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Circular Flow. The Government’s Role Imperfect Information Externalities Public Goods Lack of Competition Business Cycles Correct for:

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Presentation on theme: "Circular Flow. The Government’s Role Imperfect Information Externalities Public Goods Lack of Competition Business Cycles Correct for:"— Presentation transcript:

1 Circular Flow

2 The Government’s Role Imperfect Information Externalities Public Goods Lack of Competition Business Cycles Correct for:

3 Externalities Someone outside a transaction benefits from the transaction... and doesn’t pay  Too little produced. Someone outside a transaction incurs costs because of it... but isn’t paid  Too much produced.

4 Consumption by one person does not diminish the quantity or quality available to others. Public goods can be jointly consumed Public goods are non-excludable Everybody has incentive to be a free rider When everyone free rides, too little (or none) is produced. Public Goods

5 Macroeconomic Policy Monetary Policy –Policies that influence money and credit (money supply and interest rates). Fiscal Policy –Policies that control government spending and taxation.

6 GDP  “Output” Gross Domestic Product (GDP)Gross Domestic Product (GDP) is the market value of final goods and services produced within a country during a year. n Market Value: The worth of a thing is the price it will bring. n Only Final Goods and Services Count  GDP must be produced within our borders n Net additions to inventory are current output so they are also included in GDP.

7 GDP as Valued-Added

8 GDP as Expenditures: C + I + G + X

9 GDP (GNP) as Income

10 GDP – GNP – NNP – NI – PI – DI

11 Real and Nominal GDP “Real“ GDP adjusts for inflation. Nominal GDP ($GDP) measures national output based on current prices of goods and services. Real GDP measures of the quantity of final goods and services produced –Real GDP measures current output at constant prices

12 Consumer Price Index (CPI)Consumer Price Index (CPI) –measures the cost over time of a typical bundle of goods and services purchased by households. Producer Price Index (PPI)Producer Price Index (PPI) –measures average prices received by producers over time for raw materials, intermediate, and final goods. GDP Price Deflator (GDP Price Index, GDPPI)GDP Price Deflator (GDP Price Index, GDPPI) –measures average prices over time of all goods and services included in GDP.

13 Foreign Exchange Foreign ExchangeForeign Exchange Foreign money, including paper money and bank deposits that are denominated in foreign currency Foreign Exchange MarketForeign Exchange Market A global market in which people trade one currency for another Exchange RateExchange Rate The price of one country’s currency in terms of another country’s currency

14 Appreciation and Depreciation A currency appreciates when it buys more of a foreign currency.A currency appreciates when it buys more of a foreign currency. –Appreciation of a nation ’ s currency makes foreign goods cheaper. –Appreciation  Imports Up and Exports Down. A currency depreciates when it buys less of a foreign currency.A currency depreciates when it buys less of a foreign currency. –Depreciation makes foreign goods more expensive. –Depreciation  Imports Down and Exports Up.

15 Categories of current account transactions: 1.Merchandise trade -- import and export of goods 2.Service trade -- import and export of services 3.Income -- both investment income and employee compensation 4.Unilateral transfers -- gifts to and from foreigners Current Account

16 Current Account vs. Financial Account The balance of payments must balance—that is, Current Account + Financial Account = 0 If there is a current account deficit, then there must be a financial account surplus that exactly offsets that deficit. –If we buy more goods and services from foreigners than they buy from us, we have to borrow the difference  sell them our IOUs.

17 U.S. Real GDP (Recessions Shaded)

18 Unemployment Rate of Unemployment = number unemployed number in the Labor Force The unemployment rate is the percentage of the labor force that is not working. Discouraged Workers: workers who have looked for work in the past year, but have stopped because they believe no one will offer them a job. Underemployment: employment of workers in jobs that do not fully utilize their productive skills.

19 Flavors of Unemployment n Seasonal Unemployment n Frictional Unemployment: searching for jobs n Structural Unemployment n Reflects imperfect match between employee skills and requirements of available jobs. n Cyclical Unemployment n Results from business cycle fluctuations.

20 “Natural” Rate of Unemployment A normal rate, considering both frictional and structural factors. NAIRU –Also called the NAIRU (Nonaccelerating Inflation Rate of Unemployment) -- ~5% for US economy The “natural” rate can change Potential Real GDP The level of output when nonlabor resources are fully utilized and unemployment is at its natural rate. GDP gap = potential real GDP – actual GDP

21 Flavors of Price Inflation Demand-pull inflation: –caused by increases in aggregate demand outpacing increases in aggregate supply. Cost-push inflation: –increased production costs cause firms to raise prices. Wage-push inflation Energy costs and inflation Hyperinflation: –extremely high rate of inflation. Printing money as last resort


23 Interest Rates Nominal Interest Rate (i): the observed interest rate in the market. Real Interest Rate (r): nominal rate adjusted for inflation (  ). r = i - 

24 Aggregate Demand (AD): the economy- wide demand for goods and services. Aggregate demand curve relates aggregate expenditure for goods and services to the price level The aggregate demand curve slopes downward owing to price-level effects: –Wealth Effect (Real Wealth/Real Balances) –Interest Rate Effect –International Trade Effect (Substitution)

25 The Aggregate Demand Curve Changes in the price level result in changes in quantity demanded.

26 Factors that Affect AD  Shifts in AD Consumption –Income –Wealth –Interest Rates –Expectations –Demographics –Taxes Investment –Interest Rates –Technology –Cost of Capital Goods –Capacity Utilization AD = C + I + G + NX Government Spending Net Exports – Domestic & Foreign Income – Domestic & Foreign Prices – Exchange Rates – Government Policy

27 Shifting Aggregate Demand Curve

28 Aggregate Supply: Short – Run & Long – Run

29 Short-run Aggregate Supply Aggregate Supply (AS) shows the quantity of real GDP produced at different price levels. Short-run AS slopes upward –a higher price level (holding production costs and capital constant in the short-run)  higher profit margins  firms want to produce more.

30 The Shape of Long-run AS (LRAS) Resource costs are NOT fixed in the long-run. –As prices rises, workers demand and get higher wages  Profits don’t rise with price AS is set by production possibilities in the long- run –LRAS is not affected by prices –LRAS is vertical: higher prices cannot elicit more output in the long-run.

31 Shifting the Long- Run Aggregate Supply Curve Growth occurs as the labor force and capital stock grow and as technological innovation improves production efficiency.

32 Aggregate Demand - Aggregate Supply Equilibrium

33 Aggregate Demand and Supply Equilibrium: Short-run and long-run responses to increase in aggregate demand

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