reserve Ratio, or Lowers the Discount Rate Excess Reserves Increase Federal Funds Rate Falls Money Supply Rises Interest Rate Falls Investment Spending Increases Aggregate Demand Increases Real GDP Rises CAUSE-EFFECT CHAIN

95. Expansionary Monetary Policy ID Nominal Interest Rate (i) Quantity of Investment QI 0 Money Market- MS ↑ from MS 0 to MS 1. This ↓ nominal interest rates (i) from i 0 to i 1 and quantity ↑ from QM 0 to QM 1 MD 0 Nominal Interest Rate (i) Quantity of Money MS 0 i0i0 QM 0 i1i1 MS 1 QM 1 QI 1 Money Market Graph Investment Demand Graph Investment Demand- ↓ i from i 0 to i 1 → ↑ I from QI 0 to QI 1. ↑ I → ↑ AD.

96. Expansionary Monetary Policy pushes AD from AD 0 to AD 1 ; PL ↑ from PL 0 to PL 1, RGDP ↑ from Y 0 to Y 1. U ↓ because economy has risen to FE. But…Demand-Pull Inflation! AD 1 SRAS 0 0 PL RGDP=Y PL 1 LRAS Y1Y1 FE PL 0 Y0Y0 AD 0 The economy is below FE at an output of Y 0. The Fed can: AD/AS Graph- Expansionary Monetary Policy 1. Buy Bonds, ↓ federal funds rate 2. ↓ Discount Rate 3. ↓ Reserve Requirements ↑MS→ ↓IR → ↑C, I → ↑AD AD/ AS Graph

97. 15% CPI Increase/ Inflation Rate Economic Statistics- Contractionary Policy 5% Growth in RGDP 4% Unemployment Rate What is the problem with the economy? Inflation! How do you know this? CPI is going up at a very high rate. Higher than it’s normal range of 1-3%.

98. 15% CPI Increase/ Inflation Rate Economic Statistics- Contractionary Policy 5% Growth in RGDP 4% Unemployment Rate What can the Federal Reserve do to solve/ help this situation? Decrease the money supply! This will put less money into the economy and get it to slow down or contract.

99. 33. Contractionary Monetary Policy (Tight money) - Efforts by the Fed to constrict the economy and slow it down. Used during an expansion with high inflation. Tries to decrease aggregate demand. 3 “Tools” of Monetary Policy: 1. Open Market Operations (OMO)- Fed Sells bonds/ Increases Fed Funds Rate 2. Discount Rate (DR)- Fed increases DR 3. Reserve Requirements (RR)- Fed increases RR

100. Restrictive Monetary Policy Problem: Inflation Fed Sells Bonds, Increases Reserve Ratio, or Increases the Discount Rate Excess Reserves Decrease Federal Funds Rate Rises Money Supply Falls Interest Rate Rises Investment Spending Decreases Aggregate Demand Decreases Inflation Declines CAUSE-EFFECT CHAIN

101. Bank Panics of 1930-1933 Series of Bank Panics Before Deposit Insurance Mass Withdrawals From Fear Move to Cash Reduced Money Supply Through Reduction in Loans Multiple Contraction Slowed Lending and the Economy 1933 National Bank Holiday for One Week Resulted in FDIC and 25% Drop in Money Supply Contributed to the Great Depression Regulation Protects the System Today

102. Contractionary Monetary Policy ID Nominal Interest Rate (i) Quantity of Investment QI 0 Money Market- MS ↓ from MS 0 to MS 1. This ↑ nominal interest rates (i) from i 0 to i 1 and quantity ↓ from Q 0 to Q 1 MD 0 Nominal Interest Rate (i) Quantity of Money MS 0 i0i0 QM 0 i1i1 MS 1 QM 1 QI 1 Money Market Graph Investment Demand Graph Investment Demand- ↑ i from i 0 to i 1 → ↓ I from QI 0 to QI 1.

103. Contractionary Monetary Policy pushes AD from AD 0 to AD 1 ; PL ↓ from PL 0 to PL 1, RGDP ↓ from Y 0 to Y 1. U ↑ because economy has decreased to FE. AD 1 SRAS 0 0 PL RGDP=Y PL 1 LRAS Y1Y1 FE PL 0 Y0Y0 AD 0 The economy is above FE at an output of Y 0. The Fed can: AD/AS Graph- Contractionary/ Restrictive Monetary Policy 1. Sell Bonds, ↑ federal funds rate 2. ↑ Discount Rate 3. ↑ Reserve Requirements ↓ MS→ ↑ IR → ↓ C, I → ↓ AD AD/ AS Graph

104. 10 8 6 0 Rate of Interest, i (Percent) Amount of Money Demanded and Supplied (Billions of Dollars) Amount of Investment, I (Billions of Dollars) Price Level Real Domestic Product, GDP (Billions of Dollars) Q1Q1 QfQf Q3Q3 $125$150$175$15$20$25 P2P2 P3P3 S m1 S m2 S m3 DmDm ID AD 1 I=$15 AD 2 I=$20 AD 3 I=$25 (a) The Market For Money (b) Investment Demand (c) Equilibrium Real GDP and the Price Level Monetary Policy and Equilibrium GDP AS

105. Monetary Policy Evaluation and Issues Speed and Flexibility Isolation From Political Pressure Recent U.S. Monetary Policy Problems and Complications Recognition Lag Administrative Lag Operational Lag

106. AD-AS Theory of Price Level - Real Output and Stabilization Policy Levels of Output, Employment, Income, and Prices Aggregate Demand Aggregate Supply Input Resources With Prices Productivity Sources Legal- Institutional Environment Consumption (C d ) Investment (I g ) Net Export Spending (X n ) Government Spending (G)

107. Loanable Funds Market DLF 0 Real Interest Rate (r) Quantity of Loanable Funds r0r0 SLF QLF 0 Loanable Funds Market Loanable Funds Market- Primarily, this is the market where lenders make money available to business borrowers to expand their investment in capital.

108. Loanable Funds Market Supply of Loanable Funds- The income people have chosen to save or lend out rather than use for consumption. A ∆ savings decisions will shift SLF. Demand for Loanable Funds- The money households and businesses want to borrow. A ∆ investment or consumption decisions will shift DLF. DLF 0 Real Interest Rate (r) Quantity of Loanable Funds r0r0 SLF QLF 0 Loanable Funds Market

109. Determinants of Supply of LF 1.Domestic Saving by Individuals and Business 2.Government Budget Surpluses: G < T 3. International Savers/ Investors Determinants of Demand of LF 1.Domestic Borrowers, both individuals and business 2.Government Budget Deficit: G > T 3.International Borrowers DLF 0 Real Interest Rate (r) Quantity of Loanable Funds r0r0 SLF QLF 0 Loanable Funds Market

110. 34. Prime rate- The interest rate that the biggest banks charge their biggest and best customers. When the Fed increases Discount and/ or Federal Funds rate banks raise their Prime rate which causes other rates(car, home loans, etc.) to increase. If the Fed decreases its rates banks do the same with their prime and other rates. Fed ↑ Money Supply  Banks borrow more  Banks lend/ create more  ↓ Prime rate  ↓ rates for homes, cars, education  ↑ C, I  ↑ AD.

111. 35. Budget Deficit- When government spending exceeds government revenue. When the government spends more than it makes. To make up the deficit the government is forced to borrow money. Currently 407 billion (FY2008). A yearly total. Maybe $1.6 Trillion for 2009

112. Budget Deficit vs. Budget Surplus A deficit exists when Government Spending is > Tax Revenue. So: G > T A surplus exists when Government Spending is < Tax Revenue. So: G < T A balanced budget exists when: Government Spending = Tax Revenue. So: G = T

113. (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 -3.9% -4.4% -4.5% -3.8% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.5% +1.3% -1.5% -3.4% -3.5% -2.6% -2.2% -2.5% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% -1.1% -2.7% -2.4% -1.8% Federal Deficits and Surpluses – 1990 - 2005 as a Percentage of Potential GDP Source: Congressional Budget Office

114. Federal Budget Deficits and Surpluses Actual and Projected, Fiscal 1992-2012 Source: Congressional Budget Office $300 200 100 0 -100 -200 -300 -400 -500 Budget Deficit (-) or Surplus, Billions 19921994199619982000200220042006200820102012 ActualProjected(as of March 2006)

115. 36. National Debt- The sum of all past budget deficits. Currently $10.6 trillion (November, 2008).

117. Who do we owe the debt to? As of November 2007, Japan ($580 billion), China ($390 billon) and the United Kingdom ($320 bilion) are the biggest foreign holders of our Debt.biggest foreign holders of our Debt

118. Debt Held by the Public as a Percent of GDP 1980-2007 Source: Congressional Budget Office, January 2008 118

119. Percent of Debt Held by the Public Owned by Foreigners Source: United States Treasury Department (1980-2006)

120. GLOBAL PERSPECTIVE Publicly Held Debt: International Comparisons As a Percentage of GDP - 2005 Italy Belgium Japan Germany France United States Hungary Netherlands United Kingdom Spain Canada Poland 0 20 40 60 80 100 101.3 86.3 80.9 39.6 58.8 46.5 45.7 39.3 39.1 26.4 17.0 28.7 Source: Organization for Economic Cooperation and Development

123. 37. Discretionary Spending- Spending that is not required by law. Examples: ∆Taxes/ Tax deductions, Defense, NASA, Education

124. Examples: Social Security, Welfare, Stud. Loans, Food Stamps Growth of programs for baby boomers is a real concern for the future- S.S., Medicare, Medicaid, Prescription Drug Benefit 38. Entitlement Spending- Spending programs required by law to be paid to anyone who meets criteria set by law.

125. 40. Transfer payments- Payments made to individuals/ households by the government. 39. Mandatory Spending = Entitlements + Net Interest on the Debt. Both are required by law. Both growing dramatically because of: Examples: S.S, Welfare, Stud. Loans, Food Stamps 1. ↑ in the deficit  more debt 2. Aging Population  more spending on Social Security, Medicare, and Medicaid This then puts a squeeze on discretionary spending such as defense, NASA, national parks, law enforcement, education, etc.

126. Composition of Actual FY 2007 Federal Government Revenues and Outlays (Deficit: $163 Billion) Interest Domestic* Social Security Medicare & Medicaid Other Entitlements Defense Estate & Gift Taxes Other Taxes Corporate Taxes Social Insurance Taxes Individual Income Taxes Outlays: $2.73 trillionRevenue: $2.57 trillion *Includes all appropriated domestic spending such as education, transportation, homeland security, housing assistance, and foreign aid. Source: CBO 2008. Billions of Dollars

129. America’s Population is Aging Population age 65 and Over Source: Social Security and Medicare Trustees’ Report, April 2007 Year Percentage of Population Aged 65 and Over

130. Americans are living longer and having fewer children Consequently, fewer workers are available to support each Social Security recipient 1960: 5.1 to 1 Today: 3.3 to 1 2040: 2.1 to 1 Source: Social Security Administration, April 2007 130

131. Medicare Costs Soar in the Coming Decades Calendar Year As a Percentage of GDP General Revenues required to fund the program Income from dedicated taxes, premiums, and state transfers Source: Medicare Trustees’ Report, 2008 131

132. 68% 26% 7% 44% 14% 42% 38% 9% 53% MandatoryDiscretionaryNet Interest Source: Congressional Budget Office, January 2008 Mandatory spending is consuming a growing share of the budget NOTE: Numbers may not add up due to rounding.

133. Social Security, Medicare, & Medicaid as a Percentage of the Federal Budget All other Federal Spending $1.6 Trillion 58% Social Security, Medicare and Medicaid $1.1 Trillion 42% Source: Congressional Budget Office, January 2008.

134. Outlays of Select Mandatory Spending Programs (FY 2008 Projected) Source: Congressional Budget Office, January 2008

135. Change in Composition of Discretionary Spending 68% 32% 64% 36% 47%53% DefenseNon-defense Source: Congressional Budget Office, January 2008 135

136. Defense Discretionary Spending as a Percentage of GDP Source: Congressional Budget Office, January 2008 As a Percentage of GDP 136

137. Outlays of Select Discretionary Non-Defense Programs (FY 2008 Projected) Source: Congressional Budget Office, January 2008 *includes ground, air, and water 137

138. Automatic Growth in the Big Three Entitlements Swamps Growth of Appropriations 10 Year Growth in Social Security, Medicare and Medicaid 2009-2018 Spending for Social Security, Medicare and Medicaid.$5.9 trillion Discretionary Spending$1.9 trillion Increase Over 2007 Level of Funding In Billions of Dollars Source: Congressional Budget Office, January 2008.

139. Current fiscal policy is on an unsustainable path Social Security Medicaid Medicare All Other Interest Source: Government Accountability Office, March 2008 Average tax revenue

140. Social Security, Medicare, Medicaid and Interest Consume All Federal Revenues in Less Than 20 Years Source: GAO. 2008. Year Percentage of Revenues Social Security, Medicare and MedicaidInterest

141. Balanced Budget A balanced budget exists when: Government Spending is = Tax Revenue. So: G = T There are good economic reasons (crowding out) for a balanced budget.

142. Balanced Budget So, to have a balanced budget the government must: A deficit exists when Government Spending is > Tax Revenue. So: G > T ↓ G or ↑ T or ↓ Transfer payments

143. AD 0 SRAS 0 0 PL RGDP=Y PL 0 LRAS Y1Y1 FE PL 1 Y0Y0 AD 1 Federal Government engages in expansionary fiscal policy to close the recessionary gap. Crowding Out Illustrated R Gap ↑ G → ↑ AD ↑TP, ↓ T → ↑ DPI → ↑ C, I → ↑ AD PL ↑ from PL0 to PL1 RGDP ↑ from Y0 to Y1 U ↓ because the economy has moved up to FE. The recessionary gap is gone! AD/AS Graph

144. 41. Crowding Out effect- Federal government spends more than it makes (taxes) It must borrow the rest. The rise in interest rates caused by increased borrowing by the federal government. DLF 0 (Private Debt) 0 Real Interest Rate (r) Quantity of Loanable Funds r0r0 SLF DLF 1 (Private + Public Debt) r1r1 Q0Q0 Q1Q1 Since the Gov is borrowing more the D for loanable funds ↑ from DLF 0 to DLF 1 and real interest rates increase from r 0 to r 1. Q of loanable funds ↑ from Q 0 to Q 1. Loanable Funds Market Because of the ↑ in r the Q d of loanable funds available for private borrowing ↓ from Q 0 to Q Private. Q Private

145. Crowding Out effect- Loanable Funds and Investment Demand DLF 0 0 Real Interest Rate (r) Quantity of Loanable Funds r0r0 SLF DLF 1 r1r1 QLF 0 QLF 1 D for loanable funds has ↑ from DLF 0 to DLF 1 and real interest rates have ↑ from r 0 to r 1. ID 0 Real Interest Rate (r) Quantity of Investment Demand QI 1 QI 0 The ↑ in real interest rates will cause the Q of Investment demand to ↓ from QI 0 to QI 1. Loanable Funds Market Investment Demand

146. Crowding Out effect- Money Market and Investment Demand MD has ↑ from MD 0 to MD 1 and nominal interest rates have ↑ from i 0 to i 1. ID Nominal Interest Rate (i) Quantity of Investment Demand QI 1 QI 0 The ↑ in nominal interest rates will cause the Q of Investment Demand to ↓ from QI 0 to QI 1. MD 0 0 Nominal Interest Rate (i) Quantity of Money MS 0 i0i0 QM 0 i1i1 MD 1 Money Market Investment Demand

147. AD 0 SRAS 0 0 PL RGDP=Y PL 0 LRAS Y1Y1 FE PL 1 Y0Y0 AD 1 Because of the↑ r → ↓ I Effect of crowding out on the economy PL ↓ from PL 1 to PL 2 RGDP ↓ from Y 1 to Y 2 U ↑ because you have moved back below FE AD 2 Y2Y2 Recessionary gap is partially restored PL 2 → ↓ AD from AD1 to AD2 AD/ AS Graph

148. The Investment Demand Curve and the Crowding-Out Effect 5101520253035400 2 4 6 8 10 12 14 16 Real Interest Rate (Percent) Investment Demand (Billions of Dollars) ID 1 ID 2 a bc Interest Rate Rise Will Decrease Investment a to b Crowding- Out Effect A Large Public Debt to Finance Public Investment Will Cause… If Public Spending Spurs More Private Investment Will Increase to ID 2

149. 42. Crowding In effect- The decrease in interest rates caused by decreased borrowing by the federal government. Federal government spends less and raises taxes. It needs to borrow less OR if Tax revenue > spending (A budget surplus) it does not need to borrow at all. DLF 0 0 Real Interest Rate (r) Quantity of Loanable Funds r0r0 SLF DLF 1 r1r1 Q0Q0 Q1Q1 Since the Gov is borrowing less the D for loanable funds ↓ from DLF 0 to DLF 1 and real interest rates decrease from r 0 to r 1. ↓ r means I ↑ so AD ↑ and RGDP ↑. Loanable Funds Market

150. Phillips Curve (Short run) Tradeoff between inflation and unemployment SRPC 0 Inflation Rate Unemployment Rate U0U0 U1U1 I1I1 I0I0 Fiscal policy- ↓ T, ↑ TP or G ↓ Unemployment from U 0 to U 1 → ↑ Inflation from I 0 to I 1 Same as ↑ in AD on AD/AS graph Phillips Curve AD 0 SRAS 0 0 PL RGDP=Y PL 0 LRAS Y1Y1 FE PL 1 Y0Y0 AD 1 R Gap AD/ AS Graph

151. 1930’s-1970’s: Keynesian theory reigns supreme Monetarism Rational Expectations Theory (RET) 1970’s-2000’s: Classical theory rebounds with: and but…. Crisis of 2008- 2009: New Keynesians rebound

152. April 13 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke is siding with John Maynard Keynes against Milton Friedman by flooding the financial system with money. Bernanke’s gamble that the highest jobless rate in 25 years and the most idle factory capacity on record will hold down inflation is straight out of the late British economist Keynes. Should late Nobel-prize-winner Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” prove right, the $1 trillion or more in liquidity Bernanke has pumped into the financial system by expanding the Fed’s balance sheet may leave him to cope with surging consumer prices. So far, investors and economic data both back up the Bernanke- Keynes view. The market in Treasury Inflation-Protected Securities as of April 6 indicated long-term inflation expectations of 2.5 percent, below the 2.8 percent average inflation rate of the past 10 years.

153. Helicopter Ben

158. October, 2008 Central Bank rate cuts are occurring worldwide

159. Animated Phillips Curve

160. Supply Shock An unexpected shock to the economic system such as a ↓ in availability of oil or food supplies causes LRAS/SRAS to ↓, PL ↑, RGDP ↓, U Rate ↑. What’s the problem? FE 0 AD SRAS 0 0 PL RGDP=Y PL 1 LRAS 0 Y1Y1 SRAS 1 PL 0 Y0Y0 LRAS 1 FE 1 More stagflation! High prices and high unemployment at the same time! The worst of all economic worlds. This tends to then lead to an ↑ in inflationary expectations which causes us to demand ↑wages which ↑costs of production but… → ?

161. Phillips Curve (short run) Tradeoff between inflation and Unemployment SRPC 0 0 Inflation Rate Unemployment Rate ↑ in SRPC from SRPC 0 to SRPC 1 caused by stagflation ( ↓ in LRAS/ SRAS) Unemployment AND Inflation both ↑ SRPC 1 SRPC 2 ↓ in SRPC from SRPC 0 to SRPC 2 caused by ↑ in technology or other LRAS determinants ( ↑ in LRAS/ SRAS) Unemployment AND Inflation both ↓ Phillips Curve

162. Phillips Curve (long run) Phelps- Friedman hypothesis- There is a “natural rate of unemployment (NAIRU!) that the economy will always return to. SRPC 0 0 Inflation Rate Unemployment Rate Movement along the SRPC (from A to B) is caused by AD shift A shift in the SRPC (SRPC 0 to SRPC 1 ) is caused by AS shift LRPC A BSRPC 1 NAIRU C However, according to the theory of NAIRU, this is a short-run tradeoff b/c it will ↑ inflation expectations, shifting SRPC 0 to SRPC 1 and moving equilibrium from B to C. ↓ in U below the "Natural Rate" will be temporary, and lead only to higher inflation in the long run. Exp Fiscal Policy can ↓ U temporarily, from A to B. Phillips Curve

163. The Long-Run Vertical Phillips Curve 3456 0 3 6 9 12 15 Annual Rate of Inflation (Percent) Unemployment Rate (Percent) PC LR PC 3 PC 2 PC 1 a1a1 b1b1 a2a2 a3a3 b2b2 b3b3 c3c3 c2c2

164. C Expansionary Fiscal/ Monetary Policy pushes AD from AD 0 to AD 1 ; PL ↑ from PL 0 to PL 1, RGDP ↑ from Y 0 to Y 1. Move from A to B → Demand-Pull Inflation! Real wages decrease! AD 1 SRAS 0 0 PL RGDP=Y PL 1 LRAS Y1Y1 FE SRAS 1 PL 0 Y0Y0 AD 0 Inflation causes resource prices to ↑ (nominal wages ↑ so real wages go back ↑), which shifts SRAS from SRAS 0 to SRAS 1. The economy ↓ to LRE/ FE at Y 0 but at a ↑ PL, PL 2. Move from B to C → Cost-Push Inflation! PL 2 AD/AS Graph- Phillips curve equivalent A B AD/ AS Graph

165. Taxation and Aggregate Supply Supply-Side Economics- attempts to ↑LRAS/SRAS Δ Tax Incentives to encourage Work Δ Tax Incentives to encourage Saving and Investing to provide more $$$ for R & D, infrastructure, capital projects The Laffer Curve Tax Rate (Percent) Tax Revenue (Dollars) 100 m 0 n l m Laffer Curve Maximum Tax Revenue

166. Taxation and Aggregate Supply Criticisms of The Laffer Curve Taxes, Incentives, and Time Inflation and Higher Real Interest Rates Position on the Curve

167. From Short Run To Long Run Demand-Pull Inflation in the Extended AD-AS Model Real Domestic Output Price Level P1P1 QfQf a AS 1 AS LR AD 1 AD 2 AS 2 b c P2P2 P3P3

168. From Short Run To Long Run Cost-Push Inflation in the Extended AD-AS Model Real Domestic Output Price Level P1P1 QfQf a AS 1 AS LR AD 1 AD 2 AS 2 b c P2P2 P3P3 If Government Counters Recession With Spending… If Government Ignores Recession…

169. From Short Run To Long Run Recession in the Extended AD-AS Model Real Domestic Output Price Level P1P1 QfQf a AS 1 AS LR AD 1 AD 2 AS 2 b c P2P2 P3P3 Q1Q1

170. Intentionally Blank

171. A Contractionary Fiscal/Monetary Policy pushes AD from AD 0 to AD 1 ; PL ↓ from PL 0 to PL 1, RGDP ↓ from Y 0 to Y 1. Move from A to B. Real wages increase! AD 0 SRAS 1 0 PL RGDP=Y PL 1 LRAS Y1Y1 FE SRAS 0 PL 2 Y0Y0 AD 1 ↓ PL causes resource prices to ↓ (nominal wages ↓ so real wages go back ↓), which shifts SRAS from SRAS 0 to SRAS 1. The economy ↑ to LRE/ FE at Y 0 but at a ↓ PL, PL 2. Move from B to C PL 0 AD/AS Graph- Phillips curve equivalent C B AD/ AS Graph

172. Does the Economy Self-Correct? New Classical View of Self- Correction Rational Expectations Theory New Classical Economics Speed of Adjustment Unanticipated Price-Level Changes Price-Level Surprises Fully Anticipated Price-Level Changes O 17.3 G 17.1

173. Does the Economy Self-Correct? New Classical View of Self-Correction AD 2 AD 1 AS 1 AS 2 AS LR Price Level P1P1 P2P2 P3P3 Real Domestic Output Q1Q1 Q2Q2 a b c

174. Does the Economy Self-Correct? New Classical View of Self-Correction AD 3 AD 1 AS 1 AS 3 AS LR Price Level P1P1 P4P4 P5P5 Real Domestic Output Q1Q1 Q4Q4 Q3Q3 a e d f

175. Does the Economy Self-Correct? Mainstream View of Self-Correction Downward Wage Inflexibility Efficiency Wage Theory Greater Work Effort Lower Supervision Costs Reduced Job Turnover Insider-Outsider Relationships Insider-Outsider Theory O 17.4

176. C New Classical View- Because of wage and price flexibility, Unanticipated ↑ in AD  Demand-Pull Inflation from Pt. A to B  Cost-Push Inflation from B to C, self-correction happens very fast b/c info is very accessible so behavior changes fast! AD 1 SRAS 0 0 PL RGDP=Y PL 1 LRAS Y1Y1 FE SRAS 1 PL 0 Y0Y0 AD 0 PL 2 A B New Classical/ RET View of ↑ in AD RET= Rational Expectations Theory Anticipated ↑ in AD leads from A to C immediately. AS is a vertical line at LRAS. Since economy self-corrects then government should keep out! AD/ AS Graph

177. F D New Classical View- Because of wage and price flexibility, Demand-Pull Inflation from Pt. A to B  Cost-Push Inflation from B to C, self-correction happens very fast b/c info is very accessible so behavior changes fast! AD 0 SRAS 0 0 PL RGDP=Y PL 1 LRAS Y1Y1 FE SRAS 1 PL 0 Y0Y0 AD 1 Mainstream view- If prices are inflexible (“Sticky”) the PL stays at PL 2 and RGDP/output falls to Y 2 ( Pt. F) OR PL 2 New Classical/ RET v. Mainstream/ Keynesian View A B A RET= Rational Expectations Theory Y2Y2 Mainstream view- If PL eventually ↓to PL 3 RGDP/output still falls (to Y 3 ) b/c wage inflexibility prevents SRAS from ↓ PL 3 Y3Y3 AD/ AS Graph