Demand-Side Stabilization: Overheating, Hard Landing and Everything in Between Part 2

C + I + G + (Exp – Imp) = Y C + I + G + (Exp – Imp) = Y Assume G increase from 125 to 175 ($50 billion increase). Now E1 = 875 (see Table 5.1), an increase in Y of 125. Why? Multiplier effect = change in GDP/change in components of AD change in GDP/change in components of AD The Multiplier Effect

The mechanism of the multiplier effect MPC = change in consumption/change in national income =ΔC/ΔY =ΔC/ΔY = ( )/( ) = 0.6 = ( )/( ) = 0.6 Multiplier = 1/(1-MPC) Period 1: 60% of the initial injection ($50 billion) is spent (increases Y). 60% of the initial injection ($50 billion) is spent (increases Y). Period 2: 60% of the $30 billion (injected in the economy in period 1) is spent (increases Y). spent (increases Y). And so on… (see Table 5.2).

Changing Monetary Policy  An increase in the rate of growth of the money supply (through open market operations) leads to a fall in interest rates (i) which causes capital investment to rise.  A rise in capital investment is shown by an upward shift in the expenditure line in the goods market, which is reflected in the AD shifting right (Fig. 5.4).

Tax Policy C = C + bY C T = C + bY D C C T : consumption function with tax rate t. C C : Consumer confidence. b : Marginal propensity to consume (MPC) Y Y D : Disposable income. Y Y D = Y – tY = (1 - t)Y C = C + b C T = C + b(1 - t)Y C Thus, an increase in the tax rate (t) causes C T to fall. This decrease in consumption causes a drop in the goods market equilibrium and a shift to the left in AD. For a summary of the three methods of shifting AD see Figure 5.5.

Unemployment Unemployment rate = Unemployed / Civilian labor force Participation rate = Labor force / Population over 16 Participation rate = Labor force / Population over 16  Frictional unemployment: Unemployment associated with the ‘normal’ working of an economy (wait and search unemployment).  Structural unemployment: Generally caused when entire sectors of the economy shut down (e.g., textiles, steel, …)  Cyclical unemployment: Unemployment that fluctuates with the business cycle.  Full unemployment: When the economy has only frictional and structural unemployment.

 The Natural Rate of Unemployment is sometimes known as the non-accelerating inflation rate of Unemployment (NAIRU). When unemployment is at its natural rate there is no tendency for inflation to increase.  Congress enacted the Employment Act of 1946: The Federal Government has the responsibility “to promote maximum employment, production and purchasing power.”

 GDP deflator and CPI were covered In chapter 2.  Inflation: A percentage increase in the overall general price level.  Deflation: Average decline in the price level.  Examples: Great depression, Japan in the late 1990s.  Disinflation: Declining rates of inflation  Examples: US in the 1980s, inflation rate fell from about 10% in 1980 to 3% in Inflation

In order to understand macroeconomic phenomena such as soft-landing and overheating we will link changes in the price level to demand-side stabilization. In order to understand macroeconomic phenomena such as soft-landing and overheating we will link changes in the price level to demand-side stabilization. This process starts with a definition of different types of inflation: demand-pull inflation, cost- push inflation, and hyperinflation. This process starts with a definition of different types of inflation: demand-pull inflation, cost- push inflation, and hyperinflation. Two macroeconomic scenarios (see Fig. 5.6). Two macroeconomic scenarios (see Fig. 5.6).

The index of Leading Economic Indicators The US leading Indicators Index has 10 components: 1. Average weekly hours of manufacturing 2. Initial claims for unemployment insurance 3. New orders, consumer goods, and materials 4. Vendor performance, slower deliveries 5. New orders, non-defense capital goods 6. Building permits 7. Stock prices, 500 common stocks 8. Index of consumer expectations 9. Money supply, M2 10. Interest rate spread, 10-year T-bonds less the Federal funds rate

NAPM (ISM) Index The monthly Institute for Supply Chain Management (ISM) index of manufacturing (formerly, the National Association of Purchasing Management, NAPM). An overall reading below 50 suggest that the manufacturing sector is shrinking. Note: Most recession in the US have begun with a contraction in manufacturing activity.

Articles 5.2 and 5.3 for class discussion