2Topics and percentages 8-12% Basic Economic Concepts12-16% Measurement of Economic Performance10-15% National Income and Price Determination15-20% Financial Sector20-30% Inflation, Unemployment, and Stabilization Policies5-10% Economic Growth and Productivity10-15% Open Economy: International Trade and Finance
38-12% Basic Economic Concepts A. Scarcity, choice, and opportunity costsB. Production possibilities curveC. Comparative advantage, absolute advantage,specialization, and exchangeD. Demand, supply, and market equilibriumE. Macroeconomic issues: business cycle, unemployment,inflation, growth
4Production Possibilities Assumptions:Full EmploymentFixed Resources and TechnologyMovementsAlong curve shows opportunity costOutward shift illustrates economic growthInward shift indicates destruction of resourcesProducing Capital Goods will lead to greater economic growth than producing consumer goods. (Butter will lead to more growth than guns)
5Production Possibilities Graph Capital GoodsPoints A,B,C, are efficient pts.Point D is underutilizationPoint E is economic growthAEMay Lead to mostFuture growthMay Lead to mostFuture economic growthBDCF.E.F.E.1Consumer Goods
6Supply and Demand Factors Demand Changes when:Income changesRelated Products, complements and substitutes, (price or quality change)Expectations (future price change)Consumers (more or less added)Tastes, Fads, Preferences change
7Demand Increase: As Demand Increases, Price and Quantity Increase as well.
8Demand Decrease: As Demand Decreases, Price and Quantity decrease as well
9Supply Factors Supply Changes When: Input prices change (resources and wages)Government (tariffs, quotas, and subsidies)Number of sellers changeExpectations (about price and product profitability change)Disasters (weather, strikes, etc..)
10Supply Increase: As Supply Increases, Quantity Increases, but Price Falls. D1QuantityQ1Q2
11Supply Decrease: As Supply Decreases, Quantity Decreases, but Price Increases.
12Comparative Advantage A nation should specialize in producing goods in which it has a comparative advantage: ability to produce the good at a lower opportunity cost.Example:Cheese WineSpain: 2 pounds 2 CasesFrance 2 pounds 6 CasesSpain should produce cheese (1C = 1W)France should produce wine (1W = 1/3C):
13Currency TermsAppreciation: Currency is increasing in demand (stronger dollar)U.S. Currency will appreciate when more foreigners: travel to the U.S., buy more U.S. goods or services, or buy the U.S. dollar to invest in bonds
14Currency TermsDepreciation: Currency is decreasing in demand (weaker dollar) Being SUPPLIED in exchange for other currency.U.S. Currency will depreciate when fewer foreigners: travel to the U.S., buy fewer U.S. goods or services, or sell the U.S. dollar to invest in their own bonds
15Business CyclesThe increases and decreases in Real GDP consisting of four phases:Peak: highest point of Real GDPRecession: Real GDP declining for 6 monthsTrough: lowest point of Real GDPRecovery: Real GDP increasing (trough to peak)
16Business CycleFull EmploymentPeak -- Greatest spending and lowest unemployment. Inflation becomes a problem.Contraction/Recession -- Reduction of spending levels and increasing unemployment. Some cyclical unemployment begins.Trough -- Least spending and highest unemploymentExpansion -- Spending increases and unemployment decreasesWe want to avoid extreme inflation and extreme unemployment. We want stability!
17The two big problems…The two big problems that plague the economy are:INFLATIONUNEMPLOYMENTPeople generally prefer steady, stable growth to large “ups” and “downs.” Therefore, government policies, both fiscal and monetary (see later sections), are aimed at flattening the business cycle.The government wants not only to stimulate the economy when it’s slow, but also to slow it down when it’s growing too quickly.
1812-16% Measurement of Economic Performance A. National income accounts1. Circular flow2. Gross domestic product3. Components of gross domestic product4. Real versus nominal gross domestic productB. Inflation measurement and adjustment1. Price indices2. Nominal and real values3. Costs of inflationC. Unemployment1. Definition and measurement2. Types of unemployment3. Natural rate of unemployment
19Circular Flow of Economic Activity Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses.Businesses demand household resources and supply goods and services to the product (factor) market.
21Gross Domestic Product GDP (Gross Domestic Product): The total dollar (market) value of all final goods and services produced in a given year. Expenditure Formula:Consumption (C) +Business Investment (I) +Government Spending (G) +Net Exports (Xn)
22GDP: What Counts: Goods Produced but not Sold (I) Goods produced by a foreign country (Japan) in the U.S. (Honda, Toyota)Government spending on the militaryIncrease in business inventories
23GDP: What DOES NOT count: Intermediate Goods (Tires sold by Firestone to Ford)Used GoodsNon-Market Activities (Illegal, Underground)Transfer Payments (Social Security)Stock Transactions
24Shortcomings of GDP: Leading to GDP being understated. Nonmarket activities: (services of homemakers) does not count.Leisure: Does not include the value of leisure.Does not include improvements in product quality.Underground economy
25GDP: Overstated Includes damage to the environment Includes more spending on healthcare-Americans being unhealthy.Includes money spent to fight crime-more police officers, more jails, etc…
26Real GDP Real GDP= Nominal GDP adjusted for inflation. Calculation: Price Index in Hundredths( deflator)Example:U.S Real GDP= $12,4558 (billions)(based on 2000)$ Trillion
27Real GDP Per CapitaMost commonly used to compare and measure each country’s standard of living and overall economic growth.Real GDP/Nation’s Population
28Inflation Rise in the general level of prices Reduces the purchasing power of moneyMeasured with the Consumer Price Index (CPI)Reports the price of a market basket , more than 300 goods that are typically purchased by an urban household
29Calculating Inflation CPI in Recent Year – CPI in Past YearDivided by CPI in Past Year(Number then Multiplied by 100)Example: CPI = 179.92001 CPI = 177.1Rate of Inflation: = 1.58%177.1
30Types of InflationDemand Pull Inflation: ‘too much money chasing too few goods.”AD Curve will shift to the right, resulting in a higher Price Level and greater Output (until reaching Y*Cost-Push Inflation: Major cause is a supply shock-OPEC cutting back on oil productionAS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.
31Real and Nominal Terms Real Income = Nominal Income Price Index (Hundredths)Real Interest Rate = Nominal Interest Rate – Inflation RateNominal Interest Rate = Real Interest Rate Inflation Premium(anticipated inflation)
32Inflation: Winners & Losers Debtors who borrow money that will be repaid with “cheap” dollars.Those who have anticipated inflationLosers:Savers (especially savings accounts)Creditors (Banks will be repaid with those “cheap” dollarsFixed-Income Recipients (retirees receiving the same monthly pension)
33Unemployment Calculation: Number of Unemployed Labor Force (Multiplied by 100 to put as a %)The Labor Force is the total of employed and unemployed workers.U.S. unemployment should be about 5%
34Employed You are considered to be employed if: You work for 1 hour as a paid employee (so part-time workers count)You are temporarily absent from work (illness, strike, vacation)You work 15 hours or more as an unpaid worker (family farms are common)
35UnemployedMust be looking for work (at least 1 attempt in the past 4 weeks)Are reporting to a job within 30 daysAre temporarily laid off from their job
36Not In Labor Force A person who is not looking for work: Full-time studentsStay at home parentsDiscouraged workers: those who have given up hope of finding a job.Retirees
37Unemployment100% of the people will never be employed, so the government considers 4-6% unemployment to be “full employment.”Types of UnemploymentFrictional - temporary and unavoidableStructural - results from changes in technology or a business restructure (ex. Merger)Seasonal- occurs when industries slow or shut down for a seasonCyclical - results from a decline in the business cycle.We can never be at Full Employment if there is any percentage cyclically unemployed.
3810-15% National Income and Price Determination A. Aggregate demand1. Determinants of aggregate demand2. Multiplier and crowding-out effectsB. Aggregate supply1. Short-run and long-run analyses2. Sticky versus flexible wages and prices3. Determinants of aggregate supplyC. Macroeconomic equilibrium1. Real output and price level2. Short and long run3. Actual versus full-employment output4. Economic fluctuations
39Consumption and Saving As income increases, both consumption and savings will increase.The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption.Wealth (financial assets)Expectations about future prices and incomeReal Interest RatesHousehold DebtTaxes
40Marginal Propensities Marginal Propensity to Consume (MPC) and the Marginal Propensity to save (MPS) must equal 1.The MPS is used to derive the spending multiplier, which equals: _MPSIf the MPS is .2, the spending multiplier is 5.Any increase in spending must be multiplied by 5 to determine the overall increase in Real GDP.
41Aggregate Demand Downward sloping: Real-Balances Effect: change in purchasing power2. Interest-Rate Effect: Higherinterest rates curtail spendingForeign Purchase Effect:Substitute foreign products forU.S. productsPriceLevelAD (C + I + G + X)Real GDP
42Aggregate Demand Determinants of AD: C + I + G + Xn (Yes, its GDP) An increase in any of these, due to lower interest rates or optimism will increase AD and shift the curve to the right.A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left
43Aggregate Demand Determinants ConsumptionWealthExpectationsDebtTaxesInvestmentInterest RatesExpected ReturnsTechnologyInventoriesGovernmentChange in Gov. spendingNet ExportsNational Income AbroadExchange Rates
44Aggregate Supply Factors: R: resource prices (The CELL/ wages and materials, as well as OIL)E: environment [legal-institutional] (Taxes, Subsidies, more regulation)P: productivity (better technology)
45Aggregate Supply Short Run: Long Run: Assumes that nominal wages are “sticky” and do not respond to price level changes.Is Upward sloping as businesses will increase output to maximize profitsGenerally considered to be a year or less.Long Run:Curve is vertical because the economy is at its full-employment output.As prices go up, wages have adjusted so there is no incentive to increase production.Generally considered to be longer than a year.
46Aggregate Supply Graph Price LevelASInflationShort RunLong RunRecessionGrowthExtended vertical lineIllustrates the LRAS andY* (Full-Employment)Y*Real GDP
47Another look as AS LRAS SRAS PL Changes that lead to a new equilibrium on the left of LRAS = RecessionChanges that lead to a new equilibrium on the right of LRAS = Inflation (AKA “an overheated economy”)PLADY*RGDP
48NOTE!!For the AP exam, assume that there are only two determinants that simultaneously affect BOTH short term aggregate supply and aggregate demandbusiness tax changes andforeign currency changes.A change in business taxes shifts AD and AS in the same directionA change in FX sends both curves in the opposite directions.
49Demand-Pull Inflation ASPrice LevelP2P1AD2AD1 (C + I + G + X)Y*Real GDP
50Cost-Push Inflation AS2 Price Level AS1 P2 P1 AD1 ( C + I + G + X) Y Real GDP
53COST-PUSH INFLATION Occurs when short-run AS shifts left Price Level o ASLRAS2AS1Price LevelP2bP1aAD1oQ2Q1Real domestic output
54COST-PUSH INFLATION Even higher price levels Government response with increased ADASLRAS2AS1EvenhigherpricelevelscP3Price LevelP2bP1aAD2AD1oQ2Q1Real domestic output
55COST-PUSH INFLATION Price Level o Real domestic output If government allows a recession to occurASLRAS2AS1Price LevelP2bP1aAD1oQ2Q1Real domestic output
56COST-PUSH INFLATION Nominal wages fall & Price Level AS returns If government allows a recession to occurASLRAS2AS1Nominalwages fall &AS returnsto its originallocationPrice LevelP2bP1aAD1oQ2Q1Real domestic output
5715-20% Financial Sector (Money and Banking) A. Money, banking, and financial markets1. Definition of financial assets: money, stocks, bonds2. Time value of money (present and future value)3. Measures of money supply4. Banks and creation of money5. Money demand6. Money market7. Loanable funds marketB. Central bank and control of the money supply1. Tools of central bank policy2. Quantity theory of money3. Real versus nominal interest rates
58Money Supply Terms M1= Checkable Deposits and Currency M2= M1 + Savings deposits, money market accounts, small time deposits (less than $100,000)Velocity of Money Equation:MV = PQ ( GDP) (M= Money Supply and V = Velocity (number of times per year the average dollar is spent on goods and services.
59Banks and Balance Sheets Assets LiabilitiesReserves $15,000 Checkable Deposits $100,000Securities $15,000Loans $70,000If the current reserve requirement is 10%:1. What is the amount of new loans this bank can generate?Answer: $100,000 Checkable deposits X a 10% reserve requirement = $10,000 required reserves. If the bank has $15,000 in reserves, $5,000 of those are excess reserves and can be loaned out .2. How much in new loans can be generated by the entire bankingsystem?Answer: Money Multiplier = 1/Required Reserve Ratio=1/.1010 X $5,000 = $50,000
60FED and the Money Market Nominal InterestRateMS1MS2Vertical curve-Supply controlledBy the FED. An increase in MSleads to a rightward shift andlower nominal interest rates.nir1nir2MDQ1Q2Quantity of Money
61Interest Rate-Investment Expected Rate of Return: Amount of Profit (expressed as a percentage) a business expects to gain on a project/investment.This rate must be greater than the interest in order to be profitable.The Real Rate of Return is most important. An expected profit of 10%, that costs 5% in interest = The real rate of return: 5%.
62Investment Demand Curve: Real Rate ofReturnAt lower real interest rates businesses willIncrease investment , leading to an increaseIn AD (aggregate demand). At higher rates ofInterest, less money will be investedr1r2IDQ1Q2Quantity of Investment
63Shifts of the Investment Demand Curve Expected Rate of Return( Real Interest Rate.)A shift from ID1 to ID2Represents an increase inInvestment demand. A shiftFrom ID1 to ID3 represents adecrease in investmentDemand.ID2ID1ID3Quantity of Investment
64Loanable Funds Market and Expansionary Fiscal Policy Used for FISCAL POLICY (Government spending-Deficit Spending)An increase in Gov. spending increases the demand for loanable funds and raises real interest ratesReal Interest RateSLFR2R1DLF2DLF1Q1Q2Quantity of Funds
65Loanable Funds Market and Contractionary Fiscal Policy Used for FISCAL POLICY (Government spending-Deficit Spending)A decrease in Gov. spending decreases the demand for loanable funds and lowers real interest ratesSLFReal Interest RateR1R2DLF1DLF2Q2Q1Quantity of Funds
67GDPNominal GDP: GDP measured in terms of current Price Level at the time of measurement. (Unadjusted for inflation)Real GDP: GDP adjusted for inflation; GDP in a year divided by a GDP deflator (Price Index) for that year
68INCOMENOMINAL INCOME: number of dollars received by an individual or group for its resources during some period of timeREAL INCOME: amount of goods and services which can be purchased with nominal income during some period of time; nominal income adjusted for inflation
69INTEREST RATE (I%)NOMINAL I%: interest rate expressed in terms of annual amounts currently charged for interest; not adjusted for inflationREAL I%: interest rate expressed in dollars of constant value (adjusted for Inflation) and equal to the NOMINAL I% minus the EXPECTED RATE OF INFLATION
71WAGESNOMINAL WAGES: amount of money received by a worker per unit of time (hour, day, etc.);Money WageREAL WAGES: amount of goods and sevices a worker can purchase with their NOMINAL WAGE; purchasing power of the nominal wage.(Real = Nominal – Inflation rate)
72NOMINAL/REAL TIPsIf nominal rates INCREASE and Price Level INCREASE, the CHANGE in Real is “indeterminable.”If nominal Wage rates do NOT change and Price Level fall. REAL WAGES increase.NOMINAL RATES “PIGGY-BACK” REAL RATES & NOT VICE VERSA.
7320-30% Inflation, Unemployment, and Stabilization Policies A. Fiscal and monetary policies1. Demand-side effects2. Supply-side effects3. Policy mix4. Government deficits and debtB. Inflation and unemployment1. Types of inflationa. Demand-pull inflationb. Cost-push inflation2. The Phillips curve: short run versus long run3. Role of expectations
74FISCAL POLICY CHANGES AD …. Using Taxes and Government spending to stabilize the economy.Controlled by the President and CongressDiscretionary Fiscal Policy: Congress must take action (change the tax rates) in order for the action to be implemented.Automatic Stabilizers: Unemployment benefits, Progressive Tax System, these changes are implemented automatically to help the economy.FISCAL POLICY CHANGES AD ….EXCEPT when the question specifically states there is a change in business taxes.
75Types of Fiscal Policy Expansionary Contractionary Used to Fight a RecessionLOWER TAXESINCREASE GOVERNMENT SPENDINGContractionaryUsed to fight InflationRAISE TAXESDECREASE GOVERNMENT SPENDING
76Expansionary Fiscal Policy AS1Price LevelP2P1AD2AD1 ( C + I + G + X )Real GDPY1Y*
77Contractionary Fiscal Policy Raising taxes or reducing government spending to fight inflation and stabilize the economy.Price LevelASP1P2AD1AD2Y*Real GDP
78Tax Multiplier [-MPC/MPS] Remember, if the government decreases taxes, the result is not as great as a spending increase, since households will save a portion (MPS) of the tax cut.The Tax Multiplier = -MPC /MPSExample: If the MPC is .8 and the MPS is .2Spending Multiplier = 1/.2 or 5Tax Multiplier = -.8 /.2 or -4
79Crowding-Out EffectAn Expansionary Fiscal Policy as previously diagrammed will lead to higher interest rates.At higher interest rates, businesses will take out fewer loans and there will be a decrease in INVESTMENT (I)At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well.This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.
80Net Export Effect & Expansionary Fiscal Policy Government spending has led to an increase in interest rates.At higher interest rates, foreigners demand more U.S. dollars to invest in bonds.This leads to an appreciation of the U.S. dollar.This leads to a decrease in Net Exports, as foreigners now have to exchange more of their currency for the U.S. dollar to buy exports.This decrease in Net Exports will reduce AD and counter to some extent the expansionary fiscal policy.
81Net Export Effect & Contractionary Fiscal Policy A decrease in government spending has led to a decrease in real interest rates.At lower interest rates, foreigners demand less U.S. dollars to invest in bonds.This leads to a depreciation of the U.S. dollar.This leads to an increase in Net Exports, as foreigners now have to exchange less of their currency for the U.S. dollar to buy exports.This increase in Net Exports will increase AD and further strengthen the contractionary fiscal policy.
82Criticisms of Fiscal Policy Timing ProblemsRecognition Lag: identifying recession or inflationAdministrative Lag: getting Congress/President to agree to take actionOperational Lag: Time needed to see the results of the fiscal policyPolitical Business Cycles: Politicians may take inappropriate action to get reelected (lower taxes during an inflationary period). Plus it is difficult to raise taxes
83The Federal Reserve System (FED) Control Monetary PolicyHeadquartered in Washington D.C.12 Federal Reserve DistrictsBoard of Governors (7 members) is the central authorityMembers are appointed by the President and confirmed by the Senate
84Federal Open Market Committee (FOMC) Made up of 12 people: Board of Governors + New York FED President + 4 other regional presidents (who rotate)Meets regularly to direct OPEN MARKET OPERATIONS (buying or selling of bonds) to maintain or change interest rates
85FED and the Money Market Nominal InterestRateMS1MS2Vertical curve-Supply controlledBy the FED. An increase in MSleads to a rightward shift andlower interest rates.nir1nir2MDQ1Q2Quantity of Money
86Easy Money Policy on AD/AS Buying Government Bonds, lowering the discount rate, or lowering reserve requirements, to fight a recession, by decreasing interest rates, increasing investment spending and/or consumption and increasing AD.ASPrice LevelP2AD2P1AD1 (C + I + G + X)Q1QFReal GDP
87Effects of an Easy Money Policy LOWER INTEREST rates which will lead to an INCREASE in INVESTMENT and CONSUMPTION.The U.S. dollar will DEPRECIATE, leading to an increase in NET EXPORTS as well.These effects STRENGTHEN the overall monetary policy (opposite of fiscal policy’s crowding-out and net export effect
88FED and a TIGHT Money Policy Nominal InterestRateMS2MS1Vertical curve-Supply controlledBy the FED. A decrease in theMoney supply, shifts the MScurve to the left and raisesinterest rates.nir2nir1MDQ212Quantity of Money
89Tight Money Policy and AD/AS Selling bonds, raising the discount rate, or raising reserve requirements to fight inflation which will raise interest rates, decrease investment and/or consumption and decrease Aggregate Demand (AD).Price LevelASP1P2AD1AD2QFReal GDP
90Effects of a Tight Money Policy At the higher interest rates, INVESTMENT SPENDING, and CONSUMPTION will decrease.At higher interest rates, the U.S. dollar will APPRECIATE (foreigners demand more U.S. securities). This will lead to a DECREASE in NET EXPORTS.Again, the Monetary Policy is STRENGTHENED as a result, unlike the effects of a contractionary fiscal policy.
91Extended AD-AS Model This is the other way to graph the AD-AS Model Price LevelLRASSRASP1ADY*Real GDPThe intersection of the 3 curvesIs the Full-Employment Equilibrium
92Extended AD-AS Model and Demand-Pull Inflation In Demand-Pull Inflation, the AD curve has shifted to the right of the LRAS and SRAS intersection.LRASPrice LevelSRASP2PFAD2AD1Y*Y2Real GDPThe Price Level and Real GDP has increased.
93Extended AD-AS and Demand-Pull Inflation Mainstream economists will fight inflation as previously discussed: with either a tight monetary policy or a contractionary fiscal policy. The goal would be to move the aggregate demand curve to the left.Classical economists would argue to DO NOTHING. As nominal wages rise, the SHORT-RUN AS curve will shift to the left (resources and wages are becoming more expensive), restoring the economy to its full-employment output level, but with a higher Price Level.
94Extended AD-AS Model and Cost-Push Inflation Cost-Push inflation occurs when the SRAS has shifted to the leftOf the LRAS and AD intersection.SRAS2LRASPrice LevelSRAS1Here the Price level hasIncreased and REAL GDPhas decreased.P1PFAD1Y1Y*Real GDP
95Extended AD-AS and Cost-Push Inflation Mainstream economists must decide whether to target the Price Level or Unemployment, before taking any action.Classical economists would argue to DO NOTHING. Eventually, wages and resource prices must decrease and when they do the SRAS curve will shift back to the right, restoring the economy to its full-employment output level and the original Price Level.
96Extended AD-AS Model and Recession In a recession due to a decrease in AD, the AD curve is to the left of the LRAS and SRAS intersection; showing a decrease in boththe Price Level and Real GDP.LRASPrice LevelSRASPFP1ADY1Y*Real GDP
97Extended AD-AS and Recession Mainstream economists will fight a recession as previously discussed: with either an easy money policy or an expansionary fiscal policy. The goal would be to move the aggregate demand curve to the right.Classical economists would argue to DO NOTHING. The decrease in wages and resource prices will shift the SRAS curve to the right, restoring the economy to its full-employment output level, but with a LOWER price. (SELF-CORRECTION)
98Short-Run Phillips Curve Suggests an inverse relationship between the inflation rate and the unemployment rate.InflationRate(percent)When the unemployment rate isLow (2%), the inflation rate willMost likely be high (8%).8When theUnemployment rateIs high, inflation willlikely be low.2SRPC128Unemployment Rate (percent)
99Short-Run Phillips Curve When the Government fights unemployment, typically higher inflation will result. When the Government fights inflation, typically, more unemployment will result. Thereby, we move along the Short-Run Phillips Curve. (Changes in AD = movements on the SRPC.InflationRate(percent)B72ASRPC136Unemployment Rate (percent)
100Shifting the Short-Run Phillips Curve The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time. (A change in AS)Inflation Rate%Stagflation, unemployment andInflation occurring together(OPEC decreasing Oil supply,causes this type of shift)54SRPC2SRPC167Unemployment Rate %
101Shifting the Short-Run Phillips Curve The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time.When Supply increases(productivity surge in 90s)more than demand, prices will fall, while GDP and employmentIncrease; shifting the curve to the left.Inflation Rate %53SRPC1The SRPC is a mirror image of AS – If AS moves right, SRPC moves left.SRP257Unemployment Rate %
102Long-Run Phillips Curve The Long-Run Phillips Curve is vertical, like the Long Run Aggregate Supply Curve. So, in the long run there is no tradeoff between inflation and unemployment. Only the Price Level will change.LRPCInflation Rate%3SRPC5Unemployment Rate %
103Laffer CurveWhat is the optimal tax rate? A tax of 0% will provide no tax revenue. A tax rate of 100% will also lead to no tax revenue (no incentive to work). Answer must be somewhere in between.Tax Rate100Tax Revenue
104Economic Philosophies Classical: Believes that the government SHOULD NOT interfere in the economy. And believes in self-correction of economic problems.Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending). Most “mainstream” economists are KeynesiansRational Expectations: Believes that monetary and fiscal policy have certain effects on the economy and take action to make these policies ineffective.
1055-10% Economic Growth and Productivity A. Investment in Human CapitalB. Investment in Physical CapitalC. Research and development, and technological progressD. Growth Policy
106Economic Growth Five Factors connected to long run economic growth. Supply Factors:Increase in natural resources (quantity and quality)Increase in human resources (quantity and quality)Increase in capital goodsImprovements in technologyDemand Factors:Increase in consumption by households, businesses, and government
107Illustrating Economic Growth Production Possibilities CurveCapital GoodsBAPPC2PPC1Consumer Goods
108Illustrating Long Run Growth Can also be illustrated with the extended AD-AS Model.LRAS2LRAS1SRAS2SRAS1Price LevelP2P1AD2AD1Y1Y2Real GDP
10910-15% Open Economy: International Trade and Finance A. Balance of payments accounts1. Balance of trade2. Current account3. Capital accountB. Foreign exchange market1. Demand for and supply of foreign exchange2. Exchange rate determination3. Currency appreciation and depreciationC. Net exports and capital flowsD. Links to financial and goods markets
110International TradeComparative Advantage and Specialization allows for economic growth and efficiency. (More of each good can be obtained by trading-Trading line illustrates this)Trade barriers create more economic loss than benefits.Today there is a trend towards free trade and a reduction in trade barriers.Strongest arguments for protection are the infant industry and military self-sufficiency arguments.WTO oversees trade agreements and disputes, but has become a target of protesters lately.
111Exchange Rates and International Markets The value of a foreign nation’s currency in relation to your own currency is called the exchange rate.An increase in the value of a currency is called appreciation.A decrease in the value of a currency is called depreciation.Multinational firms convert currencies on the foreign exchange market, a network of about 2,000 banks and other financial institutions.
112Types of Exchange Rate Systems Fixed Exchange-Rate SystemsA currency system in which governments try to keep the values of their currencies constant against one another is called a fixed exchange-rate system.Flexible Exchange-Rate SystemsFlexible exchange-rate systems allow the exchange rate to be determined by supply and demand.
113Foreign Exchange Market Let’s say a U.S. citizen travels to Japan. This transaction will provide a supply of the U.S. dollar and result in a demand for yen. It will become cheaper for the Japanese to buy the dollar and more expensive for Americans to buy the Yen. The Yen is Appreciating and the dollar is Depreciating.Yen Price ofdollar(Y/$)Dollar Priceof Yen($/Y)SY1S$1P2S$2P1P1DY2P2DY1D$1Q1Q2Q1Q2Quantity of YenQuantity of U.S. Dollars
114Balance of Payments: The sum of all transactions between U. S Balance of Payments: The sum of all transactions between U.S. residents and residents of all foreign nationsCurrent Account: Shows U.S. exports and U.S. imports of goods and services.Capital Account: Shows the U.S. investment (financial as well as capital-plants and factories) abroad and Foreign investment in the U.S.Credits: A credit are those transactions for which the U.S. receives income (exports, foreign purchase of assets)Debits: Those transactions that the U.S. must pay for: imports and purchasing of assets abroad.
115Balance of Payments [continued] The Current Account and Capital Account must be equal.Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts.If the U.S. has more credits than debits it finances this difference by dipping into its reserve account.