Circular Flow Model

Gross Domestic Product Valuation of economy Value of production, not simply production Final Goods Second hand goods not included Transfers not included

GDP GDP = AD (Aggregate Demand) GDP = C + I + G + (X-M) C = Personal Consumption I = Capital Investments G = Government Expenditures No transfer payments X-M = Net Exports = eXports - iMports

GDP vs GNP Gross Domestic Product Gross National Product What is produced within a country’s borders, regardless of who produces it. Mercedes built in America count towards American GDP Fords built in Germany count towards German GDP Gross National Product What is produced by the citizens of a country, regardless of where they produce it. Mercedes built in America count towards German GNP Fords built in Germany count towards American GNP

Real vs Nominal GDP Nominal Real GDPReal = (GDPNom)(Price Index) Value of current production in current prices Real Value of current production in base year prices GDPReal = (GDPNom)(Price Index) %∆GDPReal = %∆GDPNom - %Δ Index

CPI Consumer Price Index Measure inflation Base year Market Basket What is the difference between the CPI and the GDP deflator? Both are price indices but they have different market baskets. The CPI includes consumer goods whereas the GDP deflator contains all items that are produced domestically.

Causes of Inflation 2 types Demand-pull inflation Cost-push Aggregate demand > productive capacity Causes include increases in money supply or credit. Cost-push Prices increased by producers to cover higher costs of production. Supply shocks such as changes in oil prices, crop failures & natural disasters.

5 Major Effects of Inflation Decreased purchasing power Decreased value of real wages Increased interest rates Decreased savings & investing Increased production costs

Unemployment Unemployed – must be looking for work to be part of labor force. Unemployment rate is % of labor force that is unemployed. Types of unemployment include: Frictional Seasonal Structural Cyclical Full employment is economy at full steam. Since there is always frictional & structural unemployment, the Natural unemployment rate is the unemployment rate for full employment.

Consumption Function Consumption Function C = a + b (DI) a = autonomous spending spending when income = 0 B = consumption rate Consumption DI CF Savings Dissavings Disposable Income

Marginal Propensity to Consume & Save MPC = ΔC/ΔDI MPS = ΔS/ΔDI MPC + MPS = 1 C=Consumption, S=Savings, DI=Disposable Income MPC= Consumption rate in consumption function

Multiplier Multiplier Examples = 1 / MPS = 1 / (1-MPC) Examples MPC = .9, Multiplier = 1/.1 = 10 MPC = .8, Multipler = 1/.2 = 5 MPC = .5, Multiplier = 1/.5 = 2 NB Taxes have a smaller multiplier than direct government spending

AD – AS Model Long-run Aggregate Supply (LRAS) Price Level LRAS SRAS Short-run Aggregate Supply (SRAS) P Aggregate Demand (AD) = C+I+G+(X-M) AD GDPR YO

AD – AS Model - Inflation Price Level GDP beyond L-R Equilibrium at Y1 & P LRAS SRAS Inflationary Gap Higher rates drive down interest sensitive expenditures (AD ) P P2 AD Shift causes Y to go  to L-R YO, & P  AD AD2 Economy producing Beyond L-R capacity GDPR YO Y1

AD – AS Model - Inflation GDP below L-R Equilibrium at P & Y1 Price Level SRAS LRAS SRAS2 Recessionary Gap Lack of demand drives down nominal wages ( SRAS  ) P P2 SRAS2 shift results in P  & Y  AD Economy producing under L-R capacity GDPR Y1 YO

Shifts in AD Changes in expectations Changes in wealth Expectations  – AD  Changes in wealth Wealth  , - AD  Amount of physical capital Existing Capital  – AD  Fiscal policy Government spending  – AD  Monetary policy Money supply  – AD  17

Shifts in SRAS Commodity prices Nominal wages Productivity Example is oil Prices  - AS  Nominal wages Wages  - AS  Productivity Productivity  - AS  18

AD AS Model Shifts of AD Demand shock Negative Positive Ag. Pr. Level SRAS Shifts of AD Demand shock Negative “Great Depression” ADN, EN, PN, YN Positive WWII ADP, EP, PP, YP EP PP PE ESR ADP PN EN AD ADN Real GDP YN YE YP 19

AD AS Model Positive Demand Shock SRAS2 Ag. Pr. Level SRAS Positive Demand Shock AD shifts to AD2 E1 up to E2 P1 up to P2 YP up to Y2 Inflationary Gap Inflation causes L-R increase in wages SRAS shifts to SRAS2 E2 shifts to E3 P2 up again to P3 Y2 down to YP LRAS E3 P3 P2 E2 P1 E1 AD2 AD YP Y2 Real GDP 20

AD AS Model Shifts of SRAS Supply shock Negative Positive Oil Crisis SRASN Ag. Pr. Level SRAS Shifts of SRAS Supply shock Negative Oil Crisis SRASN, EN, PN, YN Positive Internet SRASP, EP, PP, YP SRASP PN EN PE ESR PP EP AD Real GDP YN YE YP 21

Continuum – Government Policies Restrictive Low Growth Low Inflation Expansionary High Growth High Inflation

Fiscal Policy Expansionary Restrictive Restrictive Expansionary Stimulates economy Decrease taxes and/or increase spending Increases disposable incomes/demand Inflationary & leads to debt Restrictive Reduces Disposable income/demand. Lack of cash reduces investments. Reduction in government spending/programs Restrictive Expansionary

Monetary Policy Easy Money Tight Money Increases growth (good) Increases inflation (bad) Tight Money Decreases growth (bad) Decreases inflation (good) Tight Money Easy Money 24

How the Fed Can Change MS Fed Tools Open Market Operations Fed Funds Rate & Discount Rate Reserve Requirements for Banks Moral suasion 25

Expansionary Policy Money Supply up GDPR up Price Level up Invest-ments up Interest Rates down GDPN up AD up Inflation up Exports up Unemploy-ment down Exchange rates down Imports down

Phillips Curve Inflation S-R trade-off between Inflation & unemployment LRPC Trade-off does not Occur in the L-R Shifts in SRPC the result of Δ expected inflation %2 SRPC2 % SRPC Unemployment NRU/ NAIRU

Money Supply Interest i = nominal Rate, i interest rates MS Δ in MS controlled by the Fed Reserve i M * V = P * Q MS*Velocity or multiplier = Price Level * Output MD GDPR M

Money Supply & Interest Rates Increased MS leads to r  Interest rate Money supply Lower r leads to C & I  meaning AD  MS2 AD shifts right, leading to Price Level  & GDPR  Price Level SRAS P2 P1 r1 AD2 r2 MD1 AD1 Y1 Y2 Mde1 Mde2 Quantity of money GDPR 29

Loanable Funds r = real interest rates Interest Rate, r SM NB - With interest rates i includes inflation while r is for real r DM GDPR YO

Terms Crowding out Rational Expectations Theory Automatic Stabilizers Government competes with or eliminates private enterprise. Providing a service otherwise supplied by a company Competing in the marketplace for loans to finance debt. Rational Expectations Theory Businesses & consumers react to expected changes in monetary & fiscal policy, thereby negating their impact. Automatic Stabilizers adjust automatically, without government deliberation, to offset economic conditions

Crowding Out Effect – Change in Demand government debt creates additional demand for funds. Interest Rate, r S1 r2 r1 Rightward shift of demand curve results in r  & Q . D2 D1 Quantity of Loanable Funds Q1 Q2

Crowding Out Effect – Change in Supply Interest Rate, r ∆ in Supply: Government is Most credit worthy Borrower, so Fed Debt removes supply S1 r2 r1 Leftward shift of Supply curves results In r  & Q  D1 Quantity of Loanable Funds Q2 Q1

Automatic Stabilizers Deficit – Economy in recession, causes taxes to drop below govt. expenditures $ Taxes Surplus – Economy booms, causes taxes to increase above govt spending Govt Automatic adjustments to economic conditions by increasing deficit during recessions & increasing surplus in boom periods (income taxes) GDPR

Macroeconomic Theories Classical Changes in MS only affect nominal rates, not real Automatic stabilizers will correct market fluctuations No government action Keynesian Fiscal policy as a tool to correct cyclical fluctuations Govt spending up to offset recessions Monetarists Govt often wrong or late, only make matters worse MS to grow at rate of GDP growth (no fiscal remedies)

Foreign Trade Balance of Payments Exchange Rate Changes Revisit Comparative & Absolute advantages from Micro PP Balance of Payments Current Account – Transactions w/o liabilities Capital Account – Transactions w/ liabilities Exchange Rate Changes Consumer tastes Relative incomes Relative inflation Speculation Money supply/ relative interest rates

Exchange Rates Demand for $ increases as other currencies trade for $ €/$ $/€ S Demand Curve shifts to D2 causing $  & Q  S2 Looking at exchange rate from other side – euros/dollar High demand for $ means people want to trade euros in & this leads to excess supply $2 € $ €2 D2 Supply curve shifts to S2, causing €  & Q  D Q Qe Q2

International Trade & Taxes Example: US Oil Market Equilibrium at $100 & 10M Barrels. Dollars/ Euro SDom Effects of tariff include P $10, Q  1M barrels, & Imports  2M barrels $100 World price is $80. Effect on US market is Demand at $80 Is 12M while Supply is 8M. Difference of 4M is imports. $90 Imports $80 D Protective tariff of $10/Barrel added Q 8 9 10 11 12 Deadweight Loss (DWL)

Graph Relationships Money Market Investment Demand i I I M I MS MS i i i i MD I M M I I M I I I Contraction of MS leads to higher i, which reduces I, causing GDP to fall Y Y Graph reversed so GDP is falling GDPR

Graph Review – MS  Fed increases MS i  r leads to  I MS leads to Money Supply Investment Demand Loanable Funds I/R I/R MS MS Fed increases MS i  S r leads to  I S MS leads to shift right in S in loanable funds r  & q  i r r r r i MD I/D D Q Q I I Q M M q q P/L = X  & M  Supply of $  ER  & q   I =  AD  AD =  P & Y AD = Inflation  & Unemployment  Phillips Curve Exchange Rates A/B ADAS Model P/L LRPC Inflation S AS S P ER P ER % AD SRPC % D AD Real GDP U/R NRU q q Q Y Y Unemployment