The Science of Macroeconomics

The Science of Macroeconomics
1 The Science of Macroeconomics Dear Colleague, Thank you for trying these PowerPoints. I have worked hard to make them useful, accurate, and interesting in hopes of saving you prep time and contributing to an effective classroom experience for your students. To help you get the most from these slides, I have prepared a README file with User Instructions, and I have annotated many individual slides with notes – visible only to you – that appear in this area of your screen. I will be preparing minor updates about once a year between major revisions of the text, to update the data and correct typos, etc. If you find a typo or have a suggestion, please it to me and I will consider it for the next update. My address is Sincerely, Ron Cronovich

Learning Objectives This chapter introduces you to
the issues macroeconomists study the tools macroeconomists use some important concepts in macroeconomic analysis CHAPTER 1 The Science of Macroeconomics

Important issues in macroeconomics
Macroeconomics, the study of the economy as a whole, addresses many topical issues: Why does the cost of living keep rising? Why are millions of people unemployed, even when the economy is booming? What causes recessions? Can the government do anything to combat recessions? Should it? This slide and the next contain a list of some topical issues that macro can help students understand. Feel free to substitute others as new issues emerge. CHAPTER 1 The Science of Macroeconomics

Important issues in macroeconomics
Macroeconomics, the study of the economy as a whole, addresses many topical issues: What is the government budget deficit? How does it affect the economy? Why does the U.S. have such a huge trade deficit? Why are so many countries poor? What policies might help them grow out of poverty? CHAPTER 1 The Science of Macroeconomics

U.S. Real GDP per capita (2000 dollars)
9/11/2001 First oil price shock long-run upward trend… Second oil price shock Great Depression World War II CHAPTER 1 The Science of Macroeconomics

U.S. inflation rate (% per year)
CHAPTER 1 The Science of Macroeconomics

U.S. unemployment rate (% of labor force)
CHAPTER 1 The Science of Macroeconomics

Why learn macroeconomics?
1. The macroeconomy affects society’s well-being. Each one-point increase in the unemployment rate is associated with: 920 more suicides 650 more homicides 4000 more people admitted to state mental institutions 3300 more people sent to state prisons 37,000 more deaths increases in domestic violence and homelessness It might be useful to briefly define the unemployment rate so that students will be able to understand this and the next few slides. Source: Barry Bluestone and Bennett Harrison, The Deindustrialization of America (New York: Basic Books, 1982), Chapter 3, cited in Robert J. Gordon, Macroeconomics, 4th edition (Boston: Little, Brown and Company), p If you know of more recent estimates, please me so I can update this slide!!! Thanks! (My address is CHAPTER 1 The Science of Macroeconomics

2. The macroeconomy affects your well-being. change from 12 mos earlier percent change from 12 mos earlier In most years, wage growth falls when unemployment is rising. Macroeconomics helps students understand forces that will affect their financial well-being. Here’s an example. When the unemployment rate is rising, tens or hundreds of thousands of people are losing their jobs. This affects even those who don’t lose their jobs: As the graph shows, during most years there is a clear negative relationship between the (12-month) change in unemployment and the annual growth rate of real wages. In plain English, rising unemployment is associated with falling (and often negative) wage growth. So when the economy goes into recession, even if our students get to keep their jobs, they will find it much harder to get a raise, and may have to accept a real wage cut. Students find this relationship intuitive. When unemployment is rising, the supply of workers is rising faster than demand, so wages grow more slowly or even fall. Conversely, falling unemployment gives workers more bargaining power over wages, as it becomes increasingly hard for employers to replace their workers, and increasingly easy for workers to find good opportunities with other companies. CHAPTER 1 The Science of Macroeconomics

3. The macroeconomy affects politics. Unemployment & inflation in election years year U rate inflation rate elec. outcome % 5.8% Carter (D) % 13.5% Reagan (R) % 4.3% Reagan (R) % 4.1% Bush I (R) % 3.0% Clinton (D) % 3.3% Clinton (D) % 3.4% Bush II (R) % 3.3% Bush II (R) I’d also suggest you briefly define the inflation rate (as the percentage increase in the cost of living) to help students understand this slide. Main point of this data: The state of the economy has a huge impact on election outcomes. When the economy is doing poorly, there tends to be a change in the party that controls the White House. 1976: The rates of inflation () and unemployment (u) both high. Incumbent (Ford, R) loses. 1980: u still high,  even higher. Incumbent (Carter, D) loses. 1984: u still high, but  much lower. Incumbent (Reagan) wins. 1988:  the same, u much lower. Incumbent party wins. 1992:  low, but u much higher (and was higher yet in 1991). Incumbent loses. 1996: u much lower, incumbent wins. 2000: Economy doing great, and incumbent party candidate (Gore, D) wins majority of popular vote, but loses electoral college to challenger. 2004: u somewhat higher, but lower than in 2001 recession;  low; incumbent wins CHAPTER 1 The Science of Macroeconomics

Economic models …are simplified versions of a more complex reality
irrelevant details are stripped away …are used to show relationships between variables explain the economy’s behavior devise policies to improve economic performance CHAPTER 1 The Science of Macroeconomics

Example of a model: Supply & demand for new cars
shows how various events affect price and quantity of cars assumes the market is competitive: each buyer and seller is too small to affect the market price Variables: Q d = quantity of cars that buyers demand Q s = quantity that producers supply P = price of new cars Y = aggregate income Ps = price of steel (an input) Students will realize that the auto market is not competitive. However, if all we want to know is how an increase in the price of steel or a fall in consumer income affects the price and quantity of autos, then it’s fine to use this model. In general, making unrealistic assumptions is okay, even desirable, if they simplify the analysis without affecting its validity. CHAPTER 1 The Science of Macroeconomics

The demand for cars demand equation: Q d = D (P,Y )
shows that the quantity of cars consumers demand is related to the price of cars and aggregate income CHAPTER 1 The Science of Macroeconomics

Digression: functional notation
General functional notation shows only that the variables are related. Q d = D (P,Y ) A specific functional form shows the precise quantitative relationship. Example: D (P,Y ) = 60 – 10P + 2Y A list of the variables that affect Q d We often aren’t concerned with the exact quantitative relationship between variables, so we will often just use the general functional notation. CHAPTER 1 The Science of Macroeconomics

The market for cars: Demand
P Price of cars D The demand curve shows the relationship between quantity demanded and price, other things equal. Q Quantity of cars CHAPTER 1 The Science of Macroeconomics

The market for cars: Supply
Q Quantity of cars P Price of cars S The supply curve shows the relationship between quantity supplied and price, other things equal. D CHAPTER 1 The Science of Macroeconomics

The market for cars: Equilibrium
Q Quantity of cars P Price of cars S D equilibrium price equilibrium quantity CHAPTER 1 The Science of Macroeconomics

The effects of an increase in income
Q Quantity of cars P Price of cars S D1 Q1 P1 D2 An increase in income increases the quantity of cars consumers demand at each price… P2 Q2 …which increases the equilibrium price and quantity. CHAPTER 1 The Science of Macroeconomics

The effects of a steel price increase
Q Quantity of cars P Price of cars S1 D Q1 P1 S2 An increase in Ps reduces the quantity of cars producers supply at each price… P2 Q2 …which increases the market price and reduces the quantity. CHAPTER 1 The Science of Macroeconomics

Endogenous vs. exogenous variables
The values of endogenous variables are determined in the model. The values of exogenous variables are determined outside the model: the model takes their values & behavior as given. In the model of supply & demand for cars, CHAPTER 1 The Science of Macroeconomics

Now you try: Write down demand and supply equations for wireless phones; include two exogenous variables in each equation. Draw a supply-demand graph for wireless phones. Use your graph to show how a change in one of your exogenous variables affects the model’s endogenous variables. Endogenous variables: price of wireless phones, quantity of wireless phones Exogenous variables: consumer income price of wireless phone service (a complement) price of landline phones & phone service (a substitute) technology CHAPTER 1 The Science of Macroeconomics

A multitude of models No one model can address all the issues we care about. e.g., our supply-demand model of the car market… can tell us how a fall in aggregate income affects price & quantity of cars. cannot tell us why aggregate income falls. CHAPTER 1 The Science of Macroeconomics

A multitude of models So we will learn different models for studying different issues (e.g., unemployment, inflation, long-run growth). For each new model, you should keep track of its assumptions which variables are endogenous, which are exogenous the questions it can help us understand, and those it cannot CHAPTER 1 The Science of Macroeconomics

Prices: flexible vs. sticky
Market clearing: An assumption that prices are flexible, adjust to equate supply and demand. In the short run, many prices are sticky – adjust sluggishly in response to changes in supply or demand. For example, many labor contracts fix the nominal wage for a year or longer many magazine publishers change prices only once every 3-4 years CHAPTER 1 The Science of Macroeconomics

Prices: flexible vs. sticky
The economy’s behavior depends partly on whether prices are sticky or flexible: If prices are sticky, then demand won’t always equal supply. This helps explain unemployment (excess supply of labor) why firms cannot always sell all the goods they produce Long run: prices flexible, markets clear, economy behaves very differently CHAPTER 1 The Science of Macroeconomics

Outline of this book: Introductory material (Chaps. 1 & 2)
Classical Theory (Chaps. 3-6) How the economy works in the long run, when prices are flexible Growth Theory (Chaps. 7-8) The standard of living and its growth rate over the very long run Business Cycle Theory (Chaps. 9-13) How the economy works in the short run, when prices are sticky The portion of the book described on this slide comprises the core material. It is organized around time horizons: the long run (flexible prices), the very long run (growth in capital, the population, and technology itself), and the short run (sticky prices and economic fluctuations). But wait! There’s more! See the next slide…. CHAPTER 1 The Science of Macroeconomics

Outline of this book: Policy debates (Chaps ) Should the government try to smooth business cycle fluctuations? Is the government’s debt a problem? Microeconomic foundations (Chaps ) Insights from looking at the behavior of consumers, firms, and other issues from a microeconomic perspective All of the chapters listed on this slide are very good, but some instructors find that the semester isn’t always long enough to cover all of this material. Feel free to select chapters from these parts that best match the needs and interests of you and your students. *** Are you covering Chapter 2 next? The PowerPoint presentation for Chapter 2 includes some in-class exercises to immediately reinforce concepts as they are presented. These exercises also help break up the lecture into smaller pieces. If you’d like to try them, please ask your students to bring calculators to the next class meeting. CHAPTER 1 The Science of Macroeconomics

Chapter Summary Macroeconomics is the study of the economy as a whole, including growth in incomes, changes in the overall level of prices, the unemployment rate. Macroeconomists attempt to explain the economy and to devise policies to improve its performance. CHAPTER 1 The Science of Macroeconomics slide 27

Chapter Summary Economists use different models to examine different issues. Models with flexible prices describe the economy in the long run; models with sticky prices describe the economy in the short run. Macroeconomic events and performance arise from many microeconomic transactions, so macroeconomics uses many of the tools of microeconomics. CHAPTER 1 The Science of Macroeconomics slide 28

The Data of Macroeconomics
2 The Data of Macroeconomics This PowerPoint chapter contains in-class exercises requiring students to have calculators. To help motivate the chapter, it may be helpful to remind the students that much of macroeconomics---and this book---is devoted to understanding the behavior of aggregate output, prices, and unemployment. Much of Chapter 2 will be familiar to students who have taken an introductory economics course. Therefore, you might consider going over Chapter 2 fairly quickly. This would allow more class time for the subsequent chapters, which are more challenging. Instructors who wish to shorten the presentation might consider omitting : a couple of slides on GNP vs. GDP a slide on chain-weighted real GDP vs. constant dollar real GDP some of the in-class exercises (though I suggest you ask your students to try them within 8 hours of the lecture, to reinforce the concepts while the material is still fresh in their memory.) The slides on stocks vs. flows. Subsequent chapters do not refer to these concepts very much. There are hidden slides you may want to “unhide.” They show that the GDP deflator and CPI are, indeed, weighted averages of prices. If your students are comfortable with algebra, then this material might be helpful. However, it’s a bit technical, and doesn’t appear in the textbook, so I’ve hidden these slides--they won’t appear in the presentation unless you intentionally “unhide” them.

In this chapter, you will learn…
…the meaning and measurement of the most important macroeconomic statistics: Gross Domestic Product (GDP) The Consumer Price Index (CPI) The unemployment rate These are three of the most important economic statistics. Policymakers and businesspersons use them to monitor the economy and formulate appropriate policies. Economists use them to develop and test theories about how the economy works. Because we’ll be learning many of these theories, it’s worth spending some time now to really understand what these statistics mean, and how they are measured. CHAPTER 2 The Data of Macroeconomics

Gross Domestic Product: Expenditure and Income
Two definitions: Total expenditure on domestically-produced final goods and services. Total income earned by domestically-located factors of production. Most students, having taken principles of economics, will have seen this definition and be familiar with it. It’s not worth spending a lot of time on. It might be worthwhile, however, to briefly review the factors of production. Expenditure equals income because every dollar spent by a buyer becomes income to the seller. CHAPTER 2 The Data of Macroeconomics

The Circular Flow Households Firms Income ($) Labor Goods
Expenditure ($) Households Goods Firms CHAPTER 2 The Data of Macroeconomics

Value added definition:
A firm’s value added is the value of its output minus the value of the intermediate goods the firm used to produce that output. It might be useful here to remind students what “intermediate goods” are. CHAPTER 2 The Data of Macroeconomics

Compute & compare value added at each stage of production and GDP
Exercise: (Problem 2, p. 40) A farmer grows a bushel of wheat and sells it to a miller for $1.00. The miller turns the wheat into flour and sells it to a baker for $3.00. The baker uses the flour to make a loaf of bread and sells it to an engineer for $6.00. The engineer eats the bread. Compute & compare value added at each stage of production and GDP When students compute GDP, they should assume that these are the only transactions in the economy. Lessons of this problem: GDP = value of final goods = sum of value at all stages of production We don’t include the value of intermediate goods in GDP because their value is already embodied in the value of the final goods. Answer: Each person’s value-added (VA) equals the value of what he/she produced minus the value of the intermediate inputs he/she started with. Farmer’s VA = $1 Miller’s VA = $3 Baker’s VA = $3 GDP = $6 Note that GDP = value of final good = sum of value-added at all stages of production. Even though this problem is highly simplified, its main lesson holds in the real world: the value of all final goods produced equals the sum of value-added in all stages of production of all goods. CHAPTER 2 The Data of Macroeconomics

Final goods, value added, and GDP
GDP = value of final goods produced = sum of value added at all stages of production. The value of the final goods already includes the value of the intermediate goods, so including intermediate and final goods in GDP would be double-counting. CHAPTER 2 The Data of Macroeconomics

The expenditure components of GDP
consumption investment government spending net exports CHAPTER 2 The Data of Macroeconomics

Consumption (C) definition: The value of all goods and services bought by households. Includes: durable goods last a long time ex: cars, home appliances nondurable goods last a short time ex: food, clothing services work done for consumers ex: dry cleaning, air travel. A consumer’s spending on a new house counts under investment, not consumption. More on this in a few moments, when we get to Investment. A tenant’s spending on rent counts under services -- rent is considered spending on “housing services.” So what happens if a renter buys the house she had been renting? Conceptually, consumption should remain unchanged: just because she is no longer paying rent, she is still consuming the same housing services as before. In national income accounting, (the services category of) consumption includes the imputed rental value of owner-occupied housing. To help students keep all this straight, you might suggest that they think of a house as a piece of capital which is used to produce a consumer service, which we might call “housing services”. Thus, spending on the house counts in “investment”, and the value of the housing services that the house provides counts under “consumption” (regardless of whether the housing services are being consumed by the owner of the house or a tenant). CHAPTER 2 The Data of Macroeconomics

U.S. consumption, 2005 Services Nondurables Durables Consumption
% of GDP $ billions $8,745.7 70.0% 5,154.9 2,564.4 1,026.5 41.3 20.5 8.2 source: Bureau of Economic Analysis, U.S. Department of Commerce CHAPTER 2 The Data of Macroeconomics

Investment (I) Definition 1: Spending on [the factor of production] capital. Definition 2: Spending on goods bought for future use Includes: business fixed investment Spending on plant and equipment that firms will use to produce other goods & services. residential fixed investment Spending on housing units by consumers and landlords. inventory investment The change in the value of all firms’ inventories. In definition #1, note that aggregate investment equals total spending on newly produced capital goods. (If I pay $1000 for a used computer for my business, then I’m doing $1000 of investment, but the person who sold it to me is doing $1000 of disinvestment, so there is no net impact on aggregate investment.) The housing issue A consumer’s spending on a new house counts under investment, not consumption. A tenant’s spending on rent counts under services -- rent is considered spending on “housing services.” So what happens if a renter buys the house she had been renting? Conceptually, consumption should remain unchanged: just because she is no longer paying rent, she is still consuming the same housing services as before. In national income accounting, (the services category of) consumption includes the imputed rental value of owner-occupied housing. To help students keep all this straight, you might suggest that they think of a house as a piece of capital which is used to produce a consumer service, which we might call “housing services”. Thus, spending on the house counts in “investment”, and the value of the housing services that the house provides counts under “consumption” (regardless of whether the housing services are being consumed by the owner of the house or a tenant). Inventories If total inventories are $10 billion at the beginning of the year, and $12 billion at the end, then inventory investment equals $2 billion for the year. Note that inventory investment can be negative (which means inventories fell over the year). CHAPTER 2 The Data of Macroeconomics

U.S. investment, 2005 Inventory Residential Business fixed Investment
% of GDP $ billions $2,105.0 16.9% 18.9 756.3 1,329.8 0.2 6.1 10.6 source: Bureau of Economic Analysis, U.S. Department of Commerce CHAPTER 2 The Data of Macroeconomics

Investment vs. Capital Note: Investment is spending on new capital.
Example (assumes no depreciation): 1/1/2006: economy has $500b worth of capital during 2006: investment = $60b 1/1/2007: economy will have $560b worth of capital If you teach the stocks vs. flows concepts, this is a good example of the difference. CHAPTER 2 The Data of Macroeconomics

Stocks vs. Flows A stock is a quantity measured at a point in time.
E.g., “The U.S. capital stock was $26 trillion on January 1, 2006.” The bathtub example is the classic means of explaining stocks and flows, and appears in Chapter 2. A flow is a quantity measured per unit of time. E.g., “U.S. investment was $2.5 trillion during 2006.” CHAPTER 2 The Data of Macroeconomics

Stocks vs. Flows - examples
a person’s wealth a person’s annual saving Point out that a specific quantity of a flow variable only makes sense if you know the size of the time unit. If someone tells you her salary is $5000 but does not say whether it is “per month” or “per year” or otherwise, then you’d have no idea what her salary really is. A pitfall with flow variables is that many of them have a very standard time unit (e.g., per year). Therefore, people often omit the time unit: “John’s salary is $50,000.” And omitting the time unit makes it easy to forget that John’s salary is a flow variable, not a stock. Another point: It is often the case that a flow variable measures the rate of change in a corresponding stock variable, as the examples on this slide (and the investment/capital example) make clear. # of people with college degrees # of new college graduates this year the govt debt the govt budget deficit CHAPTER 2 The Data of Macroeconomics

Now you try: Stock or flow? the balance on your credit card statement
how much you study economics outside of class the size of your compact disc collection the inflation rate the unemployment rate You can use this slide to get some class participation. I suggest you display the entire slide, give students a few moments to formulate their answers, and then ask for volunteers. Doing so results in wider participation than if you ask for someone to volunteer the answer immediately after displaying each item on the list. Here are the answers, and explanations: The balance on your credit card statement is a stock. (A corresponding flow would be the amount of new purchases on your credit card statement.) How much you study is a flow. The statement “I study 10 hours” is only meaningful if we know the time period – whether 10 years per day, per week, per month, etc. The size of your compact disc collection is a stock. (A corresponding flow would be how many CDs you buy per month.) The inflation rate is a flow: we say “prices are increasing by 3.2% per year” or “by 0.4% per month”. The unemployment rate is a stock: It’s the number of unemployed people divided by the number of people in the workforce. In contrast, the number of newly unemployed people per month would be a flow. Note: Students have not yet seen official definitions of the inflation and unemployment rates. However, it is likely they are familiar with these terms, either from their introductory economics course or from reading the newspaper. Note: The stocks vs. flows concept is not mentioned very much in the subsequent chapters. If you do not want your students to forget it, then a good idea would be to do the following: As subsequent chapters introduce new variables, ask students whether each new variable is a stock or a flow. CHAPTER 2 The Data of Macroeconomics

Government spending (G)
G includes all government spending on goods and services.. G excludes transfer payments (e.g., unemployment insurance payments), because they do not represent spending on goods and services. Transfer payments are included in “government outlays,” but not in government spending. People who receive transfer payments use these funds to pay for their consumption. Thus, we avoid double-counting by excluding transfer payments from G. CHAPTER 2 The Data of Macroeconomics

U.S. government spending, 2005
$ billions % of GDP Govt spending $2,362.9 18.9% Federal 877.7 1,485.2 587.1 290.6 7.0 11.9 4.7 2.3 Non-defense source: Bureau of Economic Analysis, U.S. Department of Commerce Defense State & local CHAPTER 2 The Data of Macroeconomics

Net exports: NX = EX – IM def: The value of total exports (EX) minus the value of total imports (IM). source: FRED Database, The Federal Reserve Bank of St. Louis, Before showing the data graph, the following explanation might be helpful: Remember, GDP is the value of spending on our country’s output of goods & services. Exports represent foreign spending on our country’s output, so we include exports. Imports represent the portion of domestic spending (C, I, and G) that goes to foreign goods and services, so we subtract off imports. NX, therefore, equals net spending by the foreign sector on domestically produced goods & services.

aggregate expenditure
An important identity Y = C + I + G + NX value of total output aggregate expenditure A few slides ago, we defined GDP as the total expenditure on the economy’s output of goods and services (as well as total income). We can also define GDP as (the value of) aggregate output, not just spending on output. An identity is an equation that always holds because of the way the variables are defined. CHAPTER 2 The Data of Macroeconomics

A question for you: Suppose a firm
produces $10 million worth of final goods but only sells $9 million worth. Does this violate the expenditure = output identity? If you do not wish to pose this as a question, you can “hide” this slide and skip right to the next one, which simply gives students the information. Suggestion (applies generally, not just here): When you pose a question like this to your class, don’t ask for students to volunteer their answers right away. Instead, tell them to think about it for a minute and write their answer down on paper. Then, ask for volunteers (or call on students at random). Giving students this extra minute will increase the quality of participation as well as the number of students who participate. Correct answer to the question: Unsold output adds to inventory, and thus counts as inventory investment – whether intentional or unplanned. Thus, it’s as if a firm “purchased” its own inventory accumulation. Here’s where the “goods purchased for future use” definition of investment is handy: When firms add newly produced goods to their inventory, the “future use” of those goods, of course, is future sales. Note, also, that inventory investment counts intentional as well as unplanned inventory changes. Thus, when firms sell fewer units than planned, the unsold units go into inventory and are counted as inventory investment. This explains why “output = expenditure” -- the value of unsold output is counted under inventory investment, just as if the firm “purchased” its own output. Remember, the definition of investment is goods bought for future use. With inventory investment, that future use is to give the firm the ability in the future to sell more than its output. CHAPTER 2 The Data of Macroeconomics

Why output = expenditure
Unsold output goes into inventory, and is counted as “inventory investment”… …whether or not the inventory buildup was intentional. In effect, we are assuming that firms purchase their unsold output. CHAPTER 2 The Data of Macroeconomics

GDP: An important and versatile concept
We have now seen that GDP measures total income total output total expenditure the sum of value-added at all stages in the production of final goods This is why economists often use the terms income, output, expenditure, and GDP interchangeably. CHAPTER 2 The Data of Macroeconomics

GNP vs. GDP Gross National Product (GNP): Total income earned by the nation’s factors of production, regardless of where located. Gross Domestic Product (GDP): Total income earned by domestically-located factors of production, regardless of nationality. (GNP – GDP) = (factor payments from abroad) – (factor payments to abroad) Emphasize that the difference b/w GDP and GNP boils down to two things: location of the economic activity, and ownership (domestic vs. foreign) of the factors of production. From the perspective of the U.S., factor payments from abroad includes things like wages earned by U.S. citizens working abroad profits earned by U.S.-owned businesses located abroad income (interest, dividends, rent, etc) generated from the foreign assets owned by U.S. citizens Factor payments to abroad includes things like wages earned by foreign workers in the U.S. profits earned by foreign-owned businesses located in the U.S. income (interest, dividends, rent, etc) that foreigners earn on U.S. assets Chapter 3 introduces factor markets and factor prices. Unless you’ve already covered that material, it might be worth mentioning to your students that factor payments are simply payments to the factors of production, for example, the wages earned by labor. CHAPTER 2 The Data of Macroeconomics

In your country, which would you want to be bigger, GDP, or GNP?
Discussion question: In your country, which would you want to be bigger, GDP, or GNP? Why? This issue is subjective, and the question is intended to get students to think a little deeper about the difference between GNP and GDP. Of course, there is no single correct answer. Some students offer this response: It’s better to have GNP > GDP, because it means our nation’s income is greater than the value of what we are producing domestically. If, instead, GDP > GNP, then a portion of the income generated in our country is going to people in other countries, so there’s less income left over for us to enjoy. CHAPTER 2 The Data of Macroeconomics

(GNP – GDP) as a percentage of GDP selected countries, 2002
For the U.S., GDP and GNP are very close. Thus, students may not realize why we bother teaching them the difference. The data on this slide makes clear that the difference is very important for many countries. Source: World Bank. How to interpret the numbers in this table: In Canada, GNP is 1.9% smaller than GDP. This sounds like a tiny number, but it means that about 2% of all the income generated in Canada is taken away and paid to foreigners. In Angola, about 14% of the value of domestic production is paid to foreigners. Kuwait’s GNP is 9.5% bigger than its GDP. This means that the income earned by the citizens of Kuwait is 9.5% larger than the value of production occurring within Kuwait’s borders. Teaching suggestion: Point out a few countries with positive numbers. Ask your students to take a moment to think of possible reasons why GNP might exceed GDP in a country, and write them down. Point out a few countries with negative numbers. Ask your students to take a moment to think of possible reasons why a country’s GDP might be bigger than its GNP, and write them down. After students have had a chance to think of some reasons, ask for volunteers. (Better yet, have them pair up and compare answers with a classmate before volunteering their answers to the class.) Reasons why GNP may exceed GDP: Country has done a lot of lending or investment overseas and is earning lots of income from these foreign investments (income on nationally-owned capital located abroad). Take Kuwait. This tiny country earns (from oil revenue) more than it spends; the difference is invested (in the layperson’s sense of the term investment) in foreign assets, such as stocks and real estate. Thus, Kuwait has a lot of foreign-owned capital that generates income. This income comes back to Kuwait, making its GNP bigger than its GDP. A significant number of citizens have left the country to work overseas (their income is counted in GNP, not GDP). Reasons why GDP may exceed GNP: - Country has done a lot of borrowing from abroad, or foreigners have done a lot of investment in the country (income earned by foreign-owned domestically-located capital). This is most likely why Mexico’s GDP > GNP. - Country has a large immigrant labor force CHAPTER 2 The Data of Macroeconomics

Real vs. nominal GDP GDP is the value of all final goods and services produced. nominal GDP measures these values using current prices. real GDP measure these values using the prices of a base year. CHAPTER 2 The Data of Macroeconomics

Practice problem, part 1 Compute nominal GDP in each year.
2006 2007 2008 P Q good A $30 900 $31 1,000 $36 1,050 good B $100 192 $102 200 205 This slide (and a few of the following ones) contain exercises that you can have your students do in class for immediate reinforcement of the material. This problem requires calculators. If most of your students do not have calculators, you might “hide” this slide and instead pass out a printout of it for a homework exercise. Tell students that if they don’t have Or: just have them write down the expressions that they would enter into a calculator if they had calculators, i.e. Nominal GDP in 2001 = 30* *192. Compute nominal GDP in each year. Compute real GDP in each year using 2006 as the base year. CHAPTER 2 The Data of Macroeconomics

Answers to practice problem, part 1
nominal GDP multiply Ps & Qs from same year 2006: $46,200 = $30  $100  : $51, : $58,300 real GDP multiply each year’s Qs by 2006 Ps 2006: $46, : $50, : $52,000 = $30  $100  205 CHAPTER 2 The Data of Macroeconomics

Real GDP controls for inflation
Changes in nominal GDP can be due to: changes in prices. changes in quantities of output produced. Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices. Suppose from 2006 to 2007, nominal GDP rises by 10%. Some of this growth could be due to price increases, because an increase in the price of output causes an increase in the value of output, even if the real quantity remains the same. Hence, to control for inflation, we use real GDP. Remember, real GDP is the value of output using constant base-year prices. If real GDP grows by 6% from 2006 to 2007, we can be sure that all of this growth is due to an increase in the economy’s actual production of goods and services, because the same prices are used to construct real GDP in 2006 and 2007. CHAPTER 2 The Data of Macroeconomics

U.S. Nominal and Real GDP, 1950–2006
Real GDP (in 2000 dollars) Source: Notice that the brown line (nominal GDP) is steeper than the blue line. That’s because prices generally rise over time. So, nominal GDP grows at a faster rate than real GDP. If you’re anal like me, you might ask students what is the significance of the two lines crossing in 2000. Answer: is the base year for this real GDP data, so RGDP = NGDP in 2000 only. Before 2000, RGDP > NGDP, while after 2000, RGDP < NGDP. This is intuitive if you think about it for a minute: Take When the economy’s output of 1970 is measured in the (then) current prices, GDP is about $1 trillion. Between 1970 and 2000, most prices have risen. Hence, if you value the country’s 1970 using the higher year-2000 prices (to get real GDP), you get a bigger value than if you measure 1970’s output using 1970 prices (nominal GDP). This explains why real GDP is larger than nominal GDP in 1970 (as in most or all years before the base year). Nominal GDP CHAPTER 2 The Data of Macroeconomics

GDP Deflator The inflation rate is the percentage increase in the overall level of prices. One measure of the price level is the GDP deflator, defined as After revealing the first bullet point, mention that there are several different measures of the overall price level. Your students are probably familiar with one of them---the Consumer Price Index, which will be covered shortly. For now, though, we learn about a different one <reveal next bullet point>, the GDP deflator. The GDP deflator is so named because it is used to “deflate” (remove the effects of inflation from) GDP and other economic variables. CHAPTER 2 The Data of Macroeconomics

Practice problem, part 2 Nom. GDP Real GDP GDP deflator Inflation rate 2006 $46,200 n.a. 2007 51,400 50,000 2008 58,300 52,000 Use your previous answers to compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008. CHAPTER 2 The Data of Macroeconomics

Answers to practice problem, part 2
Nominal GDP Real GDP GDP deflator Inflation rate 2006 $46,200 100.0 n.a. 2007 51,400 50,000 102.8 2.8% 2008 58,300 52,000 112.1 9.1% CHAPTER 2 The Data of Macroeconomics

Two arithmetic tricks for working with percentage changes
1. For any variables X and Y, percentage change in (X  Y )  percentage change in X percentage change in Y These handy arithmetic tricks will be useful in many different contexts later in this book. For example, in the Quantity Theory of Money in chapter 4, they help us understand how the Quantity Equation, MV = PY, gives us a relation between the rates of inflation, money growth, and GDP growth. The example on this slide uses wage income = (hourly wage) x (number of hours worked) Another example would be revenue = price x quantity Students will see many more examples later in the textbook. EX: If your hourly wage rises 5% and you work 7% more hours, then your wage income rises approximately 12%. CHAPTER 2 The Data of Macroeconomics

Two arithmetic tricks for working with percentage changes
2. percentage change in (X/Y )  percentage change in X  percentage change in Y Again, we will see uses for this in many different contexts later in the textbook. For example, if your wage rises 10% while prices rise 6%, then your real wage – the purchasing power of your wage – rises by about 4%, because real wage = (nominal wage)/(price level) EX: GDP deflator = 100  NGDP/RGDP. If NGDP rises 9% and RGDP rises 4%, then the inflation rate is approximately 5%. CHAPTER 2 The Data of Macroeconomics

Chain-Weighted Real GDP
Over time, relative prices change, so the base year should be updated periodically. In essence, chain-weighted real GDP updates the base year every year, so it is more accurate than constant-price GDP. Your textbook usually uses constant-price real GDP, because: the two measures are highly correlated. constant-price real GDP is easier to compute. Since constant-price GDP is easier to understand and compute, and because the two measures of real GDP are so highly correlated, this textbook emphasizes the constant-price version of real GDP. However, if this topic is important to you and your students, you should have them carefully read page 24, and give them one or two exercises requiring students to computer or compare constant-price and chain-weighted real GDP. CHAPTER 2 The Data of Macroeconomics

Consumer Price Index (CPI)
A measure of the overall level of prices Published by the Bureau of Labor Statistics (BLS) Uses: tracks changes in the typical household’s cost of living adjusts many contracts for inflation (“COLAs”) allows comparisons of dollar amounts over time Regarding the comparison of dollar figures from different years: If we want to know whether the average college graduate today is better off than the average college graduate of 1975, we can’t simply compare the nominal salaries, because the cost of living is so much higher now than in We can use the CPI to express the 1975 in “current dollars”, i.e. see what it would be worth at today’s prices. Also: when the price of oil (and hence gasoline) shot up in 2000, some in the news reported that oil prices were even higher than in the 1970s. This was true, but only in nominal terms. If you use the CPI to adjust for inflation, the highest oil price in 2000 is still substantially less than the highest oil prices of the 1970s. CHAPTER 2 The Data of Macroeconomics

How the BLS constructs the CPI
1. Survey consumers to determine composition of the typical consumer’s “basket” of goods. 2. Every month, collect data on prices of all items in the basket; compute cost of basket 3. CPI in any month equals CHAPTER 2 The Data of Macroeconomics

Exercise: Compute the CPI
Basket contains 20 pizzas and 10 compact discs. prices: pizza CDs 2002 $10 $15 2003 $11 $15 2004 $12 $16 2005 $13 $15 For each year, compute the cost of the basket the CPI (use 2002 as the base year) the inflation rate from the preceding year From 2002 to 2003, it’s not obvious that the inflation rate will be positive (that the basket’s cost will increase): the price of pizza rises by $1, the price of CDs falls by $1. However, since the basket contains twice as many pizzas as CDs, a given change in the price of pizza will have a bigger impact on the basket’s cost (and CPI) than the same sized price change in CDs. CHAPTER 2 The Data of Macroeconomics

Answers: Cost of Inflation basket CPI rate 2002 $350 100.0 n.a.
% % % CHAPTER 2 The Data of Macroeconomics

The composition of the CPI’s “basket”
Each number is the percent of the “typical” household’s total expenditure. source: Bureau of Labor Statistics, Ask students for examples of how the breakdown of their own expenditure differs from that of the typical household shown here. Then, ask students how the typical elderly person’s expenditure might differ from that shown here. (This is relevant because the CPI is used to give Social Security COLAs to the elderly; however, the elderly spend a much larger fraction of their income on medical care, a category in which prices grow much faster than the CPI.) The website listed above also gives a very fine disaggregation of each category, which enables students to compare their own spending on compact discs, beer, or cell phones to that of the “typical” household. CHAPTER 2 The Data of Macroeconomics

Reasons why the CPI may overstate inflation
Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have fallen. Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights. Unmeasured changes in quality: Quality improvements increase the value of the dollar, but are often not fully measured. CHAPTER 2 The Data of Macroeconomics

The size of the CPI’s bias
In 1995, a Senate-appointed panel of experts estimated that the CPI overstates inflation by about 1.1% per year. So the BLS made adjustments to reduce the bias. Now, the CPI’s bias is probably under 1% per year. CHAPTER 2 The Data of Macroeconomics

CPI vs. GDP Deflator prices of capital goods
included in GDP deflator (if produced domestically) excluded from CPI prices of imported consumer goods included in CPI excluded from GDP deflator the basket of goods CPI: fixed GDP deflator: changes every year CHAPTER 2 The Data of Macroeconomics

Two measures of inflation in the U.S.
Percentage change from 12 months earlier source: In 1980, the CPI increased much faster than the GDP deflator. Ask students if they can offer a possible explanation. In 1955, the CPI showed slightly negative inflation, while the GDP deflator showed positive inflation. Ask students for possible explanations. (For possible answers, just refer to previous slide.) CHAPTER 2 The Data of Macroeconomics

Categories of the population
employed working at a paid job unemployed not employed but looking for a job labor force the amount of labor available for producing goods and services; all employed plus unemployed persons not in the labor force not employed, not looking for work CHAPTER 2 The Data of Macroeconomics

Two important labor force concepts
unemployment rate percentage of the labor force that is unemployed labor force participation rate the fraction of the adult population that “participates” in the labor force CHAPTER 2 The Data of Macroeconomics

Exercise: Compute labor force statistics
U.S. adult population by group, June 2006 Number employed = million Number unemployed = 7.0 million Adult population = million source: Bureau of Labor Statistics, U.S. Department of Labor. Use the above data to calculate the labor force the number of people not in the labor force the labor force participation rate the unemployment rate CHAPTER 2 The Data of Macroeconomics

Answers: data: E = 144.4, U = 7.0, POP = 228.8
labor force L = E +U = = 151.4 not in labor force NILF = POP – L = – = 77.4 unemployment rate U/L x 100% = (7/151.4) x 100% = 4.6% labor force participation rate L/POP x 100% = (151.4/228.8) x 100% = 66.2% CHAPTER 2 The Data of Macroeconomics

The establishment survey
The BLS obtains a second measure of employment by surveying businesses, asking how many workers are on their payrolls. Neither measure is perfect, and they occasionally diverge due to: treatment of self-employed persons new firms not counted in establishment survey technical issues involving population inferences from sample data This slide and the next correspond to new material in the 6th edition on the Establishment Survey. See pp The material on Okun’s Law, which formerly appeared at this point in Chapter 2, has been moved to Chapter 9, section 9-1. CHAPTER 2 The Data of Macroeconomics

Two measures of employment growth
Percentage change from 12 months earlier Source: This graph shows the percentage change in total U.S. non-farm employment from 12 months earlier (based on monthly, seasonally-adjusted data from the Bureau of Labor Statistics), from two surveys: The household survey, which is used to generate the widely-known unemployment rate data, and the establishment survey. Pp discusses the establishment survey in detail and contrasts it with the household survey to help explain the divergences. CHAPTER 2 The Data of Macroeconomics

Chapter Summary 1. Gross Domestic Product (GDP) measures both total income and total expenditure on the economy’s output of goods & services. 2. Nominal GDP values output at current prices; real GDP values output at constant prices. Changes in output affect both measures, but changes in prices only affect nominal GDP. 3. GDP is the sum of consumption, investment, government purchases, and net exports. CHAPTER 2 The Data of Macroeconomics slide 87

Chapter Summary 4. The overall level of prices can be measured by either the Consumer Price Index (CPI), the price of a fixed basket of goods purchased by the typical consumer, or the GDP deflator, the ratio of nominal to real GDP 5. The unemployment rate is the fraction of the labor force that is not employed. CHAPTER 2 The Data of Macroeconomics slide 88

National Income: Where it Comes From and Where it Goes
3 National Income: Where it Comes From and Where it Goes The material in this chapter is the basis of much of the remaining material in this book. So, the time your students spend mastering this material will pay dividends throughout the semester. New to the 6th edition, the appendix on the Cobb-Douglas production function is now integrated into the chapter – and into this PowerPoint presentation. Also, if you used the previous edition of these PowerPoints, you will find that I have cleaned up and expanded the returns to scale section and the optional last section on the loanable funds model with an upward-sloping saving curve. As a result of these changes, this PowerPoint presentation is longer. I suggest you look through it before presenting it in class to determine whether there’s any material you might want to cut out or shorten.

what determines the economy’s total output/income how the prices of the factors of production are determined how total income is distributed what determines the demand for goods and services how equilibrium in the goods market is achieved CHAPTER 3 National Income

A closed economy, market-clearing model
Outline of model A closed economy, market-clearing model Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market It’s useful for students to keep in mind the “big picture” as they learn the individual components of the model in the following slides. CHAPTER 3 National Income

Factors of production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers In the simple model of this chapter, we think of capital as plant & equipment. In the real world, capital also includes inventories and residential housing, as discussed in Chapter 2. Students may have learned in their principles course that “land” or “land and natural resources” is an additional factor of production. In macro, we mainly focus on labor and capital, though. So, to keep our model simple, we usually omit land as a factor of production, as we can learn a lot about the macroeconomy despite the omission of land. CHAPTER 3 National Income

The production function
denoted Y = F(K, L) shows how much output (Y ) the economy can produce from K units of capital and L units of labor reflects the economy’s level of technology exhibits constant returns to scale CHAPTER 3 National Income

Returns to scale: A review
Initially Y1 = F (K1 , L1 ) Scale all inputs by the same factor z: K2 = zK1 and L2 = zL1 (e.g., if z = 1.25, then all inputs are increased by 25%) What happens to output, Y2 = F (K2, L2 )? If constant returns to scale, Y2 = zY1 If increasing returns to scale, Y2 > zY1 If decreasing returns to scale, Y2 < zY1 This material has been improved and expanded from the previous edition of these PowerPoints. However, it is longer: 7 slides instead of 2. To shorten your presentation, you might consider omitting one or two of the following three examples, and/or eliminating one of the two “now you try” in-class exercises. CHAPTER 3 National Income

constant returns to scale for any z > 0
Example 1 constant returns to scale for any z > 0 CHAPTER 3 National Income

decreasing returns to scale for any z > 1
Example 2 decreasing returns to scale for any z > 1 CHAPTER 3 National Income

increasing returns to scale for any z > 1
Example 3 increasing returns to scale for any z > 1 CHAPTER 3 National Income

Now you try… Determine whether constant, decreasing, or increasing returns to scale for each of these production functions: (a) (b) CHAPTER 3 National Income

Answer to part (a) constant returns to scale for any z > 0 CHAPTER 3 National Income

Answer to part (b) constant returns to scale for any z > 0 CHAPTER 3 National Income

Assumptions of the model
Technology is fixed. The economy’s supplies of capital and labor are fixed at Emphasize that “K” and “L” (without bars on top) are variables - they can take on various magnitudes. On the other hand, “Kbar” and “Lbar” are specific values of these variables. Hence, “K = Kbar” means that the variable K equals the specific amount Kbar. Regarding the assumptions: In chapters 7 and 8 (the Economic Growth chapters), we will relax these assumptions: K and L will grow in response to investment and population growth, respectively, and the level of technology will increase over time. CHAPTER 3 National Income

Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: Again, emphasize that “F(Kbar,Lbar)” means we are evaluating the function at a particular combination of capital and labor. The resulting value of output is called “Ybar”. CHAPTER 3 National Income

The distribution of national income
determined by factor prices, the prices per unit that firms pay for the factors of production wage = price of L rental rate = price of K Recall from chapter 2: the value of output equals the value of income. The income is paid to the workers, capital owners, land owners, and so forth. We now explore a simple theory of income distribution. CHAPTER 3 National Income

Notation W = nominal wage R = nominal rental rate P = price of output
W /P = real wage (measured in units of output) R /P = real rental rate It might be worthwhile to refresh students’ memory about nominal and real variables. The nominal wage & rental rate are measured in currency units. The real wage is measured in units of output. To see this, suppose W = $10/hour and P = $2 per unit of output. Then, W/P = ($10/hour) / ($2/unit of output) = 5 units of output per hour of work. It’s true, the firm is paying the workers in money units, not in units of output. But, the real wage is the purchasing power of the wage - the amount of stuff that workers can buy with their wage. CHAPTER 3 National Income

How factor prices are determined
Factor prices are determined by supply and demand in factor markets. Recall: Supply of each factor is fixed. What about demand? Since the distribution of income depends on factor prices, we need to see how factor prices are determined. Each factor’s price is determined by supply and demand in a market for that factor. For instance, supply and demand for labor determine the wage. CHAPTER 3 National Income

Demand for labor Assume markets are competitive: each firm takes W, R, and P as given. Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit. cost = real wage benefit = marginal product of labor CHAPTER 3 National Income

Marginal product of labor (MPL )
definition: The extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = F (K, L +1) – F (K, L) CHAPTER 3 National Income

Exercise: Compute & graph MPL
L Y MPL 0 0 n.a. 1 10 ? 2 19 ? 3 27 8 4 34 ? 5 40 ? 6 45 ? 7 49 ? 8 52 ? 9 54 ? 10 55 ? a. Determine MPL at each value of L. b. Graph the production function. c. Graph the MPL curve with MPL on the vertical axis and L on the horizontal axis. This exercise is pretty basic review. It’s good for students who have not had principles of economics in a few years, and students whose graphing skills could benefit from some remedial attention. Many instructors could probably “hide” or omit this and the next slide from their presentations. CHAPTER 3 National Income

Answers: CHAPTER 3 National Income

MPL and the production function
Y output 1 MPL As more labor is added, MPL  1 MPL (Figure 3-3 on p.51) It’s straightforward to see that the MPL = the prod function’s slope: The definition of the slope of a curve is the amount the curve rises when you move one unit to the right. On this graph, moving one unit to the right simply means using one additional unit of labor. The amount the curve rises is the amount by which output increases: the MPL. Slope of the production function equals MPL MPL 1 L labor CHAPTER 3 National Income

Diminishing marginal returns
As a factor input is increased, its marginal product falls (other things equal). Intuition: Suppose L while holding K fixed  fewer machines per worker  lower worker productivity Tell class: Many production functions have this property. This slide introduces some short-hand notation that will appear throughout the PowerPoint presentations of the remaining chapters: The up and down arrows mean increase and decrease, respectively. The symbol “” means “causes” or “leads to.” Hence, the text after “Intuition” should be read as follows: “An increase in labor while holding capital fixed causes there to be fewer machines per worker, which causes lower productivity.” Many instructors use this type of short-hand (or something very similar), and it’s much easier and quicker for students to write down in their notes. CHAPTER 3 National Income

Check your understanding:
Which of these production functions have diminishing marginal returns to labor? Answers: (a) does NOT have diminishing MPL. MPL = 15, regardless of the value of L. (b) and (c) both feature diminishing MPL To get the answers: - using calculus: take the derivative of F( ) with respect to L. The resulting expression is the MPL. Looking at this expression, determine whether MPL falls as L rises. (Or, take derivative of your MPL function w.r.t. L and see whether it’s positive, negative, or zero.) - using algebra: plug in any value for K and another value for L. See what happens if you increase L, then increase it again, and again. This may require a calculator. - finally, you can sketch the graph of these production functions (Y on the vertical, L on the horizontal, assuming a given value of K). If you know the general shape of the square root function, then it’s easy to tell that (b) and (c) have diminishing marginal returns. CHAPTER 3 National Income

Exercise (part 2) L Y MPL 0 0 n.a. 1 10 10 2 19 9 3 27 8
2 19 9 3 27 8 4 34 7 5 40 6 6 45 5 7 49 4 8 52 3 9 54 2 Suppose W/P = 6. If L = 3, should firm hire more or less labor? Why? If L = 7, should firm hire more or less labor? Why? If L=3, then the benefit of hiring the fourth worker (MPL=7) exceeds the cost of doing so (W/P = 6), so it pays the firm to increase L. If L=7, then the firm should hire fewer workers: the 7th worker adds only MPL=4 units of output, yet cost W/P = 6. The point of this slide is to get students to see the idea behind the labor demand = MPL curve. CHAPTER 3 National Income

MPL and the demand for labor
Units of output Units of labor, L Each firm hires labor up to the point where MPL = W/P. MPL, Labor demand Real wage Quantity of labor demanded It’s easy to see that the MPL curve is the firm’s L demand curve. Let L* be the value of L such that MPL = W/P. Suppose L < L*. Then, benefit of hiring one more worker (MPL) exceeds cost (W/P), so firm can increase profits by hiring one more worker. Instead, suppose L > L*. Then, the benefit of the last worker hired (MPL) is less than the cost (W/P), so firm should reduce labor to increase its profits. When L = L*, then firm cannot increase its profits either by raising or lowering L. Hence, firm hires L to the point where MPL = W/P. This establishes that the MPL curve is the firm’s labor demand curve. CHAPTER 3 National Income

The equilibrium real wage
Units of output Units of labor, L Labor supply The real wage adjusts to equate labor demand with supply. MPL, Labor demand equilibrium real wage The labor supply curve is vertical: We are assuming that the economy has a fixed quantity of labor, Lbar, regardless of whether the real wage is high or low. Combining this labor supply curve with the demand curve we’ve developed in previous slides shows how the real wage is determined. CHAPTER 3 National Income

Determining the rental rate
We have just seen that MPL = W/P. The same logic shows that MPK = R/P : diminishing returns to capital: MPK  as K  The MPK curve is the firm’s demand curve for renting capital. Firms maximize profits by choosing K such that MPK = R/P . In our model, it’s easiest to think of firms renting capital from households (the owners of all factors of production). R/P is the real cost of renting a unit of K for one period of time. In the real world, of course, many firms own some of their capital. But, for such a firm, the market rental rate is the opportunity cost of using its own capital instead of renting it to another firm. Hence, R/P is the relevant “price” in firms’ capital demand decisions, whether firms own their capital or rent it. CHAPTER 3 National Income

The equilibrium real rental rate
Units of output Units of capital, K Supply of capital The real rental rate adjusts to equate demand for capital with supply. MPK, demand for capital equilibrium R/P The previous slide used the same logic behind the labor demand curve to assert that the capital demand curve is the same as the downward-sloping MPK curve. The supply of capital is fixed (by assumption), so the supply curve is vertical. The real rental rate (R/P) is determined by the intersection of the two curves. CHAPTER 3 National Income

The Neoclassical Theory of Distribution
states that each factor input is paid its marginal product is accepted by most economists When I teach this theory, after saying “accepted by most economists” I append “at least, as a starting point.” This theory is fine for macro models with only one type of labor. But taken literally, it implies that people who earn low wages have low marginal products. Thus, this theory would attribute the entire observed wage gap between white males and minorities to productivity differences, a conclusion that most would find objectionable. CHAPTER 3 National Income

How income is distributed:
total labor income = total capital income = If production function has constant returns to scale, then The last equation follows from Euler’s theorem, discussed in text on p. 54. national income labor income capital income CHAPTER 3 National Income

The ratio of labor income to total income in the U.S.
Labor’s share of total income Labor’s share of income is approximately constant over time. (Hence, capital’s share is, too.) This graph appears in the textbook as Figure 3-5 on p.57. This and the next two slides cover the Cobb-Douglas production function. In the textbook’s previous edition, this material was covered in an appendix. Source: CHAPTER 3 National Income

The Cobb-Douglas Production Function
The Cobb-Douglas production function has constant factor shares:  = capital’s share of total income: capital income = MPK x K =  Y labor income = MPL x L = (1 –  )Y The Cobb-Douglas production function is: where A represents the level of technology. CHAPTER 3 National Income

The Cobb-Douglas Production Function
Each factor’s marginal product is proportional to its average product: These formulas can be derived with basic calculus and algebra. CHAPTER 3 National Income

A closed economy, market-clearing model
Outline of model A closed economy, market-clearing model Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market DONE  DONE  Next  We’ve now completed the supply side of the model. CHAPTER 3 National Income

Demand for goods & services
Components of aggregate demand: C = consumer demand for g & s I = demand for investment goods G = government demand for g & s (closed economy: no NX ) “g & s” is short for “goods & services” CHAPTER 3 National Income

Consumption, C def: Disposable income is total income minus total taxes: Y – T. Consumption function: C = C (Y – T ) Shows that (Y – T )  C def: Marginal propensity to consume (MPC) is the increase in C caused by a one-unit increase in disposable income. Again, we are using the short-hand notation that will appear throughout the remaining PowerPoints: X  Y means “an increase in X causes a decrease in Y.” Please feel free to edit slides if you wish to substitute other notation. CHAPTER 3 National Income

The consumption function
Y – T C (Y –T ) The slope of the consumption function is the MPC. MPC 1 CHAPTER 3 National Income

Investment, I The investment function is I = I (r ),
where r denotes the real interest rate, the nominal interest rate corrected for inflation. The real interest rate is the cost of borrowing the opportunity cost of using one’s own funds to finance investment spending. So, r  I CHAPTER 3 National Income

The investment function
r I Spending on investment goods depends negatively on the real interest rate. I (r ) CHAPTER 3 National Income

Government spending, G G = govt spending on goods and services.
G excludes transfer payments (e.g., social security benefits, unemployment insurance benefits). Assume government spending and total taxes are exogenous: It might be useful to remind students of the meaning of the terms “exogenous” and “transfer payments.” CHAPTER 3 National Income

The market for goods & services
Aggregate demand: Aggregate supply: Equilibrium: The real interest rate adjusts to equate demand with supply. Note the only variable in the equilibrium condition that doesn’t have a “bar” over it is the real interest rate. When the full slide is showing, before you advance to the next one, you might want to note that the interest rate is important in financial markets as well, so we will next develop a simple model of the financial system. CHAPTER 3 National Income

The loanable funds market
A simple supply-demand model of the financial system. One asset: “loanable funds” demand for funds: investment supply of funds: saving “price” of funds: real interest rate CHAPTER 3 National Income

Demand for funds: Investment
The demand for loanable funds… comes from investment: Firms borrow to finance spending on plant & equipment, new office buildings, etc. Consumers borrow to buy new houses. depends negatively on r, the “price” of loanable funds (cost of borrowing). CHAPTER 3 National Income

Loanable funds demand curve
I The investment curve is also the demand curve for loanable funds. I (r ) CHAPTER 3 National Income

Supply of funds: Saving
The supply of loanable funds comes from saving: Households use their saving to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending. The government may also contribute to saving if it does not spend all the tax revenue it receives. CHAPTER 3 National Income

Types of saving private saving = (Y – T ) – C public saving = T – G
national saving, S = private saving + public saving = (Y –T ) – C T – G = Y – C – G After showing definition of private saving, - give the interpretation of the equation: private saving is disposable income minus consumption spending - explain why private saving is part of the supply of loanable funds: Suppose a person earns $50,000/year, pays $10,000 in taxes, and spends $35,000 on goods and services. There’s $5000 remaining. What happens to that $5000? The person might use it to buy stocks or bonds, or she might put it in her savings account or money market deposit account. In all of these cases, this $5000 becomes part of the supply of loanable funds in the financial system. After displaying public saving, explain the equation’s interpretation: public saving is tax revenue minus government spending. Notice the analogy to private saving – both concepts represent income less spending: for the private household, income is (Y-T) and spending is C. For the government, income is T and spending is G. CHAPTER 3 National Income

Notation:  = change in a variable
For any variable X, X = “the change in X ”  is the Greek (uppercase) letter Delta Examples: If L = 1 and K = 0, then Y = MPL. More generally, if K = 0, then The Delta notation will be used throughout the text, so it would be very helpful if your students started getting accustomed to it now. If your students have taken a semester of calculus, tell them that X is (practically) the same thing as dX (if X is small). Furthermore, some basic rules from calculus apply here with s: The derivative of a sum is the sum of the derivatives: (X+Y) = X + Y The product rule: XY = (X)(Y) + (X)(Y) In fact, you can derive the two arithmetic tricks for working with percentage changes presented in chapter 2. Just take the preceding expression for the product rule and divide through by XY to get (XY)/XY = X/X + Y/Y, the first of the two arithmetic tricks. (YT ) = Y  T , so C = MPC  (Y  T ) = MPC Y  MPC T CHAPTER 3 National Income

EXERCISE: Calculate the change in saving
Suppose MPC = 0.8 and MPL = 20. For each of the following, compute S : a. G = 100 b. T = 100 c. Y = 100 d. L = 10 This problem reinforces the concepts with concrete numerical examples. It’s also a good way to break up the lecture and get students actively involved with the material. CHAPTER 3 National Income

Answers CHAPTER 3 National Income
First, in the box at the top of the slide, we plug the given value for the MPC into the expression for S and simplify. Then, finding the answers is straightforward: just plug in the given values into the expression for S. CHAPTER 3 National Income

digression: Budget surpluses and deficits
If T > G, budget surplus = (T – G ) = public saving. If T < G, budget deficit = (G – T ) and public saving is negative. If T = G , “balanced budget,” public saving = 0. The U.S. government finances its deficit by issuing Treasury bonds – i.e., borrowing. CHAPTER 3 National Income

U.S. Federal Government Surplus/Deficit, 1940-2004
Notes: 1. The huge deficit in the early 1940s was due to WW2: wars are expensive. 2. The budget is closed to balanced in the ’50s and ’60s, and begins a downward trend in the ’70s. 3. The early ’80s saw the largest deficits (as % of GDP) of the post-WW2 era, due to the Reagan tax cuts, defense buildup, and growth in entitlement program outlays. 4. The budget begins a positive trend in the early 1990s, and a surplus emerges in the late 1990s. There are several possible explanations for the improvement. First, President Bush (the first one) broke his campaign promise not to raise taxes. Second, the Clinton administration barely squeaked a deficit reduction deal through Congress (with Al Gore casting the tie-breaking vote in the Senate). And third, and probably most important, there was a swelling of tax revenues due to the surge in economic growth and the stock market boom. (A stock market boom leads to large capital gains, which leads to large revenues from the capital gains tax.) 5. The budget swings to deficit again in 2001, due to the Bush tax cuts and a recession. 6. Recently, the budget deficit has reached all-time highs, when measured in current dollars. As a percentage of GDP, though, the deficit does not seem quite as worrisome relative to the time period captured in this graph. Source of data: U.S. Department of Commerce, Bureau of Economic Analysis. CHAPTER 3 National Income

U.S. Federal Government Debt, 1940-2004
Fact: In the early 1990s, about 18 cents of every tax dollar went to pay interest on the debt (Today it’s about 9 cents.) A later chapter will give more details, but for now, tell students that the government finances its deficits by borrowing from the public. (This borrowing takes the form of selling Treasury bonds). Persistent deficits over time imply persistent borrowing, which causes the debt to increase. After WW2, occasional budget surpluses allowed the government to retire some of its WW2 debt; also, normal economic growth increased the denominator of the debt-to-GDP ratio. Starting in the early 1980s, corresponding to the beginning of huge and persistent deficits, we see a huge increase in the debt-to-GDP ratio, from 32% in 1981 to 66% in In the mid 1990s, budget surpluses and rapid growth started to reduce the debt-to-GDP ratio, but it started rising again in 2001 due to the economic slowdown, the Bush tax cuts, and higher spending (Afghanistan & Iraq, war on terrorism, 2002 airline bailout, etc). Students are typically shocked when they realize how much extra we are paying in taxes just to service the debt; if it weren’t for the debt, we’d either pay much lower taxes, or have a lot of revenue available for other purposes, like financial aid for college students, AIDS and cancer research, national defense, Social Security reform, etc. Source of data: U.S. Dept of Commerce Bureau of Economic Analysis. CHAPTER 3 National Income

Loanable funds supply curve
S, I National saving does not depend on r, so the supply curve is vertical. At the end of this chapter, we will briefly consider how things would be different if Consumption (and therefore Saving) were allowed to depend on the interest rate. For now, though, they do not. CHAPTER 3 National Income

Loanable funds market equilibrium
S, I I (r ) Equilibrium real interest rate Equilibrium level of investment CHAPTER 3 National Income

The special role of r Eq’m in L.F. market Eq’m in goods market
r adjusts to equilibrate the goods market and the loanable funds market simultaneously: If L.F. market in equilibrium, then Y – C – G = I Add (C +G ) to both sides to get Y = C + I + G (goods market eq’m) Thus, This slide establishes that we can use the loanable funds supply/demand diagram to see how the interest rate that clears the goods market is determined. Explain that the symbol  means each one implies the other. The thing on the left implies the thing on the right, and vice versa. More short-hand: “eq’m” is short for “equilibrium” and “LF” for “loanable funds.” Eq’m in L.F. market Eq’m in goods market CHAPTER 3 National Income

Digression: Mastering models
To master a model, be sure to know: 1. Which of its variables are endogenous and which are exogenous. 2. For each curve in the diagram, know a. definition b. intuition for slope c. all the things that can shift the curve 3. Use the model to analyze the effects of each item in 2c. This is good general advice for students. They will learn many models in this course. Many exams include questions requiring students to show how some event shifts a curve, and then use the model to analyze its effect on the endogenous variables. If students methodically follow the steps presented on this slide for each model they learn in this course (and other economics courses), they will likely do better on the exams and get more out of the course. CHAPTER 3 National Income

Mastering the loanable funds model
Things that shift the saving curve public saving fiscal policy: changes in G or T private saving preferences tax laws that affect saving 401(k) IRA replace income tax with consumption tax Continuing from the previous slide, let’s look at all the things that affect the S curve. Then, we will pick one of those things and use the model to analyze its effects on the endogenous variables. Then, we’ll do the same for the I curve. CHAPTER 3 National Income

CASE STUDY: The Reagan deficits
Reagan policies during early 1980s: increases in defense spending: G > 0 big tax cuts: T < 0 Both policies reduce national saving: CHAPTER 3 National Income

CASE STUDY: The Reagan deficits
1. The increase in the deficit reduces saving… r S, I I (r ) r2 2. …which causes the real interest rate to rise… r1 3. …which reduces the level of investment. I2 I1 CHAPTER 3 National Income

Are the data consistent with these results?
variable 1970s 1980s T – G –2.2 –3.9 S r I Display the data line by line, noting that it matches the model’s predictions---UNTIL YOU GET TO Investment. The model says that investment should have fallen as much as savings. Ask students why they think it didn’t. Answer: in our closed economy model of chapter 3, the only source of loanable funds is national saving. But the U.S. is actually an open economy. In the face of a fall in national saving (i.e. the domestic supply of loanable funds), firms can finance their investment spending by importing foreign loanable funds. More on this in an upcoming chapter. T–G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown. CHAPTER 3 National Income

Now you try… Draw the diagram for the loanable funds model.
Suppose the tax laws are altered to provide more incentives for private saving. (Assume that total tax revenue T does not change) What happens to the interest rate and investment? Students may be confused because we are (somehow) changing taxes, but assuming T is unchanged. Taxes have different effects. The total amount of taxes (T ) affects disposable income. But even if we hold total taxes constant, a change in the structure or composition of taxes can have effects. In this problem, we’re holding total taxes constant, so disposable income does not change, but we are changing the composition of taxes to give consumers an incentive to increase their saving. CHAPTER 3 National Income

Mastering the loanable funds model, continued
Things that shift the investment curve some technological innovations to take advantage of the innovation, firms must buy new investment goods tax laws that affect investment investment tax credit CHAPTER 3 National Income

An increase in investment demand
S, I I2 I1 …raises the interest rate. An increase in desired investment… r2 r1 But the equilibrium level of investment cannot increase because the supply of loanable funds is fixed. CHAPTER 3 National Income

Saving and the interest rate
Why might saving depend on r ? How would the results of an increase in investment demand be different? Would r rise as much? Would the equilibrium value of I change? Suggestion: Display these questions and give your students 3-4 minutes, working in pairs, to try to find the answers. Then display the analysis on the next slide. CHAPTER 3 National Income

An increase in investment demand when saving depends on r
S, I An increase in investment demand raises r, which induces an increase in the quantity of saving, which allows I to increase. I(r)2 I(r) r2 I2 r1 I1 CHAPTER 3 National Income

Chapter Summary Total output is determined by
the economy’s quantities of capital and labor the level of technology Competitive firms hire each factor until its marginal product equals its price. If the production function has constant returns to scale, then labor income plus capital income equals total income (output). CHAPTER 3 National Income slide 155

Chapter Summary A closed economy’s output is used for
consumption investment government spending The real interest rate adjusts to equate the demand for and supply of goods and services loanable funds CHAPTER 3 National Income slide 156

Chapter Summary A decrease in national saving causes the interest rate to rise and investment to fall. An increase in investment demand causes the interest rate to rise, but does not affect the equilibrium level of investment if the supply of loanable funds is fixed. CHAPTER 3 National Income slide 157

4 Money and Inflation Chapter 4 is longer than average. If you omit anything from this chapter to save time, I recommend that you NOT omit the following, which I think are the most important concepts from this chapter: the Quantity Theory of Money’s implication that inflation in the long run equals money growth minus real GDP growth the money demand function L(i,Y), which will be used in the IS-LM model and other parts of the rest of this book the Classical Dichotomy and Neutrality of Money (which includes the Fisher effect and the Layman’s view of the costs of inflation) In addition to those three critical topics, Chapter 4 covers many other topics, such as: the 3 functions and 2 types of money – these will likely be review if your students have previously taken an introductory economics course; hence, to save time, you can ask your students to read these on their own the social costs of inflation (here, I think the Shoeleather cost is a good candidate for cutting – it just does not seem very relevant in a world with ATMs in most grocery stores and online bank account management) ex ante vs. ex post real interest rate seigniorage the causes and costs of hyperinflation

The classical theory of inflation causes effects social costs “Classical” – assumes prices are flexible & markets clear Applies to the long run CHAPTER 4 Money and Inflation

U.S. inflation and its trend, 1960-2006
0% 3% 6% 9% 12% 15% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 % change in CPI from 12 months earlier long-run trend In this chapter, we learn about the long-run trend behavior of prices and inflation. The factors that make inflation deviate from its trend in the short run will be studied in chapter 13 (on Aggregate Supply and the Phillips Curve). source: BLS obtained from slide 160

The connection between money and prices
Inflation rate = the percentage increase in the average level of prices. Price = amount of money required to buy a good. Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled. CHAPTER 4 Money and Inflation

Money: Definition Money is the stock of assets that can be readily used to make transactions. CHAPTER 4 Money and Inflation

Money: Functions medium of exchange we use it to buy stuff
store of value transfers purchasing power from the present to the future unit of account the common unit by which everyone measures prices and values If your students have taken principles of economics, they will probably be familiar with the material on this slide. It might be worthwhile, though, to take an extra moment to be sure that students understand that the definition of store of value (an item that transfers purchasing power from the present to the future) simply means that money retains its value over time, so you need not spend all your money as soon as you receive it. The idea should be familiar, even though Mankiw’s wording is a bit more sophisticated than most other texts. CHAPTER 4 Money and Inflation

Money: Types has no intrinsic value example: the paper currency we use
1. fiat money has no intrinsic value example: the paper currency we use 2. commodity money has intrinsic value examples: gold coins, cigarettes in P.O.W. camps Again, this material should be review for most students. Note: Many students have seen the film The Shawshank Redemption starring Tim Robbins and Morgan Freeman. Most of this film takes place in a prison. The prisoners have an informal “underground economy” in which cigarettes are used as money, even by prisoners who don’t smoke. Students who have seen the film will better understand “commodity money” if you mention this example. Also, the textbook (p.79) has a case study on cigarettes being used as money in POW camps during WWII. CHAPTER 4 Money and Inflation

Discussion Question Which of these are money? a. Currency b. Checks
c. Deposits in checking accounts (“demand deposits”) d. Credit cards e. Certificates of deposit (“time deposits”) You might want to ask students to determine, for each item listed, which of the functions of money it serves. Answers: a - yes b - no, not the checks themselves, but the funds in checking accounts are money. c - yes (see b) d - no, credit cards are a means of deferring payment. e - CDs are a store of value, and they are measured in money units. They are not readily spendable, though. CHAPTER 4 Money and Inflation

The money supply and monetary policy definitions
The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply. Again, this is mostly review. CHAPTER 4 Money and Inflation

The Federal Reserve Building Washington, DC
The central bank Monetary policy is conducted by a country’s central bank. In the U.S., the central bank is called the Federal Reserve (“the Fed”). The Federal Reserve Building Washington, DC Again, this is mostly review. CHAPTER 4 Money and Inflation

Money supply measures, April 2006
symbol assets included amount ($ billions) $739 Currency C $1391 C + demand deposits, travelers’ checks, other checkable deposits M1 This table is an updated version of Table 4-1 on p.82 of the textbook, with one change: This slide excludes M3, which the Federal Reserve discontinued in March For more info, see The most important thing that students should get from this slide is the following: Each successive measure of the money supply is BIGGER and LESS LIQUID than the one it follows. I.e., checking account deposits (in M1 but not C) are less liquid than currency. Money market deposit account and savings account balances (in M2 but not M1) are less liquid than demand deposits. Whether you require your students to learn the definitions of every component of each monetary aggregate is up to you. Most professors agree that students should learn the definitions of M1, M2, demand deposits, and time deposits. Some professors feel that, since the quantity of information students can learn in a semester is finite, it is not worthwhile to require students to learn such terms as “repurchase agreements.” However, you might verbally state the definitions of such terms to help students better understand the nature of the monetary aggregates. $6799 M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts M2 CHAPTER 4 Money and Inflation

The Quantity Theory of Money
A simple theory linking the inflation rate to the growth rate of the money supply. Begins with the concept of velocity… CHAPTER 4 Money and Inflation

Velocity basic concept: the rate at which money circulates
definition: the number of times the average dollar bill changes hands in a given time period example: In 2007, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2007 So, velocity = 5 In order for $500 billion in transactions to occur when the money supply is only $100b, each dollar must be used, on average, in five transactions. CHAPTER 4 Money and Inflation

Velocity, cont. where V = velocity T = value of all transactions
This suggests the following definition: where V = velocity T = value of all transactions M = money supply CHAPTER 4 Money and Inflation

Velocity, cont. Use nominal GDP as a proxy for total transactions.
Then, where P = price of output (GDP deflator) Y = quantity of output (real GDP) P Y = value of output (nominal GDP) You might ask students if they know the difference between nominal GDP and the value of transactions. Answer: nominal GDP includes the value of purchases of final goods; total transactions also includes the value of intermediate goods. Even though they are different, they are highly correlated. Also, our models focus on GDP, and there’s lots of great data on GDP. So from this point on, we’ll use the income version of velocity. CHAPTER 4 Money and Inflation

The quantity equation The quantity equation M V = P Y follows from the preceding definition of velocity. It is an identity: it holds by definition of the variables. CHAPTER 4 Money and Inflation

Money demand and the quantity equation
M/P = real money balances, the purchasing power of the money supply. A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income (k is exogenous) CHAPTER 4 Money and Inflation

Money demand and the quantity equation
money demand: (M/P )d = k Y quantity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low). CHAPTER 4 Money and Inflation

Back to the quantity theory of money
starts with quantity equation assumes V is constant & exogenous: With this assumption, the quantity equation can be written as CHAPTER 4 Money and Inflation

The quantity theory of money, cont.
How the price level is determined: With V constant, the money supply determines nominal GDP (P Y ). Real GDP is determined by the economy’s supplies of K and L and the production function (Chap 3). The price level is P = (nominal GDP)/(real GDP). It’s worthwhile to underscore the order (logical order, though not necessarily chronological order) in which variables are determined in this model (as well as the other models students will learn in this course). First, real GDP is already determined outside this model (real GDP is determined by the model from chapter 3, which was completely independent of the money supply or velocity or other nominal variables). Second, the Quantity Theory of money determines nominal GDP. Third, the values of nominal GDP (PY) and real GDP (Y) together determine P (as a ratio of PY to Y). If, on an exam or homework problem, students forget the logical order in which endogenous variables are determined --- or on a more fundamental level, forget which variables are endogenous and which are exogenous --- then they are much less likely to earn the high grades that most of them desire. [Note the similarity between the way P is determined and the definition of the GDP deflator from chapter 2.] CHAPTER 4 Money and Inflation

Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates. The quantity equation in growth rates: CHAPTER 4 Money and Inflation

 (Greek letter “pi”) denotes the inflation rate: The result from the preceding slide was: Solve this result for  to get CHAPTER 4 Money and Inflation

Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. The text on this slide is an intuitive way to understand the equation. For students that are more comfortable with concrete numerical examples, you could offer the following: Suppose real GDP is growing by 3% per year over the long run. Thus, production, income, and spending are all growing by 3%. This means that the volume of transactions will be growing as well. The central bank can achieve zero inflation (on average over the long run) simply by setting the growth rate of the money supply at 3%, in which case exactly enough new money is being supplied to facilitate the growth in transactions. CHAPTER 4 Money and Inflation

Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Note: the theory doesn’t predict that the inflation rate will equal the money growth rate. It *does* predict that a change in the money growth rate will cause an equal change in the inflation rate. CHAPTER 4 Money and Inflation

Confronting the quantity theory with data
The quantity theory of money implies 1. countries with higher money growth rates should have higher inflation rates. 2. the long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate. Are the data consistent with these implications? CHAPTER 4 Money and Inflation

International data on inflation and money growth
Turkey Ecuador Indonesia Belarus Argentina U.S. Switzerland Singapore Figure 4-2, p.89 Each variable is measured as an annual average over the period The strong positive correlation is evidence for the Quantity Theory of Money. Source: International Financial Statistics. CHAPTER 4 Money and Inflation

U.S. inflation and money growth, 1960-2006
0% 3% 6% 9% 12% 15% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Over the long run, the inflation and money growth rates move together, as the quantity theory predicts. M2 growth rate The quantity theory of money is intended to explain the long-run relation of inflation and money growth, not the short-run relation. In the long run, inflation and money growth are positively related, as the theory predicts. (In the short run, however, inflation and money growth appear highly negatively correlated! One possible reason is that the causality is reversed in the short run: when inflation rises – or is expected to rise – the Fed cuts back on money growth. If the economy slumps and inflation falls, the Fed increases money growth. It might be appropriate to discuss this when covering the chapters on short-run fluctuations.) sources: CPI - BLS Money supply - Board of Governors of the Federal Reserve obtained from inflation rate slide 184

Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The “revenue” raised from printing money is called seigniorage (pronounced SEEN-your-idge). The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. Introduction of abbreviation “govt” for “government” It’s quicker and easier for students to write “govt” in their notes. In the U.S., seigniorage accounts for only about 3% of total government revenue. In Italy and Greece, seigniorage has often been more than 10% of total revenue. In countries experiencing hyperinflation, seigniorage is often the government’s main source of revenue, and the need to print money to finance government expenditure is a primary cause of hyperinflation. See Case Study on p.90 “Paying for the American Revolution.” CHAPTER 4 Money and Inflation

Inflation and interest rates
Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i   This is probably review, if your students have taken an introductory course in economics. CHAPTER 4 Money and Inflation

The Fisher effect The Fisher equation: i = r + 
Chap 3: S = I determines r . Hence, an increase in  causes an equal increase in i. This one-for-one relationship is called the Fisher effect. Note that S and I are real variables. In chapter 3, we learned about the factors that determine S and I. These factors did not include the money supply, velocity, inflation, or other nominal variables. Hence, in the classical (long-run) theory we are learning, changes in money growth or inflation do not affect the real interest rate. This is why there’s a one-for-one relationship between changes in the inflation rate and changes in the nominal interest rate. (Again, the Fisher effect does not imply that the nominal interest rate EQUALS the inflation rate. It implies that CHANGES in the nominal interest rate equal CHANGES in the inflation rate, given a constant value of the real interest rate.) CHAPTER 4 Money and Inflation

Inflation and nominal interest rates in the U.S., 1955-2006
percent per year 15 nominal interest rate 10 5 A replica of Fig 4-3, p.92 The data are consistent with the Fisher effect: inflation and the nominal interest rate are very highly correlated. However, they are not perfectly correlated, which absolutely does not invalidate the Fisher effect. Over time, the saving and investment curves move around, causing the real interest rate to move, which, in turn, causes the nominal interest rate to change for a given value of inflation. About the data: The inflation rate is the percentage change in the (not seasonally adjusted) CPI from 12 months earlier. The nominal interest rate is the (not seasonally adjusted) 3-month Treasury bill rate in the secondary market. Data obtained from inflation rate -5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 4 Money and Inflation

Inflation and nominal interest rates across countries
Romania Zimbabwe Brazil Bulgaria Israel Germany U.S. Fig 4-4, p.93 The nominal interest rate is the rate on short-term government debt. Inflation and interest rates are measured as annual averages over the period The strong positive relation is evidence for the Fisher effect. Switzerland CHAPTER 4 Money and Inflation

Exercise: Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. a. Solve for i. b. If the Fed increases the money growth rate by 2 percentage points per year, find i. c. Suppose the growth rate of Y falls to 1% per year. What will happen to  ? What must the Fed do if it wishes to keep  constant? This exercise gives students an immediate application of the Quantity Theory of Money and the Fisher effect. The math is not difficult. CHAPTER 4 Money and Inflation

Answers---the details:
V is constant, M grows 5% per year, Y grows 2% per year, r = 4. a. First, find  = 5  2 = 3. Then, find i = r +  = = 7. b. i = 2, same as the increase in the money growth rate. c. If the Fed does nothing,  = 1. To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year. Answers---the details: a. First, we need to find . Constant velocity implies  = (M/M) - (Y/Y) = = 3. Then, i = r +  = = 7. b. Changes in the money growth rate do not affect real GDP or its growth rate. So, a two-point increase in money growth causes a two-point increase in inflation. According to the Fisher effect, the nominal interest rate should rise by the increase in inflation: two points (from i=7 to i=9). c.  = (M/M) - (Y/Y). If (Y/Y) falls by 1 point, then  will increase by 1 point; the Fed can prevent this by reducing (M/M) by 1 point. Intuition: With slower growth in the economy, the volume of transactions will be growing more slowly, which means that the need for new money will grow more slowly. CHAPTER 4 Money and Inflation

Two real interest rates
 = actual inflation rate (not known until after it has occurred)  e = expected inflation rate i –  e = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan i –  = ex post real interest rate: the real interest rate actually realized CHAPTER 4 Money and Inflation

Money demand and the nominal interest rate
In the quantity theory of money, the demand for real money balances depends only on real income Y. Another determinant of money demand: the nominal interest rate, i. the opportunity cost of holding money (instead of bonds or other interest-earning assets). Hence, i   in money demand. The concept of “money demand” can be a bit awkward for students the first time they learn it. A good way to explain it is to imagine that a consumer has a certain amount of wealth, which is divided between money and other assets. The other assets typically generate some type of income (e.g. interest income in the case of bonds), but are much less liquid than money. There is therefore a trade-off: the more money the consumer holds in his portfolio, the more interest income he foregoes; the less money he holds, the more interest income he makes, but the less liquid is his portfolio. With this for background, a consumer’s “money demand” refers to the fraction of his wealth he would like to hold in the form of money (as opposed to less-liquid income-generating assets like bonds). CHAPTER 4 Money and Inflation

The money demand function
(M/P )d = real money demand, depends negatively on i i is the opp. cost of holding money positively on Y higher Y  more spending  so, need more money (“L” is used for the money demand function because money is the most liquid asset.) An increase in the nominal interest rate represents the increase in the opportunity cost of holding money rather than bonds, and would motivate the typical consumer to hold less of his wealth in the form of money, and more in the form of bonds (or other interest-earning assets). An increase in real income (other things equal) causes an increase in the consumer’s consumption and therefore spending. To facilitate this extra spending, the consumer will require more money. Thus, the consumer would like a larger fraction of his wealth to be in the form of money (rather than bonds, etc). This might involve redeeming some of his bonds. Or it might simply involve holding the additional income in the form of money rather than putting it into bonds. CHAPTER 4 Money and Inflation

When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r +  e. CHAPTER 4 Money and Inflation

The supply of real money balances
Equilibrium The supply of real money balances Real money demand CHAPTER 4 Money and Inflation

What determines what variable how determined (in the long run)
M exogenous (the Fed) r adjusts to make S = I Y P adjusts to make Again, it is very important for students to learn the logical order in which variables are determined. I.e., you do NOT need to know P in order to determine Y. You DO need to know Y in order to determine L, and you need to know L and M in order to determine P. CHAPTER 4 Money and Inflation

How P responds to M For given values of r, Y, and  e,
a change in M causes P to change by the same percentage – just like in the quantity theory of money. This slide shows the connection between the money market equilibrium condition and the (simpler) Quantity Theory of Money, presented earlier in this chapter. CHAPTER 4 Money and Inflation

What about expected inflation?
Over the long run, people don’t consistently over- or under-forecast inflation, so  e =  on average. In the short run,  e may change when people get new information. EX: Fed announces it will increase M next year. People will expect next year’s P to be higher, so  e rises. This affects P now, even though M hasn’t changed yet…. This slide and the next correspond to the subsection of Chapter 4 entitled “Future Money and Current Prices,” appearing on pp CHAPTER 4 Money and Inflation

How P responds to  e For given values of r, Y, and M ,
CHAPTER 4 Money and Inflation

Discussion question Why is inflation bad?
What costs does inflation impose on society? List all the ones you can think of. Focus on the long run. Think like an economist. Many of the social costs of inflation are not hard to figure out, if students “think like an economist.” Suggestion: After you pose the question, don’t immediately ask for students to volunteer their answers. Instead, tell them to think about the question for a moment, jot down their answers, and THEN ask for volunteers. You will get more participation (quantity & quality) this way, especially from students who don’t consider themselves fast thinkers. After presenting the following slides (which describe the costs), see how many of the costs presented here were anticipated by the students’ responses to the question on this slide. CHAPTER 4 Money and Inflation

A common misperception
Common misperception: inflation reduces real wages This is true only in the short run, when nominal wages are fixed by contracts. (Chap. 3) In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate. Consider the data… CHAPTER 4 Money and Inflation

Average hourly earnings and the CPI, 1964-2006
$20 250 $18 $16 200 $14 $12 150 hourly wage $10 CPI ( = 100) $8 100 First, note that the CPI has risen tremendously over the past 40 years. However, nominal wages have risen by a roughly similar magnitude. If the common misperception were true, then the real wage should show exactly the opposite behavior as the CPI. It doesn’t. The real wage is not constant - it varies within the range of $15 to $19 - but there is no downward trend in the real wage over the long term. Note: We wouldn’t expect the real wage to be constant over the long run – we would expect it to change in response to shifts in the labor supply and MPL curves. source: BLS Obtained from: $6 CPI (right scale) $4 50 wage in current dollars $2 wage in 2006 dollars $0 CHAPTER 4 Money and Inflation 1964 1970 1976 1982 1988 1994 2000 2006

The classical view of inflation
The classical view: A change in the price level is merely a change in the units of measurement. So why, then, is inflation a social problem? CHAPTER 4 Money and Inflation

The social costs of inflation
…fall into two categories: 1. costs when inflation is expected 2. costs when inflation is different than people had expected CHAPTER 4 Money and Inflation

The costs of expected inflation: 1. Shoeleather cost
def: the costs and inconveniences of reducing money balances to avoid the inflation tax.   i   real money balances Remember: In long run, inflation does not affect real income or real spending. So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash. CHAPTER 4 Money and Inflation

The costs of expected inflation: 2. Menu costs
def: The costs of changing prices. Examples: cost of printing new menus cost of printing & mailing new catalogs The higher is inflation, the more frequently firms must change their prices and incur these costs. CHAPTER 4 Money and Inflation

The costs of expected inflation: 3. Relative price distortions
Firms facing menu costs change prices infrequently. Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall. Different firms change their prices at different times, leading to relative price distortions… …causing microeconomic inefficiencies in the allocation of resources. CHAPTER 4 Money and Inflation

The costs of expected inflation: 4. Unfair tax treatment
Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: Jan 1: you buy $10,000 worth of IBM stock Dec 31: you sell the stock for $11,000, so your nominal capital gain is $1000 (10%). Suppose  = 10% during the year. Your real capital gain is $0. But the govt requires you to pay taxes on your $1000 nominal gain!! In the 1970s, the income tax was not adjusted for inflation. There were a lot of people who received nominal salary increases large enough to push them into a higher tax bracket, but not large enough to prevent their real salaries from falling in the face of high inflation. This led to political pressure to index the income tax brackets. If inflation had been higher during , when lots of people were earning high capital gains, then there might have been more political pressure to index the capital gains tax. CHAPTER 4 Money and Inflation

The costs of expected inflation: 5. General inconvenience
Inflation makes it harder to compare nominal values from different time periods. This complicates long-range financial planning. Examples: Parents trying to decide how much to save for the future college expenses of their (now) young child. Thirty-somethings trying to decide how much to save for retirement. The CEO of a big corporation trying to decide whether to build a new factory, which will yield a revenue stream for 20 years or more. Your grandmother claiming that things were so much cheaper when she was your age. A silly digression: My grandmother often has these conversations with me, concluding that the dollar just isn’t worth what it was when she was young. I ask her “well, how much is a dollar worth today?”. She considers the question, and then offers her estimate: “About 60 cents.” I then offer her 60 cents for every dollar she has. She doesn’t accept the offer. :) CHAPTER 4 Money and Inflation

Many long-term contracts not indexed, but based on  e.
Additional cost of unexpected inflation: Arbitrary redistribution of purchasing power Many long-term contracts not indexed, but based on  e. If  turns out different from  e, then some gain at others’ expense. Example: borrowers & lenders If  >  e, then (i  ) < (i   e) and purchasing power is transferred from lenders to borrowers. If  <  e, then purchasing power is transferred from borrowers to lenders. Ask students this rhetorical question: Would it upset you off if somebody arbitrarily took wealth away from some people and gave it to others? Well, this in effect is what’s happening when inflation turns out different than expected. Furthermore, it’s impossible to predict when inflation will turn out higher than expected, when it will be lower, and how big the difference will be. So, these redistributions of purchasing power are arbitrary and random. The text gives a simple numerical example starting on the bottom of p.100. (In the short run, when many nominal wages are fixed by contracts, there are transfers of purchasing power between firms and their employees whenever inflation is different than expected when the contract was written and signed.) CHAPTER 4 Money and Inflation

Additional cost of high inflation: Increased uncertainty
When inflation is high, it’s more variable and unpredictable:  turns out different from  e more often, and the differences tend to be larger (though not systematically positive or negative) Arbitrary redistributions of wealth become more likely. This creates higher uncertainty, making risk averse people worse off. CHAPTER 4 Money and Inflation

One benefit of inflation
Nominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. Therefore, moderate inflation improves the functioning of labor markets. Students will better appreciate this point when they learn chapter 6 (the natural rate of unemployment). In this chapter, we will see how the failure of wages to adjust contributes to a long-term unemployment problem. CHAPTER 4 Money and Inflation

Hyperinflation def:   50% per month
All the costs of moderate inflation described above become HUGE under hyperinflation. Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange). People may conduct transactions with barter or a stable foreign currency. Page 104 has an excellent example of life during a hyperinflation, which involves beer, a commodity with which your students may be somewhat familiar. See also the excellent case study on pp Note: On p.103, the text states “Hyperinflation is often defined as inflation that exceeds 50 percent per month.” I’ve included this definition at the top of this slide, to be consistent with the textbook. However, some professors are a bit uncomfortable assigning a specific number (such as 50% per month) to the definition of hyperinflation, because, for example, most would agree that 49% per month inflation is high enough to be considered hyperinflation. The definition I like to use in my own teaching is this: hyperinflation: a really, really, really high rate of inflation Feel free to edit the definition of “hyperinflation” on this slide if you wish. CHAPTER 4 Money and Inflation

What causes hyperinflation?
Hyperinflation is caused by excessive money supply growth: When the central bank prints money, the price level rises. If it prints money rapidly enough, the result is hyperinflation. CHAPTER 4 Money and Inflation

A few examples of hyperinflation
money growth (%) inflation (%) Israel, 295 275 Poland, 344 400 Brazil, 1350 1323 Argentina, 1264 1912 Peru, 2974 3849 Nicaragua, 4991 5261 Bolivia, 4208 6515 Examples of hyperinflation from the textbook: 1. interwar Germany (data and discussion) 2. Bolivia in 1985 (Case Study) This table provides data on Bolivia’s hyperinflation, and some additional examples. CHAPTER 4 Money and Inflation

Why governments create hyperinflation
When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money. In theory, the solution to hyperinflation is simple: stop printing money. In the real world, this requires drastic and painful fiscal restraint. Before revealing the contents of this slide, you might consider asking students the following question: “Solving the problem of hyperinflation is easy. Why, then, do governments allow hyperinflation to occur?” CHAPTER 4 Money and Inflation

The Classical Dichotomy
Real variables: Measured in physical units – quantities and relative prices, for example: quantity of output produced real wage: output earned per hour of work real interest rate: output earned in the future by lending one unit of output today Nominal variables: Measured in money units, e.g., nominal wage: Dollars per hour of work. nominal interest rate: Dollars earned in future by lending one dollar today. the price level: The amount of dollars needed to buy a representative basket of goods. CHAPTER 4 Money and Inflation

The Classical Dichotomy
Note: Real variables were explained in Chap 3, nominal ones in Chapter 4. Classical dichotomy: the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. Neutrality of money: Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run. CHAPTER 4 Money and Inflation

Chapter Summary Money the stock of assets used for transactions
serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls the money supply. Quantity theory of money assumes velocity is stable, concludes that the money growth rate determines the inflation rate. CHAPTER 4 Money and Inflation slide 220

Chapter Summary Nominal interest rate
equals real interest rate + inflation rate the opp. cost of holding money Fisher effect: Nominal interest rate moves one-for-one w/ expected inflation. Money demand depends only on income in the Quantity Theory also depends on the nominal interest rate if so, then changes in expected inflation affect the current price level. CHAPTER 4 Money and Inflation slide 221

Chapter Summary Costs of inflation
Expected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors CHAPTER 4 Money and Inflation slide 222

Chapter Summary Hyperinflation
caused by rapid money supply growth when money printed to finance govt budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing money CHAPTER 4 Money and Inflation slide 223

Chapter Summary Classical dichotomy
In classical theory, money is neutral--does not affect real variables. So, we can study how real variables are determined w/o reference to nominal ones. Then, money market eq’m determines price level and all nominal variables. Most economists believe the economy works this way in the long run. CHAPTER 4 Money and Inflation slide 224

5 The Open Economy Chapter 5 extends the analysis to a small open economy. This PowerPoint presentation contains a slide explaining why the U.S. is often called “the world’s largest debtor nation.” This material will help motivate the rest of the chapter: First, students learn exactly what trade surpluses and trade deficits are. Next, students learn the link between the trade balance and net capital outflow or net lending to/borrowing from abroad. Finally, students see a new time series graph on the U.S. trade deficit, and get the latest available numbers on U.S. net indebtedness to the rest of the world. This data begs the question: how did it come to this? why has the U.S. had such huge trade deficits? what can the government do about this? These are among the many topical questions that students will better understand as they study this chapter. NOTE: If you are planning on covering chapter 12 (Aggregate Demand in the Open Economy), then covering this chapter is highly recommended.

accounting identities for the open economy the small open economy model what makes it “small” how the trade balance and exchange rate are determined how policies affect trade balance & exchange rate CHAPTER 5 The Open Economy

Trade-GDP ratio, selected countries, 2004 (Imports + Exports) as a percentage of GDP
Luxembourg 275.5% Ireland 150.9 Czech Republic 143.0 Hungary 134.5 Austria 97.1 Switzerland 85.1 Sweden 83.8 Korea, Republic of 83.7 Poland 80.0 Canada 73.1 Germany 71.1% Turkey 63.6 Mexico 61.2 Spain 55.6 United Kingdom 53.8 France 51.7 Italy 50.0 Australia 39.6 United States 25.4 Japan 24.4 This data shows the degree of “openness” (measured by the trade-to-GDP ratio) of selected OECD countries. Despite the huge absolute value of U.S. trade, most of the other countries shown have higher trade-GDP ratios. Source: OECD.org CHAPTER 5 The Open Economy

In an open economy, spending need not equal output
saving need not equal investment Regarding “spending need not equal output”: Residents of an open economy can spend more than the country’s output simply by importing foreign goods. Residents can spend less than output, and the extra output will be exported. Regarding “saving need not equal investment”: If individuals in an open economy want to save more than domestic firms want to borrow, no problem. The savers simply send their extra funds abroad to buy foreign assets. Similarly, if domestic firms want to borrow more than individuals are willing to save, then the firms simply borrow from abroad (i.e. sell bonds to foreigners). CHAPTER 5 The Open Economy

Preliminaries EX = exports = foreign spending on domestic goods
superscripts: d = spending on domestic goods f = spending on foreign goods EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods NX = net exports (a.k.a. the “trade balance”) = EX – IM Before displaying the second and subsequent lines, explain the first one: Total consumption expenditure is the sum of consumer spending on domestically produced goods and foreign produced goods. EX: The value of the goods we export to other countries equals their expenditure on our output. IM: The value of our imports equals the portion of our country’s expenditure (the portion of C+I+G) that falls on foreign products. CHAPTER 5 The Open Economy

GDP = expenditure on domestically produced g & s
A country’s GDP is total expenditure on its output of final goods & services. The first line adds up all sources of spending on domestically produced goods & services. The second & subsequent lines present an algebraic derivation of the national income accounting identity for an open economy. CHAPTER 5 The Open Economy

The national income identity in an open economy
Y = C + I + G + NX or, NX = Y – (C + I + G ) output domestic spending net exports Solving this identity for NX yields the second equation, which says: A country’s net exports---its net outflow of goods---equals the difference between its output and its expenditure. Example: If we produce $500b worth of goods, and only buy $400b worth, then we export the remainder. Of course, NX can be a negative number, which would occur if our spending exceeds our income/output. CHAPTER 5 The Open Economy

Trade surpluses and deficits
NX = EX – IM = Y – (C + I + G ) trade surplus: output > spending and exports > imports Size of the trade surplus = NX trade deficit: spending > output and imports > exports Size of the trade deficit = –NX CHAPTER 5 The Open Economy

U.S. net exports, After learning the terms trade surplus and trade deficit on the preceding slides, we see here that the U.S. has had trade deficits since the early 1980s. In the early 1990s, the trade deficit shrunk relative to GDP, but since then it’s become huge. The next slides show the link between the trade balance and capital flows. Students will see that the huge trade deficits on this slide have caused the U.S. to become the world’s largest debtor nation (and will learn exactly what that means). source: FRED Database, The Federal Reserve Bank of St. Louis,

International capital flows
Net capital outflow = S – I = net outflow of “loanable funds” = net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a net lender When S < I, country is a net borrower In chapter 3, we examined a closed economy model of the loanable funds market. Savers could only lend money to domestic borrowers. Firms borrowing to finance their investment could only borrow from domestic savers. Thus, S = I. But in an open economy, S need not equal I. A country’s supply of loanable funds can be used to finance domestic investment, or to finance foreign investment (e.g. buying bonds from a foreign company that needs funding to build a new factory in its country). Similarly, domestic firms can finance their investment projects by borrowing loanable funds from domestic savers or by borrowing them from foreign savers. International borrowing and lending is called “international capital flows” even though it’s not the physical capital that is flowing abroad --- we don’t see factories uprooted and shipped to Mexico (Ross Perot’s famous remark notwithstanding). Rather, what can flow internationally is “loanable funds,” or financial capital, which of course is used to finance the purchase of physical capital. Note: foreign investment might involve the purchase of financial assets – stocks and bonds and so forth – or physical assets, such as direct ownership in office buildings or factories. In either case, a person in one country ends up owning part of the capital stock of another country. The equation “net capital outflow = S – I” shows that, if a country’s savers supply more funds than its firms wish to borrow for investment, the excess of loanable funds will flow abroad in the form of net capital outflow (the purchase of foreign assets). Alternatively, if firms wish to borrow more than domestic savers wish to lend, then the firms borrow the excess on international financial markets; in this case, there’s a net inflow of loanable funds, and S < I. CHAPTER 5 The Open Economy

The link between trade & cap. flows
NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflow Starting from the equation derived on slides 6 and 7, we can derive another important identity: NX = S – I This equation says that Net exports (the net outflow of goods) = net capital outflow (the net outflow of loanable funds) While the identity and its derivation are very simple, we learn a very important lesson from it: A country (such as the U.S.) with persistent, large trade deficits (NX < 0) also has low saving, relative to its investment, and is a net borrower of assets. Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ). CHAPTER 5 The Open Economy

“The world’s largest debtor nation”
U.S. has had large trade deficits, been a net borrower each year since the early 1980s. As of 12/31/2005: U.S. residents owned $10.0 trillion worth of foreign assets Foreigners owned $12.7 trillion worth of U.S. assets U.S. net indebtedness to rest of the world: $2.7 trillion--higher than any other country, hence U.S. is the “world’s largest debtor nation” Source: Bureau of Economic Analysis, Look for “International Investment Position” under “International” or “International Economic Accounts” The U.S.’ net indebtedness to the rest of the world (henceforth NIROW) is $2.7 trillion as of the end of 2005. The U.S. NIROW is bigger than any other country’s NIROW, which is why the U.S. has earned the dubious distinction of being “the world’s largest debtor nation.” Servicing this huge debt, of course, uses up some of our GDP each year (though fortunately relatively little). How did it get to this point? Why do we have such huge trade deficits year after year? How do government policies affect the trade deficit? These are the questions your students will learn about in the rest of this chapter. CHAPTER 5 The Open Economy

Saving and investment in a small open economy
An open-economy version of the loanable funds model from Chapter 3. Includes many of the same elements: production function consumption function investment function exogenous policy variables CHAPTER 5 The Open Economy

National saving: The supply of loanable funds
r S, I As in Chapter 3, national saving does not depend on the interest rate CHAPTER 5 The Open Economy

Assumptions re: Capital flows
a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* This slide is the first on which students see a foreign variable, in this case, the foreign interest rate r*. In general, a star or asterisk “*” on a variable denotes the foreign or world version of that variable. Thus, Y* = foreign GDP, P* = foreign price level, etc. The assumption that domestic & foreign bonds are perfect substitutes is implicit in the text, but necessary for the equality of the domestic and foreign interest rate. Students will realize that assumption a is unrealistic, and c is unrealistic for the U.S. (as well as Japan and the Euro zone). However, these assumptions keep our model simple, and we can still learn a LOT about how the world works (just as the model of supply and demand in perfectly competitive markets is often not realistic, yet teaches us a great deal about how the world works). At the end of the chapter, there’s a brief section discussing how the results we are about to derive differ in a large open economy. And you may wish to have your students read the appendix to chapter 5, which presents a formal model of the large open economy. a & b imply r = r* c implies r* is exogenous CHAPTER 5 The Open Economy

Investment: The demand for loanable funds
Investment is still a downward-sloping function of the interest rate, r S, I I (r ) but the exogenous world interest rate… r * …determines the country’s level of investment. I (r* ) CHAPTER 5 The Open Economy

If the economy were closed…
S, I …the interest rate would adjust to equate investment and saving: I (r ) rc CHAPTER 5 The Open Economy

But in a small open economy…
r S, I the exogenous world interest rate determines investment… I (r ) NX r* I 1 …and the difference between saving and investment determines net capital outflow and net exports rc This graph really determines net capital outflow, not NX. But, the national accounting identities say that NX = net capital outflow, so we write “NX” on the graph as shown. A little bit later in the chapter, we will see that it is the adjustment of the exchange rate that ensures that NX = net capital outflow. For now, though, students will just have to trust the accounting identities. CHAPTER 5 The Open Economy

Next, three experiments:
1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand In the textbook, NX = 0 in the economy’s initial equilibrium for each of these three experiments. In these slides, NX > 0 in the initial equilibrium. For completeness, you might have your students repeat the three experiments for the case of NX < 0 in the initial equilibrium. This would be a good homework or in-class exercise. CHAPTER 5 The Open Economy

1. Fiscal policy at home r S, I I (r ) I 1
An increase in G or decrease in T reduces saving. I (r ) NX2 I 1 NX1 Results: In a small open economy, the fixed world interest rate pins down the value of investment, regardless of fiscal policy changes. Thus, a $1 decrease in saving causes a $1 decrease in NX and net capital outflow. Note that the analysis on this slide applies to ANYTHING that causes a decrease in saving. Other examples: a shift in consumer preferences regarding the tradeoff between saving and consumption, or a change in the tax laws that reduces the incentive to save. Our model generates a prediction: the government’s budget deficit and the country’s trade balance should be negatively related. Does this prediction come true in the real world? Let’s look at the data…. CHAPTER 5 The Open Economy

NX and the federal budget deficit (% of GDP), 1960-2006
4% 8% Budget deficit (right scale) 6% 2% 4% 0% 2% -2% 0% Our model implies a negative relationship between NX and the budget deficit. We observe this negative relationship during most periods. Exceptions: 1. Late 1970s. In the latter period, the U.S. enjoyed an unusually long expansion, which fueled a surge in both imports and tax revenues. Source: Department of Commerce. Obtained from: Net exports (left scale) -4% -2% -6% -4% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 slide 245

2. Fiscal policy abroad r S, I I (r )
Expansionary fiscal policy abroad raises the world interest rate. NX2 NX1 Results: It might be worth taking a moment to explain that the world interest rate r* is determined by saving and investment in the world loanable funds market. S* is the sum of all countries’ saving; I* the sum of all countries’ investment. r* adjusts to equate I* with S*, just like in Chapter 3, because the world as a whole is a closed economy. A fiscal expansion in other countries would reduce S* and raise r* (same results as in chapter 3). The higher world interest rate reduces investment in our small open economy, and hence reduces the demand for loanable funds. The supply of loanable funds (national saving) is unchanged, so there’s an increase in the amount of funds flowing abroad. CHAPTER 5 The Open Economy

3. An increase in investment demand
S, I S I (r )1 I 1 NX1 EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. Have students get out a piece of paper, draw this graph on it, and then do the analysis. A couple minutes should suffice. It might be useful to have them compare their answers with the results from the closed economy case. CHAPTER 5 The Open Economy

3. An increase in investment demand
S, I S I (r )2 I (r )1 NX2 ANSWERS: I > 0, S = 0, net capital outflow and NX fall by the amount I I 1 NX1 I 2 In contrast to a closed economy, investment is not constrained by the fixed (domestic) supply of loanable funds. Hence, the increase in firm’s demand for loanable funds can be satisfied by borrowing abroad, which reduces net outflow of financial capital. And since net capital outflow = NX, we see a fall in NX equal to the increase in investment. CHAPTER 5 The Open Economy

The nominal exchange rate
e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) Warning to students: Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counter-intuitive. So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency. CHAPTER 5 The Open Economy

A few exchange rates, as of 7/14/06
country exchange rate Euro 0.79 Euro/$ Indonesia 9,105 Rupiahs/$ Japan 116.3 Yen/$ Mexico 11.0 Pesos/$ Russia 27.0 Rubles/$ South Africa 7.2 Rand/$ U.K. 0.54 Pounds/$ If you’d like to update these figures before your lecture, you can find good exchange rate data at: CHAPTER 5 The Open Economy

the lowercase Greek letter epsilon
The real exchange rate = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) ε the lowercase Greek letter epsilon CHAPTER 5 The Open Economy

Understanding the units of ε
Students often have trouble understanding the units of the real exchange rate. It’s worth explaining each line carefully, and making sure students understand it before displaying the next line. Note: The examples here and in the text are in terms of one good, i.e. Big Macs. But P and P* are the overall price levels of the domestic & foreign countries. Thus, they each measure the price of a basket of goods. When you get to the bottom line, emphasize that the real exchange rate measures the amount of purchasing power in Japan that must be sacrificed for each unit of purchasing power in the U.S. CHAPTER 5 The Open Economy

~ McZample ~ ε one good: Big Mac price in Japan: P* = 200 Yen
price in USA: P = $2.50 nominal exchange rate e = 120 Yen/$ To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs. ε CHAPTER 5 The Open Economy slide 253

ε in the real world & our model
In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods In our macro model: There’s just one good, “output.” So ε is the relative price of one country’s output in terms of the other country’s output A good candidate for the basket of goods mentioned here is the CPI basket. Perhaps a better candidate would be a basket including all goods & services that comprise GDP. Then, the real exchange rate would measure how many units of foreign GDP trade for one unit of domestic GDP. CHAPTER 5 The Open Economy

How NX depends on ε ε  U.S. goods become more expensive relative to foreign goods  EX, IM  NX CHAPTER 5 The Open Economy

U.S. net exports and the real exchange rate, 1973-2006
3% Trade-weighted real exchange rate index 140 2% 120 1% 100 0% -1% (March 1973 = 100) 80 (% of GDP) -2% 60 -3% NX The real exchange rate here is a broad index. Source: Federal Reserve Statistical Release H.10, Board of Governors. (To find it, simply google “Federal Reserve Statistical Release H.10”) NX as a percent of GDP was computed from NX and GDP source data from Department of Commerce, Bureau of Economic Analysis, obtained at: -4% Net exports (left scale) 40 Index -5% 20 -6% -7% 1973 1977 1981 1985 1989 1993 1997 2001 2005 CHAPTER 5 The Open Economy

The net exports function
The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε ) CHAPTER 5 The Open Economy

The NX curve for the U.S. ε ε1 so U.S. net exports will be high
NX ε NX (ε) NX(ε1) so U.S. net exports will be high ε1 When ε is relatively low, U.S. goods are relatively inexpensive CHAPTER 5 The Open Economy

The NX curve for the U.S. ε2 At high enough values of ε, U.S. goods become so expensive that NX ε NX (ε) NX(ε2) we export less than we import CHAPTER 5 The Open Economy

How ε is determined The accounting identity says NX = S – I
We saw earlier how S – I is determined: S depends on domestic factors (output, fiscal policy variables, etc) I is determined by the world interest rate r * So, ε must adjust to ensure In the equation, ε is the only endogenous variable, hence this equation determines the value of ε. CHAPTER 5 The Open Economy

How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε NX NX(ε ) ε 1 ε adjusts to equate NX with net capital outflow, S - I. *** Note *** At the lower left corner (origin) of this graph, NX does NOT NECESSARILY EQUAL ZERO!!! NX 1 CHAPTER 5 The Open Economy

Interpretation: Supply and demand in the foreign exchange market
Foreigners need dollars to buy U.S. net exports. ε NX NX(ε ) supply: Net capital outflow (S - I ) is the supply of dollars to be invested abroad. ε 1 WARNING: Don’t let your students confuse the demand for dollars in the foreign exchange market with demand for real money balances (chapter 4), or the supply of dollars in the foreign exchange market with the supply of money (chapter 4). If you and your students are into details: NX is actually the net demand for dollars: foreign demand for dollars to purchase our exports minus our supply of dollars to purchase imports. Net capital outflow is the net supply of dollars: The supply of dollars from U.S. residents investing abroad minus the demand for dollars from foreigners buying U.S. assets. NX 1 CHAPTER 5 The Open Economy

Next, four experiments:
1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports CHAPTER 5 The Open Economy

1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars in the foreign exchange market… NX 2 ε 2 ε NX NX(ε ) ε 1 NX 1 …causing the real exchange rate to rise and NX to fall. CHAPTER 5 The Open Economy

2. Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market… ε NX NX(ε ) NX 1 ε 1 ε 2 NX 2 …causing the real exchange rate to fall and NX to rise. CHAPTER 5 The Open Economy

3. Increase in investment demand
An increase in investment reduces net capital outflow and the supply of dollars in the foreign exchange market… NX 2 ε 2 ε NX NX 1 NX(ε ) ε 1 Suggestion: Have your students do this experiment as an in-class exercise. Have them take out a piece of paper, draw the graph, then show what happens when there’s an increase in the country’s investment demand (perhaps in response to an investment tax credit). …causing the real exchange rate to rise and NX to fall. CHAPTER 5 The Open Economy

4. Trade policy to restrict imports
At any given value of ε, an import quota  IM  NX  demand for dollars shifts right ε NX NX (ε )1 NX1 ε 1 NX (ε )2 ε 2 Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed. The analysis here applies for import restrictions (tariffs, quotas) as well as export subsidies. It also applies for exogenous changes in preferences regarding domestic vs. foreign goods. CHAPTER 5 The Open Economy

4. Trade policy to restrict imports
Results: ε > 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) EX < 0 (rise in ε ) ε NX NX1 NX (ε )2 NX (ε )1 ε 2 ε 1 In the text box, the remarks in parentheses after each result are an abbreviated explanation for that result. The real exchange rate appreciates because the quota has raised the net demand for dollars associated with any given value of the exchange rate. But the equilibrium level of net exports doesn’t change, because the supply of dollars in the foreign exchange market (S-I) has not been affected by the trade policy. (Remember, S = Y-C-G, and the trade policy does not affect Y, C, or G; the policy also does not affect I, because I = I(r*) and r* is exogenous.) The appreciation causes exports to fall. And, since exports are lower but NX is unchanged, it must be the case that IM is lower too, which is what you’d expect from a trade policy that restricts imports. CHAPTER 5 The Open Economy

The determinants of the nominal exchange rate
Start with the expression for the real exchange rate: Solve for the nominal exchange rate: CHAPTER 5 The Open Economy

So e depends on the real exchange rate and the price levels at home and abroad… …and we know how each of them is determined: It’s important here for students to learn the (logical, not necessarily chronological) order in which the variables are determined. I.e., what causes what. CHAPTER 5 The Open Economy

Rewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ): Here we again see the Classical Dichotomy in action. The real exchange rate is determined by real factors, and nominal variables only affect nominal variables. Suppose the U.S. is the home country and Mexico is the foreign (starred) country, and suppose that Mexico’s inflation rate (pi*) is higher than that of the U.S. This equation implies: the greater is Mexico’s inflation relative to the U.S., the faster the dollar should rise relative to the peso. The next slide presents cross-country data consistent with this implication. For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates. CHAPTER 5 The Open Economy

Inflation differentials and nominal exchange rates
Mexico Iceland Singapore South Africa Canada Figure 5-13 on p The horizontal axis measures the country’s inflation rate minus the U.S. inflation rate. The vertical axis measures the percentage change in the U.S. dollar exchange rate with that country. All variables are annual averages over the period This figure shows a very clear relationship between the inflation differential and the rate of dollar appreciation. The higher a country’s inflation relative to U.S. inflation, the faster the U.S. dollar will appreciate against that country’s currency. Or, for the few countries like Japan that have lower inflation than the U.S., we see the U.S. exchange rate depreciating relative to those countries’ currencies. Source: International Financial Statistics South Korea U.K. Japan CHAPTER 5 The Open Economy

Purchasing Power Parity (PPP)
Two definitions: A doctrine that states that goods must sell at the same (currency-adjusted) price in all countries. The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: arbitrage, the law of one price CHAPTER 5 The Open Economy

PPP: e P = P* Cost of a basket of foreign goods, in foreign currency. Cost of a basket of domestic goods, in foreign currency. Cost of a basket of domestic goods, in domestic currency. Solve for e : e = P*/ P PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels. PPP implies that the cost of a basket of goods (even a basket with just one good, like a Big Mac or a latte) should be the same across countries. e P = the foreign-currency cost of a basket of goods in the U.S., while P* the cost of a basket of foreign goods. PPP implies that the baskets cost the same in both countries: eP = P*, which implies that e = P*/P. CHAPTER 5 The Open Economy

If e = P*/P, then and the NX curve is horizontal: ε NX ε = 1 S - I Under PPP, changes in (S – I ) have no impact on ε or e. Revisiting our model, PPP implies that the NX curve should be horizontal at  = 1. Intuition for the horizontal NX curve: Under PPP, different countries’ goods are perfect substitutes, and international arbitrage is possible. If the relative price of U.S. goods falls even a tiny bit below 1, then there’s a profit opportunity: buy U.S. goods and sell them abroad. Hence, the tiniest drop in the U.S. real exchange rate causes a massive increase in NX. Similarly, if the relative price of U.S. goods rises even a tiny amount above 1, then it is profitable to buy foreign goods and sell them in the U.S., so this arbitrage causes a massive increase increase in imports---and decrease in NX. Thus, under PPP, the real exchange rate equals 1 regardless of net capital outflow S-I. Changes in S or I have no impact on the real exchange rate. CHAPTER 5 The Open Economy

Does PPP hold in the real world?
No, for two reasons: 1. International arbitrage not possible. nontraded goods transportation costs 2. Different countries’ goods not perfect substitutes. Nonetheless, PPP is a useful theory: It’s simple & intuitive In the real world, nominal exchange rates tend toward their PPP values over the long run. CHAPTER 5 The Open Economy

CASE STUDY: The Reagan deficits revisited
closed economy small open economy actual change ε NX I r S G – T 1980s 1970s 115.1 -0.3 19.9 1.1 19.6 2.2 129.4 -2.0 19.4 6.3 17.4 3.9   no change     no change This is a continuation of the case study begun in Chapter 3 (both the textbook and the PowerPoint presentation). It is placed here to motivate the last topic of Chapter 5: the U.S. as a large open economy. As we saw in chapter 3, the closed economy model correctly predicted that national saving would fall and the interest rate would rise. But, the closed economy model predicted that investment would fall as much as saving; actually, investment fell by much less than saving. Also, the closed economy model by definition could not have predicted the effects on the trade balance or exchange rate. The small open economy model correctly predicted what would happen to NX and the real exchange rate, but incorrectly predicted that the interest rate and investment would not change. In order to explain the U.S. experience, we need to combine the insights of the closed & small open economy models. Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. CHAPTER 5 The Open Economy

The U.S. as a large open economy
So far, we’ve learned long-run models for two extreme cases: closed economy (chap. 3) small open economy (chap. 5) A large open economy – like the U.S. – falls between these two extremes. The results from large open economy analysis are a mixture of the results for the closed & small open economy cases. For example… CHAPTER 5 The Open Economy

A fiscal expansion in three models
A fiscal expansion causes national saving to fall. The effects of this depend on openness & size: NX I r large open economy small open economy closed economy rises rises, but not as much as in closed economy no change falls falls, but not as much as in closed economy no change In the table, there’s a cell for NX in the closed economy column. Instead of putting “N.A.” in this cell, I put “no change.” Why? In a closed economy, EX = IM = NX = 0. After a change in saving, NX = 0 still. Hence, it is not incorrect to say “no change”. More importantly we are trying to show students how the results for a large open economy are in between the results for the closed & small open cases. Looking at the items in the last row of the table, “falls, but not as much as in small open economy” seems to be in between “no change” and “falls,” but does not seem to be in between “N.A.” and “falls”. It would be completely understandable if you still feel that “N.A.” should be in the closed economy NX cell of the table, so please feel free to edit that cell. no change falls, but not as much as in small open economy falls CHAPTER 5 The Open Economy

Chapter Summary Net exports--the difference between
exports and imports a country’s output (Y ) and its spending (C + I + G) Net capital outflow equals purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment CHAPTER 5 The Open Economy slide 280

Chapter Summary National income accounts identities:
Y = C + I + G + NX trade balance NX = S - I net capital outflow Impact of policies on NX : NX increases if policy causes S to rise or I to fall NX does not change if policy affects neither S nor I. Example: trade policy CHAPTER 5 The Open Economy slide 281

Chapter Summary Exchange rates
nominal: the price of a country’s currency in terms of another country’s currency real: the price of a country’s goods in terms of another country’s goods The real exchange rate equals the nominal rate times the ratio of prices of the two countries. CHAPTER 5 The Open Economy slide 282

Chapter Summary How the real exchange rate is determined
NX depends negatively on the real exchange rate, other things equal The real exchange rate adjusts to equate NX with net capital outflow CHAPTER 5 The Open Economy slide 283

Chapter Summary How the nominal exchange rate is determined
e equals the real exchange rate times the country’s price level relative to the foreign price level. For a given value of the real exchange rate, the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates. CHAPTER 5 The Open Economy slide 284

6 Unemployment This presentation has lots of data. Some from the textbook (or updated versions of what’s in the textbook), plus some additional data, including data that supports some of the textbook’s key points about the causes of the natural rate of unemployment. Yet, it is one of the shorter chapters. It is also less difficult than the preceding chapters. So, most professors are able to cover this material more quickly than usual.

…about the natural rate of unemployment: what it means what causes it understanding its behavior in the real world CHAPTER 6 Unemployment

Natural rate of unemployment
Natural rate of unemployment: The average rate of unemployment around which the economy fluctuates. In a recession, the actual unemployment rate rises above the natural rate. In a boom, the actual unemployment rate falls below the natural rate. The natural rate of unemployment is the “normal” unemployment rate the economy experiences when it is neither in a recession nor a boom. CHAPTER 6 Unemployment

Actual and natural rates of unemployment in the U.S., 1960-2006
12 Unemployment rate 10 8 Percent of labor force Natural rate of unemployment 6 4 Figure 6-1, p.160. The actual unemployment rate fluctuates considerably over the short run. These fluctuations will be the focus of chapters 9-13 later in the book. For this chapter, though, our goal is to understand the red line: the so-called “natural rate of unemployment,” or the long-run trend in the unemployment rate. Source: BLS Obtained from Unemployment data are based on seasonally-adjusted, monthly unemployment rates for the civilian non-institutional population of the U.S. The actual u-rate for each quarter is an average of the three monthly unemployment rates in that quarter. The natural u-rate in a given quarter is estimated by averaging all unemployment rates from 10 years earlier to 10 years later; future unemployment rates are set at 5.5%. 2 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 6 Unemployment

A first model of the natural rate
Notation: L = # of workers in labor force E = # of employed workers U = # of unemployed U/L = unemployment rate Section 6-1 CHAPTER 6 Unemployment

Assumptions: 1. L is exogenously fixed. 2. During any given month,
s = fraction of employed workers that become separated from their jobs s is called the rate of job separations f = fraction of unemployed workers that find jobs f is called the rate of job finding s and f are exogenous CHAPTER 6 Unemployment

The transitions between employment and unemployment
s E Employed Unemployed f U Figure 6-2, p. 161 (note: The size of the boxes containing the words “employed” and “unemployed” are not proportional to the number of people in each category.) CHAPTER 6 Unemployment

The steady state condition
Definition: the labor market is in steady state, or long-run equilibrium, if the unemployment rate is constant. The steady-state condition is: s E = f U # of unemployed people who find jobs # of employed people who lose or leave their jobs CHAPTER 6 Unemployment

Finding the “equilibrium” U rate
f U = s  E = s  (L – U ) = s  L – s  U Solve for U/L: (f + s)  U = s  L so, CHAPTER 6 Unemployment

Example: Each month, Find the natural rate of unemployment:
1% of employed workers lose their jobs (s = 0.01) 19% of unemployed workers find jobs (f = 0.19) Find the natural rate of unemployment: CHAPTER 6 Unemployment

Policy implication A policy will reduce the natural rate of unemployment only if it lowers s or increases f. CHAPTER 6 Unemployment

Why is there unemployment?
If job finding were instantaneous (f = 1), then all spells of unemployment would be brief, and the natural rate would be near zero. There are two reasons why f < 1: 1. job search 2. wage rigidity CHAPTER 6 Unemployment

Job search & frictional unemployment
frictional unemployment: caused by the time it takes workers to search for a job occurs even when wages are flexible and there are enough jobs to go around occurs because workers have different abilities, preferences jobs have different skill requirements geographic mobility of workers not instantaneous flow of information about vacancies and job candidates is imperfect CHAPTER 6 Unemployment

Sectoral shifts def: Changes in the composition of demand among industries or regions. example: Technological change more jobs repairing computers, fewer jobs repairing typewriters example: A new international trade agreement labor demand increases in export sectors, decreases in import-competing sectors Result: frictional unemployment Sometimes the unemployment caused by sectoral shifts is severe. Due to increasing imports of cheaper foreign-made textiles (particularly since the expiration in 2005 of long-standing quotas on textiles from China), the U.S. textile industry has been in decline for years. Tens of thousands of workers in this industry have lost jobs. Many of these workers are in their 50s and have worked in this industry for decades. Such workers are unlikely to have the skills necessary to get jobs available in newly booming industries, and they are less likely to invest in the acquisition of the necessary skills for these jobs. Hence, such workers are at greater risk for becoming “discouraged workers.” CHAPTER 6 Unemployment

CASE STUDY: Structural change over the long run
All figures are industry shares in U.S. GDP. “Other industry” includes construction, mining, electricity, water, and gas. From 1960 to 2000, there are huge changes in all four categories. Manufacturing falls by about a third. Even the “tiny” category of agriculture drops by nearly two-thirds: from 4.2% to 1.6% of GDP. These changes represent HUGE structural shifts, which vastly alter the kinds of jobs in demand. Source: World Development Indicators, World Bank. CHAPTER 6 Unemployment

More examples of sectoral shifts
Late 1800s: decline of agriculture, increase in manufacturing Late 1900s: relative decline of manufacturing, increase in service sector 1970s: energy crisis caused a shift in demand away from gas guzzlers toward smaller cars. Most of the examples on this and the previous slides are big changes that have occurred over many years. These examples give students a good idea of what sectoral shifts are. Perhaps more important for the natural rate, though, are the many smaller changes that occur more frequently. Ours is a dynamic economy: the structure of demand is shifting almost continuously, due to changes in preferences, technology, and the location of production. As a result, there is a near-continual flow of newly frictionally unemployed workers. Sectoral shifts are distinct from recessions (which also cause unemployment). In recessions, there is a general fall in demand across industries, and the unemployment that results is cyclical. Sectoral shifts, though, are changes in the composition of demand across industries, and lead to frictional unemployment as described above. In our dynamic economy, smaller sectoral shifts occur frequently, contributing to frictional unemployment. CHAPTER 6 Unemployment

Public policy and job search
Govt programs affecting unemployment Govt employment agencies: disseminate info about job openings to better match workers & jobs. Public job training programs: help workers displaced from declining industries get skills needed for jobs in growing industries. You might want to “hide” (omit) this slide from your presentation if you plan on doing the class discussion in Slide 27, which asks students to think of things the government can do to try to reduce the natural rate of unemployment. CHAPTER 6 Unemployment

Unemployment insurance (UI)
UI pays part of a worker’s former wages for a limited time after losing his/her job. UI increases search unemployment, because it reduces the opportunity cost of being unemployed the urgency of finding work f Studies: The longer a worker is eligible for UI, the longer the duration of the average spell of unemployment. The text includes a nice case study on unemployment insurance (pp ). It discusses evidence that unemployment insurance reduces the job finding rate. CHAPTER 6 Unemployment

Benefits of UI By allowing workers more time to search,
UI may lead to better matches between jobs and workers, which would lead to greater productivity and higher incomes. CHAPTER 6 Unemployment

Why is there unemployment?
The natural rate of unemployment: Two reasons why f < 1: 1. job search 2. wage rigidity DONE  Next  CHAPTER 6 Unemployment

Unemployment from real wage rigidity
Supply Labor Real wage If real wage is stuck above its eq’m level, then there aren’t enough jobs to go around. Unemployment Demand Rigid real wage Amount of labor hired Figure 6-3 on p.166. Abbreviation: “eq’m” = equilibrium Amount of labor willing to work CHAPTER 6 Unemployment

Unemployment from real wage rigidity
If real wage is stuck above its eq’m level, then there aren’t enough jobs to go around. Then, firms must ration the scarce jobs among workers. Structural unemployment: The unemployment resulting from real wage rigidity and job rationing. Other texts define “structural unemployment” as unemployment that results from a mismatch between the skills or locations of workers and the skill or location requirements of job openings. This would occur, for example, if there were a decrease in demand for domestic steel (and hence steel workers) and a simultaneous increase in demand for financial consulting services (and hence employees of such firms). However, if wages are perfectly flexible, then the decrease in demand for steel workers would simply cause their wage to fall until all were again employed, and the increase in demand for workers in financial firms would simply increase until equilibrium in that labor market was reestablished. So, the critical ingredient for structural unemployment is wage rigidity. Hence Mankiw’s definition. CHAPTER 6 Unemployment

Reasons for wage rigidity
1. Minimum wage laws 2. Labor unions 3. Efficiency wages CHAPTER 6 Unemployment

1. The minimum wage The min. wage may exceed the eq’m wage of unskilled workers, especially teenagers. Studies: a 10% increase in min. wage reduces teen unemployment by 1-3% But, the min. wage cannot explain the majority of the natural rate of unemployment, as most workers’ wages are well above the min. wage. CHAPTER 6 Unemployment

2. Labor unions Unions exercise monopoly power to secure higher wages for their members. When the union wage exceeds the eq’m wage, unemployment results. Insiders: Employed union workers whose interest is to keep wages high. Outsiders: Unemployed non-union workers who prefer eq’m wages, so there would be enough jobs for them. See p.165 for more discussion about insiders and outsiders. The theory has two implications we can confront with data: 1) Union members’ average earnings should be higher than non-union members’ average earnings. 2) The difference between union and non-union wages should be higher in industries that are more heavily unionized (and hence, in which unions have more market power) than in less heavily unionized industries. The following slide shows 2005 data on union membership and wage ratios by industry in the U.S. The data are consistent with the theory. CHAPTER 6 Unemployment

Union membership and wage ratios by industry, 2005
# employed (1000s) U % of total wage ratio Private sector (total) 105,508 8.5% 40.5 8 15.4 3.1 2.1 24.4 5.8 13.7 9.5 13.8 122.3 121.7 115.1 112.7 90.6 90.7 129.2 114.0 107.8 113.7 156.9 Government (total) 20,381 Construction 8,053 Mining 600 Manufacturing 15,518 Retail trade 14,973 Transportation 4,379 For this slide, “union members” includes workers that are in a union or similar worker association, or whose jobs are covered by a union contract. U % of total = “union members” (as defined above) as a percentage of all workers Wage ratio = average weekly earnings of “union members” (as defined above) as a percentage of average weekly earnings of nonunion workers. For example, in the transportation industry, 24.4% of workers are in unions and earn 29.2% more than non-union workers in this industry. Source: BLS.gov Note: Due to space constraints on the slide, some industries were omitted. In 2005, about 13% of all workers in the U.S. were members of unions. The data on this slide show two things: 1) union workers typically earn more than non-union workers (about 22-23% more on average). 2) the greater the percentage of union workers in an industry, the higher the wage ratio is likely to be (the correlation is about 0.5) Finance, insurance 6,304 Professional services 10,951 Education 3,312 Health care 14,045 wage ratio = 100(union wage)/(nonunion wage) slide 310

3. Efficiency wage theory
Theories in which higher wages increase worker productivity by: attracting higher quality job applicants increasing worker effort, reducing “shirking” reducing turnover, which is costly to firms improving health of workers (in developing countries) Firms willingly pay above-equilibrium wages to raise productivity. Result: structural unemployment. CHAPTER 6 Unemployment

Question for discussion:
Use the material we’ve just covered to come up with a policy or policies to try to reduce the natural rate of unemployment. Note whether your policy targets frictional or structural unemployment. It is useful to pause your lecture at this point and give students an opportunity to apply what you’ve covered so far to answer this policy question. Possible answers: Stop raising the (nominal) minimum wage, so that its real value will gradually erode to zero. Regulate unions (just like other monopolies are regulated) to reduce unions’ impact on wages. Reduce the generosity of unemployment insurance benefits. Implement government employment agencies to increase the accessibility of information about job vacancies and available workers. Increase public funding to help retrain workers displaced from jobs in declining industries. Suggestions for conducting the discussion: If you ask for responses immediately after posing the question, it is likely that a small number of students will volunteer to participate - the same students that always do, the ones that are the best prepared and/or the quickest thinkers. To elicit participation from a larger number of students, I suggest the following: Pair students up. Allow 10 minutes for the students, working in their pairs, to come up with answers to the question. During this time, circulate around the room and ask the pairs if you can be of assistance, either to help them get started or give feedback on what they’re coming up with. Then, reconvene the class and ask for volunteers. Doing this increases the quantity and quality of participation: students who would not otherwise participate are more likely to do so because they have had time to formulate their answers and have had a chance to run their answers by a classmate. Additionally, even students who don’t participate will have at least had the opportunity to discuss the question with one other student. CHAPTER 6 Unemployment

The duration of U.S. unemployment, average over 1/1990-5/2006
# of weeks unemployed # of unemployed persons as % of total # of unemployed amount of time these workers spent unemployed as % of total time all workers spent unemployed 1-4 38% 7.2% 5-14 31% 22.3% 15 or more 70.5% Source: Bureau of Labor Statistics ( and author’s calculations. How to interpret this data: The second column shows the percentage of all unemployed workers whose spell lasted the number of weeks shown (average over January 1990 to May 2006). The third column shows the share of total time spent unemployed attributed to workers in that category. I calculated it as a ratio. The denominator is the total number of weeks spent unemployed, obtained by multiplying the total number of unemployed persons by the number of weeks of the average spell of unemployment. The numerator is, for each category, the number of people in that category times the duration of the average spell of unemployment for that category. (I assume the duration of the average spell is the midpoint of each category, and 30 weeks for the “15 or more” category. I have tried different assumptions and the results are similar to those shown.) 7.2% of total time spent unemployed was spent by people who were unemployed for less than 5 weeks. 70.5% of total time spent unemployed is attributed to people who were unemployed for 15 or weeks or longer. The point of this data: More spells of unemployment are short term (38%) than medium term (31%) or long term (31%). But, most of the time spent unemployed is long-term. CHAPTER 6 Unemployment

The duration of unemployment
The data: More spells of unemployment are short-term than medium-term or long-term. Yet, most of the total time spent unemployed is attributable to the long-term unemployed. This long-term unemployment is probably structural and/or due to sectoral shifts among vastly different industries. Knowing this is important because it can help us craft policies that are more likely to work. Regarding the point about structural unemployment and sectoral shifts: Structural unemployment - workers are waiting for jobs to become available, but there just aren’t enough jobs to go around; hence, this can be long-term unemployment. Sectoral shifts across vastly different industries, e.g. a shift in demand from textiles to software design; obviously, jobs in these industries require vastly different skill sets. Sectoral shifts can occur among similar industries (e.g., demand shifts from desktop to laptop computers), but this is less likely to produce long-term unemployment. CHAPTER 6 Unemployment

TREND: The natural rate rises during 1960-1984, then falls during 1985-2006
The purpose of this slide is to establish the trend behavior of the natural rate in recent decades: rising until the early 80s, then falling from the mid-80s through the early 2000s. The following slides will show that the theories in this chapter are (mostly) consistent with the trend behavior of the natural rate. The graph on this slide is similar to Figure 6-1 (near the beginning of this PowerPoint presentation). However, since we are now focusing on the trend behavior in the natural rate, I have altered the vertical axis to make the trend more apparent, and I’ve dimmed the actual unemployment rate data – now light gray. CHAPTER 6 Unemployment

EXPLAINING THE TREND: The minimum wage
The trend in the real minimum wage is similar to that of the natural rate of unemployment. 9 8 7 6 minimum wage in 2006 dollars 5 Dollars per hour 4 The trend in the real minimum wage rises until the mid to late 1970s, then falls. This is fairly similar to the trend of the natural rate of unemployment. The U.S. Department of Labor has lots of good information on the minimum wage, at: 3 minimum wage in current dollars 2 1 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 6 Unemployment

EXPLAINING THE TREND: Union membership
Union membership selected years year percent of labor force 1930 12% 1945 35% 1954 1970 27% 1983 20.1% 2005 12.5% Since the early 1980s, the natural rate of unemploy-ment and union membership have both fallen. But, from 1950s to about 1980, the natural rate rose while union membership fell. source: AFL-CIO website and, for the 2005 figure, Also see good set of links to info on labor unions The BLS’ annual news release of info on union membership, earnings. Earlier in the chapter, we saw cross-sectional data that showed a positive correlation between the union wage premium and union members’ share of the labor force across industries. We would expect that, other things equal, changes over time in the aggregate share of unions in employment should be associated with similar changes in unions’ impact on average wages, and hence on the natural rate of unemployment. In plain English, we would expect that the decline in the extent of unionization shown on this slide would correspond to a decline in the natural rate of unemployment. Unfortunately for the theory, this is only true for the time period beginning in the early 1980s, when the natural rate started coming down. From the 1950s through 1980, the natural rate rose, but union membership fell. Does this mean the theory is not relevant? Not necessarily, as other things (other determinants of the natural rate) were not constant during this time period. CHAPTER 6 Unemployment

EXPLAINING THE TREND: Sectoral shifts
From mid 1980s to early 2000s, oil prices less volatile, so fewer sectoral shifts. Price per barrel of oil, in 2006 dollars source: Dow Jones & Company obtained from: Earlier in the chapter, we learned that sectoral shifts are a source of job separations and lead to frictional unemployment. One would expect that a decrease in the frequency and magnitude of sectoral shifts would be associated with fewer job separations, less frictional unemployment, and a lower natural rate of unemployment. Unfortunately, there is no single “index of sectoral shocks.” However, we know that large changes in oil prices are one source of sectoral shocks. A significant fall in the price of oil causes a decrease in demand for workers at oil fields in Oklahoma and Texas, and an increase in demand for workers at factories that produce SUVs. A significant increase in oil prices would do the opposite. The graph shows data on the price of oil since 1970. During , the real price of oil fluctuated between $18 and $98. Also during this time, the natural rate of unemployment was rising. During , the real price of oil fluctuated between $20 and $40, except for a brief spike during the Gulf War. Also during this time, the natural rate of unemployment was falling. The data are roughly consistent with the notion that sectoral shifts contribute to the natural rate. Note the recent increase in oil prices: from about $22 to $70 during :1. This represents a sectoral shift and may contribute to an increase in the natural rate of unemployment. Or maybe not, as oil consumption per dollar of GDP is lower today than in the 1970s and 1980s. CHAPTER 6 Unemployment

EXPLAINING THE TREND: Demographics
1970s: The Baby Boomers were young. Young workers change jobs more frequently (high value of s). Late 1980s through today: Baby Boomers aged. Middle-aged workers change jobs less often (low s). For details on this, plus one other explanation involving productivity, see pp CHAPTER 6 Unemployment

Unemployment in Europe, 1960-2005
France 12 9 Percent of labor force 6 Italy U.K. Figure 6-4, p.177 Source: bls.gov, obtained from 3 Germany 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 slide 320

The rise in European unemployment
Shock Technological progress has shifted labor demand from unskilled to skilled workers in recent decades. Effect in United States An increase in the “skill premium” – the wage gap between skilled and unskilled workers. Effect in Europe Higher unemployment, due to generous govt benefits for unemployed workers and strong union presence. CHAPTER 6 Unemployment

Percent of workers covered by collective bargaining
United States 18% United Kingdom 47 Switzerland 53 Spain 68 Sweden 83 Germany 90 France 92 Austria 98 Table 6-1, p.169 Source: Same as text (OECD Economic Outlook 2004, as reported in NBER Macroeconomics Annual 2005.) CHAPTER 6 Unemployment

Chapter Summary 1. The natural rate of unemployment the long-run average or “steady state” rate of unemployment depends on the rates of job separation and job finding 2. Frictional unemployment due to the time it takes to match workers with jobs may be increased by unemployment insurance CHAPTER 6 Unemployment slide 323

Chapter Summary 3. Structural unemployment results from wage rigidity: the real wage remains above the equilibrium level caused by: minimum wage, unions, efficiency wages 4. Duration of unemployment most spells are short term but most weeks of unemployment are attributable to a small number of long-term unemployed persons CHAPTER 6 Unemployment slide 324

Chapter Summary rose from 1960 to early 1980s, then fell
5. Behavior of the natural rate in the U.S. rose from 1960 to early 1980s, then fell possible explanations: trends in real minimum wage, union membership, prevalence of sectoral shifts, and aging of the Baby Boomers CHAPTER 6 Unemployment slide 325

Chapter Summary has risen sharply since 1970
6. European unemployment has risen sharply since 1970 probably due to generous unemployment benefits, strong union presence, and a technology-driven shift in demand away from unskilled workers CHAPTER 6 Unemployment slide 326

Economic Growth I: Capital Accumulation and Population Growth
7 Economic Growth I: Capital Accumulation and Population Growth Chapters 7 and 8 cover one of the most important topics in macroeconomics. The material in these chapters is more challenging than average for the book, yet Mankiw explains it especially clearly. New to the 6th edition is a brief section at the end of the chapter on alternative perspectives on population growth. If you taught with the PowerPoint slides I prepared for the previous edition of this textbook, you will find that I’ve streamlined the introduction a bit. If you have not, you will find an introduction here, not appearing in the textbook, that provides data to motivate the study of economic growth.

the closed economy Solow model how a country’s standard of living depends on its saving and population growth rates how to use the “Golden Rule” to find the optimal saving rate and capital stock CHAPTER 7 Economic Growth I

Why growth matters Data on infant mortality rates:
20% in the poorest 1/5 of all countries 0.4% in the richest 1/5 In Pakistan, 85% of people live on less than $2/day. One-fourth of the poorest countries have had famines during the past 3 decades. Poverty is associated with oppression of women and minorities. Economic growth raises living standards and reduces poverty…. CHAPTER 7 Economic Growth I

Income and poverty in the world selected countries, 2000
source: The Elusive Quest for Growth, by William Easterly. (MIT Press, 2001) This slide shows a negative relationship between income per capita and poverty. So, if we can figure out how to get poor countries growing, then poverty in those countries will diminish.

Why growth matters Anything that effects the long-run rate of economic growth – even by a tiny amount – will have huge effects on living standards in the long run. percentage increase in standard of living after… annual growth rate of income per capita …25 years …50 years …100 years 2.0% 64.0% 169.2% 624.5% 2.5% 85.4% 243.7% 1,081.4% CHAPTER 7 Economic Growth I

Why growth matters If the annual growth rate of U.S. real GDP per capita had been just one-tenth of one percent higher during the 1990s, the U.S. would have generated an additional $496 billion of income during that decade. The $496 billion is in 2006 prices. How I did this calculation: 1. Computed actual quarterly growth rate of real income per capita from 1989:4 through 1999:4. 2. Added one-fourth of one-tenth of one percent to each quarter’s actual growth rate. 3. Computed what real income per capita in would have been with the new growth rates. 4. Multiplied this hypothetical real income per capita by the population to get hypothetical real GDP. 5. Computed the difference between hypothetical and actual real GDP for each quarter. 6. Cumulated these differences over the period 1990:1-1999:4. Like the original real GDP data, the cumulative difference was in 1996 dollars. I multiplied this amount by 21%, the amount by which the GDP deflator rose between 1996 and 2006, so the final result is expressed in 2006 dollars. SOURCE of DATA: Real GDP, GDP deflator - Dept of Commerce, Bureau of Economic Analysis. Population - Dept of Commerce, Census Bureau. All obtained from “FRED” - the St. Louis Fed’s database, on the web at CHAPTER 7 Economic Growth I

The lessons of growth theory
…can make a positive difference in the lives of hundreds of millions of people. These lessons help us understand why poor countries are poor design policies that can help them grow learn how our own growth rate is affected by shocks and our government’s policies CHAPTER 7 Economic Growth I

The Solow model due to Robert Solow, won Nobel Prize for contributions to the study of economic growth a major paradigm: widely used in policy making benchmark against which most recent growth theories are compared looks at the determinants of economic growth and the standard of living in the long run CHAPTER 7 Economic Growth I

How Solow model is different from Chapter 3’s model
1. K is no longer fixed: investment causes it to grow, depreciation causes it to shrink 2. L is no longer fixed: population growth causes it to grow 3. the consumption function is simpler It’s easier for students to learn the Solow model if they see that it’s just an extension of something they already know, the classical model from Chapter 3. So, this slide and the next point out the differences. CHAPTER 7 Economic Growth I

How Solow model is different from Chapter 3’s model
4. no G or T (only to simplify presentation; we can still do fiscal policy experiments) 5. cosmetic differences The cosmetic differences include things like the notation (lowercase letters for per-worker magnitudes instead of uppercase letters for aggregate magnitudes) and the variables that are measured on the axes of the main graph. CHAPTER 7 Economic Growth I

In aggregate terms: Y = F (K, L) Define: y = Y/L = output per worker k = K/L = capital per worker Assume constant returns to scale: zY = F (zK, zL ) for any z > 0 Pick z = 1/L. Then Y/L = F (K/L, 1) y = F (k, 1) y = f(k) where f(k) = F(k, 1) When everything on the slide is showing on the screen, explain to students how to interpret f(k): f(k) is the “per worker production function,” it shows how much output one worker could produce using k units of capital. You might want to point out that this is the same production function we worked with in chapter 3. We’re just expressing it differently. CHAPTER 7 Economic Growth I

Output per worker, y Capital per worker, k f(k) 1 MPK = f(k +1) – f(k) Note: this production function exhibits diminishing MPK. CHAPTER 7 Economic Growth I

The national income identity
Y = C + I (remember, no G ) In “per worker” terms: y = c + i where c = C/L and i = I /L CHAPTER 7 Economic Growth I

The consumption function
s = the saving rate, the fraction of income that is saved (s is an exogenous parameter) Note: s is the only lowercase variable that is not equal to its uppercase version divided by L Consumption function: c = (1–s)y (per worker) CHAPTER 7 Economic Growth I

Saving and investment saving (per worker) = y – c = y – (1–s)y = sy
National income identity is y = c + i Rearrange to get: i = y – c = sy (investment = saving, like in chap. 3!) Using the results above, i = sy = sf(k) The real interest rate r does not appear explicitly in any of the Solow model’s equations. This is to simplify the presentation. You can tell your students that investment still depends on r, which adjusts behind the scenes to keep investment = saving at all times. CHAPTER 7 Economic Growth I

Output, consumption, and investment
Output per worker, y Capital per worker, k f(k) y1 k1 c1 sf(k) i1 CHAPTER 7 Economic Growth I

Depreciation  = the rate of depreciation
= the fraction of the capital stock that wears out each period Depreciation per worker, k Capital per worker, k k  1 CHAPTER 7 Economic Growth I

k = s f(k) – k Capital accumulation
The basic idea: Investment increases the capital stock, depreciation reduces it. Change in capital stock = investment – depreciation k = i – k Since i = sf(k) , this becomes: k = s f(k) – k CHAPTER 7 Economic Growth I

The equation of motion for k
k = s f(k) – k The Solow model’s central equation Determines behavior of capital over time… …which, in turn, determines behavior of all of the other endogenous variables because they all depend on k. E.g., income per person: y = f(k) consumption per person: c = (1–s) f(k) CHAPTER 7 Economic Growth I

k = s f(k) – k The steady state
If investment is just enough to cover depreciation [sf(k) = k ], then capital per worker will remain constant: k = 0. This occurs at one value of k, denoted k*, called the steady state capital stock. CHAPTER 7 Economic Growth I

Investment and depreciation
The steady state Investment and depreciation Capital per worker, k k sf(k) k* CHAPTER 7 Economic Growth I

Moving toward the steady state
k = sf(k)  k Investment and depreciation Capital per worker, k k sf(k) k* investment k1 k depreciation CHAPTER 7 Economic Growth I

k = sf(k)  k Investment and depreciation Capital per worker, k k sf(k) k* k1 k k2 CHAPTER 7 Economic Growth I

k = sf(k)  k Investment and depreciation Capital per worker, k k sf(k) k* investment k depreciation k2 CHAPTER 7 Economic Growth I

k = sf(k)  k Investment and depreciation Capital per worker, k k sf(k) k* k k2 k3 CHAPTER 7 Economic Growth I

k = sf(k)  k Investment and depreciation Capital per worker, k k Summary: As long as k < k*, investment will exceed depreciation, and k will continue to grow toward k*. sf(k) k* k3 CHAPTER 7 Economic Growth I

Now you try: Draw the Solow model diagram, labeling the steady state k*. On the horizontal axis, pick a value greater than k* for the economy’s initial capital stock. Label it k1. Show what happens to k over time. Does k move toward the steady state or away from it? CHAPTER 7 Economic Growth I

A numerical example Production function (aggregate):
To derive the per-worker production function, divide through by L: Then substitute y = Y/L and k = K/L to get CHAPTER 7 Economic Growth I

A numerical example, cont.
Assume: s = 0.3  = 0.1 initial value of k = 4.0 As each assumption appears on the screen, explain it’s interpretation. I.e., “The economy saves three-tenths of income,” “every year, 10% of the capital stock wears out,” and “suppose the economy starts out with four units of capital for every worker.” CHAPTER 7 Economic Growth I

Approaching the steady state: A numerical example
Year k y c i k k …  Before revealing the numbers in the first row, ask your students to determine them and write them in their notes. Give them a moment, then reveal the first row and make sure everyone understands where each number comes from. Then, ask them to determine the numbers for the second row and write them in their notes. After the second round of this, it’s probably fine to just show them the rest of the table. CHAPTER 7 Economic Growth I

Exercise: Solve for the steady state
Continue to assume s = 0.3,  = 0.1, and y = k 1/2 Use the equation of motion k = s f(k)  k to solve for the steady-state values of k, y, and c. Suggestion: give your students 3-5 minutes to work on this exercise in pairs. Working alone, a few students might not know that they need to start by setting k = 0. But working in pairs, they are more likely to figure it out. Also, this gives students a little psychological momentum to make it easier for them to start on the end-of-chapter exercises (if you assign them as homework). (If any need a hint, remind them that the steady state is defined by k = 0. A further hint is that they answers they get should be the same as the last row of the big table on the preceding slide, since we are still using all the same parameter values.) CHAPTER 7 Economic Growth I

Solution to exercise: CHAPTER 7 Economic Growth I
The first few lines of this slide show the calculations and intermediate steps necessary to arrive at the correct answers, which are given in the last 2 lines of the slide. CHAPTER 7 Economic Growth I

An increase in the saving rate
An increase in the saving rate raises investment… …causing k to grow toward a new steady state: Investment and depreciation k k s2 f(k) s1 f(k) Next, we see what the model says about the relationship between a country’s saving rate and its standard of living (income per capita) in the long run (or steady state). An earlier slide said that the model’s omission of G and T was only to simplify the presentation. We can still do policy analysis. We know from Chapter 3 that changes in G and/or T affect national saving. In the Solow model as presented here, we can simply change the exogenous saving rate to analyze the impact of fiscal policy changes. CHAPTER 7 Economic Growth I

Prediction: Higher s  higher k*.
And since y = f(k) , higher k*  higher y* . Thus, the Solow model predicts that countries with higher rates of saving and investment will have higher levels of capital and income per worker in the long run. After showing this slide, you might also note that the converse is true, as well: a fall in s (caused, for example, by tax cuts or government spending increases) leads ultimately to a lower standard of living. In the static model of Chapter 3, we learned that a fiscal expansion crowds out investment. The Solow model allows us to see the long-run dynamic effects: the fiscal expansion, by reducing the saving rate, reduces investment. If we were initially in a steady state (in which investment just covers depreciation), then the fall in investment will cause capital per worker, labor productivity, and income per capita to fall toward a new, lower steady state. (If we were initially below a steady state, then the fiscal expansion causes capital per worker and productivity to grow more slowly, and reduces their steady-state values.) This, of course, is relevant because actual U.S. public saving has fallen sharply since 2001. CHAPTER 7 Economic Growth I

International evidence on investment rates and income per person
100,000 Income per person in 2000 (log scale) 10,000 1,000 Figure 7-6, p Source: Penn World Table version 6.1. Number of countries = 97 High investment is associated with high income per person, as the Solow model predicts. 100 5 10 15 20 25 30 35 Investment as percentage of output (average ) CHAPTER 7 Economic Growth I

The Golden Rule: Introduction
Different values of s lead to different steady states. How do we know which is the “best” steady state? The “best” steady state has the highest possible consumption per person: c* = (1–s) f(k*). An increase in s leads to higher k* and y*, which raises c* reduces consumption’s share of income (1–s), which lowers c*. So, how do we find the s and k* that maximize c*? CHAPTER 7 Economic Growth I

The Golden Rule capital stock
the Golden Rule level of capital, the steady state value of k that maximizes consumption. To find it, first express c* in terms of k*: c* = y*  i* = f (k*)  i* = f (k*)  k* In the steady state: i* = k* because k = 0. CHAPTER 7 Economic Growth I

steady state output and depreciation steady-state capital per worker, k*  k* Then, graph f(k*) and k*, look for the point where the gap between them is biggest. f(k*) Students sometimes confuse this graph with the other Solow model diagram, as the curves look similar. Be sure to clarify the differences: On this graph, the horizontal axis measures k*, not k. Thus, once we have found k* using the other graph, we plot that k* on this graph to see where the economy’s steady state is in relation to the golden rule capital stock. On this graph, the curve measures f(k*), not sf(k). On the other diagram, the intersection of the two curves determines k*. On this graph, the only thing determined by the intersection of the two curves is the level of capital where c*=0, and we certainly wouldn’t want to be there. There are no dynamics in this graph, as we are in a steady state. In the other graph, the gap between the two curves determines the change in capital. CHAPTER 7 Economic Growth I

c* = f(k*)  k* is biggest where the slope of the production function equals the slope of the depreciation line:  k* f(k*) If your students have had a semester of calculus, you can show them that deriving the condition MPK =  is straight-forward: The problem is to find the value of k* that maximizes c* = f(k*)  k*. Just take the first derivative of that expression and set equal to zero: f(k*)   = 0 where f(k*) = MPK = slope of production function and  = slope of steady-state investment line. MPK =  steady-state capital per worker, k* CHAPTER 7 Economic Growth I

The transition to the Golden Rule steady state
The economy does NOT have a tendency to move toward the Golden Rule steady state. Achieving the Golden Rule requires that policymakers adjust s. This adjustment leads to a new steady state with higher consumption. But what happens to consumption during the transition to the Golden Rule? Remember: policymakers can affect the national saving rate: - changing G or T affects national saving - holding T constant overall, but changing the structure of the tax system to provide more incentives for private saving (e.g., a revenue-neutral shift from the income tax to a consumption tax) CHAPTER 7 Economic Growth I

Starting with too much capital
then increasing c* requires a fall in s. In the transition to the Golden Rule, consumption is higher at all points in time. time y c i t0 is the time period in which the saving rate is reduced. It would be helpful if you explained the behavior of each variable before t0, at t0 , and in the transition period (after t0 ). Before t0: in a steady state, where k, y, c, and i are all constant. At t0: The change in the saving rate doesn’t immediately change k, so y doesn’t change immediately. But the fall in s causes a fall in investment [because saving equals investment] and a rise in consumption [because c = (1-s)y, s has fallen but y has not yet changed.]. Note that c = -i, because y = c + i and y has not changed. After t0: In the previous steady state, saving and investment were just enough to cover depreciation. Then saving and investment were reduced, so depreciation is greater than investment, which causes k to fall toward a new, lower steady state value. As k falls and settles on its new, lower steady state value, so will y, c, and i (because each of them is a function of k). Even though c is falling, it doesn’t fall all the way back to its initial value. Policymakers would be happy to make this change, as it produces higher consumption at all points in time (relative to what consumption would have been if the saving rate had not been reduced. t0 CHAPTER 7 Economic Growth I

Starting with too little capital
then increasing c* requires an increase in s. Future generations enjoy higher consumption, but the current one experiences an initial drop in consumption. y c Before t0: in a steady state, where k, y, c, and i are all constant. At t0: The increase in s doesn’t immediately change k, so y doesn’t change immediately. But the increase in s causes investment to rise [because higher saving means higher investment] and consumption to fall [because we are saving more of our income, and consuming less of it]. After t0: Now, saving and investment exceed depreciation, so k starts rising toward a new, higher steady state value. The behavior of k causes the same behavior in y, c, and i (qualitatively the same, that is). Ultimately, consumption ends up at a higher steady state level. But initially consumption falls. Therefore, if policymakers value the current generation’s well-being more than that of future generations, they might be reluctant to adjust the saving rate to achieve the Golden Rule. Notice, though, that if they did increase s, an infinite number of future generations would benefit, which makes the sacrifice of the current generation seem more acceptable. i t0 time CHAPTER 7 Economic Growth I

Population growth Assume that the population (and labor force) grow at rate n. (n is exogenous.) EX: Suppose L = 1,000 in year 1 and the population is growing at 2% per year (n = 0.02). Then L = n L = 0.02  1,000 = 20, so L = 1,020 in year 2. CHAPTER 7 Economic Growth I

Break-even investment
( + n)k = break-even investment, the amount of investment necessary to keep k constant. Break-even investment includes:  k to replace capital as it wears out n k to equip new workers with capital (Otherwise, k would fall as the existing capital stock would be spread more thinly over a larger population of workers.) CHAPTER 7 Economic Growth I

The equation of motion for k
With population growth, the equation of motion for k is k = s f(k)  ( + n) k actual investment break-even investment Of course, “actual investment” and “break-even investment” here are in “per worker” magnitudes. CHAPTER 7 Economic Growth I

The Solow model diagram
k = s f(k)  ( +n)k Investment, break-even investment Capital per worker, k ( + n ) k sf(k) k* CHAPTER 7 Economic Growth I

The impact of population growth
Investment, break-even investment ( +n2) k ( +n1) k An increase in n causes an increase in break-even investment, sf(k) k2* leading to a lower steady-state level of k. k1* Capital per worker, k CHAPTER 7 Economic Growth I

Prediction: Higher n  lower k*.
And since y = f(k) , lower k*  lower y*. Thus, the Solow model predicts that countries with higher population growth rates will have lower levels of capital and income per worker in the long run. This and the preceding slide establish an implication of the model. The following slide confronts this implication with data. CHAPTER 7 Economic Growth I

International evidence on population growth and income per person
100,000 per Person in 2000 (log scale) 10,000 1,000 Figure 7-13, p Number of countries = 96. Source: Penn World Table version 6.1. The model predicts that faster population growth should be associated with a lower long-run income per capital The data is consistent with this prediction. So far, we’ve now learned two things a poor country can do to raise its standard of living: increase national saving (perhaps by reducing its budget deficit) and reduce population growth. 100 1 2 3 4 5 Population Growth (percent per year; average ) CHAPTER 7 Economic Growth I

The Golden Rule with population growth
To find the Golden Rule capital stock, express c* in terms of k*: c* = y*  i* = f (k* )  ( + n) k* c* is maximized when MPK =  + n or equivalently, MPK   = n In the Golden Rule steady state, the marginal product of capital net of depreciation equals the population growth rate. CHAPTER 7 Economic Growth I

Alternative perspectives on population growth
The Malthusian Model (1798) Predicts population growth will outstrip the Earth’s ability to produce food, leading to the impoverishment of humanity. Since Malthus, world population has increased sixfold, yet living standards are higher than ever. Malthus omitted the effects of technological progress. This and the next slide cover new material in the 6th edition. They can be omitted without loss of continuity. CHAPTER 7 Economic Growth I

Alternative perspectives on population growth
The Kremerian Model (1993) Posits that population growth contributes to economic growth. More people = more geniuses, scientists & engineers, so faster technological progress. Evidence, from very long historical periods: As world pop. growth rate increased, so did rate of growth in living standards Historically, regions with larger populations have enjoyed faster growth. Michael Kremer, “Population Growth and Technological Change: One Million B.S. to 1990,” Quarterly Journal of Economics 108 (August 1993): CHAPTER 7 Economic Growth I

Chapter Summary positively on its saving rate
1. The Solow growth model shows that, in the long run, a country’s standard of living depends positively on its saving rate negatively on its population growth rate 2. An increase in the saving rate leads to higher output in the long run faster growth temporarily but not faster steady state growth. CHAPTER 7 Economic Growth I slide 381

Chapter Summary 3. If the economy has more capital than the Golden Rule level, then reducing saving will increase consumption at all points in time, making all generations better off. If the economy has less capital than the Golden Rule level, then increasing saving will increase consumption for future generations, but reduce consumption for the present generation. CHAPTER 7 Economic Growth I slide 382

Economic Growth II: Technology, Empirics, and Policy
8 Economic Growth II: Technology, Empirics, and Policy Chapter 7 had a single focus: the in-depth development of the Solow model with population growth. In contrast, Chapter 8 is a survey of many growth topics. First, the Solow model is extended to incorporate labor-augmenting technological progress at an exogenous rate. This is followed by a discussion of growth empirics, including balanced growth, convergence, and growth from factor accumulation vs. increases in efficiency. Next, policy implications are discussed. Finally, the chapter presents two very simple endogenous growth models. New material has been added in the 6th edition: At the end of the “growth empirics” discussion, there’s a case study on the effects of free trade on economic growth. At the end of the chapter, there’s a discussion of Schumpeter’s notion of “creative destruction.” The models in this chapter are presented very concisely. If you want your students to master these models, you will need to have them do exercises and policy experiments with the models. The chapter includes some excellent Problems and Applications for this, which you can assign as homework or use in class to break up your lecture. If you are pressed for time and are considering skipping this chapter, I encourage you to at least cover section 8-1, so that your students will have learned the full Solow model with technological progress. One class period should be enough time to cover it, allowing for one or two in-class exercises if you wish. If you can spare a few more minutes, also consider section 8-3: it discusses policy implications, it’s not difficult or time-consuming, and students find it very interesting - it gives additional real-world relevance to the material in Chap 7 and in Section 8-1.

how to incorporate technological progress in the Solow model about policies to promote growth about growth empirics: confronting the theory with facts two simple models in which the rate of technological progress is endogenous CHAPTER 8 Economic Growth II

Introduction In the Solow model of Chapter 7,
the production technology is held constant. income per capita is constant in the steady state. Neither point is true in the real world: : U.S. real GDP per person grew by a factor of 7.6, or 2% per year. examples of technological progress abound (see next slide). Source: data used to construct Figure 1-1, p.4, and some simple calculations. CHAPTER 8 Economic Growth II

Examples of technological progress
From 1950 to 2000, U.S. farm sector productivity nearly tripled. The real price of computer power has fallen an average of 30% per year over the past three decades. Percentage of U.S. households with ≥ 1 computers: 8% in 1984, 62% in 2003 1981: 213 computers connected to the Internet 2000: 60 million computers connected to the Internet 2001: iPod capacity = 5gb, 1000 songs. Not capable of playing episodes of Desperate Housewives. 2005: iPod capacity = 60gb, 15,000 songs. Can play episodes of Desperate Housewives. Students are certainly aware that rapid technological progress has occurred. Yet, it’s fun to show these figures, to take stock of some specific kinds of technological progress. Sources: U.S. Census Bureau Wikipedia.org The Economist, various issues The Elusive Quest for Growth, by William Easterly The 2001 Statistical Abstract of the United States at USDA: CHAPTER 8 Economic Growth II

Technological progress in the Solow model
A new variable: E = labor efficiency Assume: Technological progress is labor-augmenting: it increases labor efficiency at the exogenous rate g: CHAPTER 8 Economic Growth II

We now write the production function as: where L  E = the number of effective workers. Increases in labor efficiency have the same effect on output as increases in the labor force. CHAPTER 8 Economic Growth II

Notation: y = Y/LE = output per effective worker k = K/LE = capital per effective worker Production function per effective worker: y = f(k) Saving and investment per effective worker: s y = s f(k) If your students have trouble wrapping their heads around quantities in “per effective worker” terms, tell them not to worry: it’s not exactly intuitive, it’s merely a mathematical device to make the model tractable. CHAPTER 8 Economic Growth II

( + n + g)k = break-even investment: the amount of investment necessary to keep k constant. Consists of:  k to replace depreciating capital n k to provide capital for new workers g k to provide capital for the new “effective” workers created by technological progress The only thing that’s new here, compared to Chapter 7, is that gk is part of break-even investment. Remember: k = K/LE, capital per effective worker. Tech progress increases the number of effective workers at rate g, which would cause capital per effective worker to fall at rate g (other things equal). Investment equal to gk would prevent this. CHAPTER 8 Economic Growth II

k = s f(k)  ( +n +g)k Investment, break-even investment Capital per worker, k ( +n +g ) k sf(k) k* The equation that appears above the graph is the equation of motion modified to allow for technological progress. There are minor differences between this and the Solow model graph from Chapter 7: Here, k and y are in “per effective worker” units rather than “per worker” units. The break-even investment line is a little bit steeper: at any given value of k, more investment is needed to keep k from falling - in particular, gk is needed. Otherwise, technological progress will cause k = K/LE to fall at rate g (because E in the denominator is growing at rate g). With this graph, we can do the same policy experiments as in Chapter 7. We can examine the effects of a change in the savings or population growth rates, and the analysis would be much the same. The main difference is that in the steady state, income per worker/capita is growing at rate g instead of being constant. CHAPTER 8 Economic Growth II

Steady-state growth rates in the Solow model with tech. progress
Symbol Variable Capital per effective worker k = K/(LE ) Output per effective worker y = Y/(LE ) Output per worker Table 8-1, p.219. Explanations: k is constant (has zero growth rate) by definition of the steady state y is constant because y = f(k) and k is constant To see why Y/L grows at rate g, note that the definition of y implies (Y/L) = yE. The growth rate of (Y/L) equals the growth rate of y plus that of E. In the steady state, y is constant while E grows at rate g. Y grows at rate g + n. To see this, note that Y = yEL = (yE)L. The growth rate of Y equals the growth rate of (yE) plus that of L. We just saw that, in the steady state, the growth rate of (yE) equals g. And we assume that L grows at rate n. (Y/ L) = yE g Total output Y = yEL n + g CHAPTER 8 Economic Growth II

The Golden Rule To find the Golden Rule capital stock, express c* in terms of k*: c* = y*  i* = f (k* )  ( + n + g) k* c* is maximized when MPK =  + n + g or equivalently, MPK   = n + g In the Golden Rule steady state, the marginal product of capital net of depreciation equals the pop. growth rate plus the rate of tech progress. Remember: investment in the steady state, i*, equals break-even investment. If your students are comfortable with basic calculus, have them derive the condition that must be satisfied to be in the Golden Rule steady state. CHAPTER 8 Economic Growth II

Growth empirics: Balanced growth
Solow model’s steady state exhibits balanced growth - many variables grow at the same rate. Solow model predicts Y/L and K/L grow at the same rate (g), so K/Y should be constant. This is true in the real world. Solow model predicts real wage grows at same rate as Y/L, while real rental price is constant. This is also true in the real world. Check out the third paragraph on p.221: It gives a nice contrast of the Solow model and Marxist predictions for the behavior of factor prices, comparing both models’ predictions with the data. CHAPTER 8 Economic Growth II

Growth empirics: Convergence
Solow model predicts that, other things equal, “poor” countries (with lower Y/L and K/L) should grow faster than “rich” ones. If true, then the income gap between rich & poor countries would shrink over time, causing living standards to “converge.” In real world, many poor countries do NOT grow faster than rich ones. Does this mean the Solow model fails? CHAPTER 8 Economic Growth II

Growth Empirics: Convergence
Solow model predicts that, other things equal, “poor” countries (with lower Y/L and K/L) should grow faster than “rich” ones. No, because “other things” aren’t equal. In samples of countries with similar savings & pop. growth rates, income gaps shrink about 2% per year. In larger samples, after controlling for differences in saving, pop. growth, and human capital, incomes converge by about 2% per year. CHAPTER 8 Economic Growth II

Growth empirics: Convergence
What the Solow model really predicts is conditional convergence - countries converge to their own steady states, which are determined by saving, population growth, and education. This prediction comes true in the real world. CHAPTER 8 Economic Growth II

Growth empirics: Factor accumulation vs. production efficiency
Differences in income per capita among countries can be due to differences in 1. capital – physical or human – per worker 2. the efficiency of production (the height of the production function) Studies: both factors are important. the two factors are correlated: countries with higher physical or human capital per worker also tend to have higher production efficiency. The two reasons on this slide are both implied by the Solow model. CHAPTER 8 Economic Growth II

Growth empirics: Factor accumulation vs. production efficiency
Possible explanations for the correlation between capital per worker and production efficiency: Production efficiency encourages capital accumulation. Capital accumulation has externalities that raise efficiency. A third, unknown variable causes capital accumulation and efficiency to be higher in some countries than others. CHAPTER 8 Economic Growth II

Growth empirics: Production efficiency and free trade
Since Adam Smith, economists have argued that free trade can increase production efficiency and living standards. Research by Sachs & Warner: Average annual growth rates, closed open This slide and the following one present material from a new case study in the 6th edition, on pp See note 4 on p.224 for references. Interpreting the numbers in this table: Sachs and Warner classify countries as either “open” or “closed.” Among the developed nations classified as “open,” the average annual growth rate was 2.3%. Among developed nations classified as “closed,” the growth rate was only 0.7% per year. The average growth rate for “open” developing nations was 4.5%. The average growth rate for “closed” developing countries was only 0.7%. 0.7% 2.3% developed nations 0.7% 4.5% developing nations CHAPTER 8 Economic Growth II

Growth empirics: Production efficiency and free trade
To determine causation, Frankel and Romer exploit geographic differences among countries: Some nations trade less because they are farther from other nations, or landlocked. Such geographical differences are correlated with trade but not with other determinants of income. Hence, they can be used to isolate the impact of trade on income. Findings: increasing trade/GDP by 2% causes GDP per capita to rise 1%, other things equal. See note 4 on p.224 for references. CHAPTER 8 Economic Growth II

Policy issues Are we saving enough? Too much?
What policies might change the saving rate? How should we allocate our investment between privately owned physical capital, public infrastructure, and “human capital”? How do a country’s institutions affect production efficiency and capital accumulation? What policies might encourage faster technological progress? CHAPTER 8 Economic Growth II

Policy issues: Evaluating the rate of saving
Use the Golden Rule to determine whether the U.S. saving rate and capital stock are too high, too low, or about right. If (MPK   ) > (n + g ), U.S. is below the Golden Rule steady state and should increase s. If (MPK   ) < (n + g ), U.S. economy is above the Golden Rule steady state and should reduce s. This section (this and the next couple of slides) presents a very clever and fairly simple analysis of the U.S. economy. When asked, students often have reasonable ideas of how to estimate MPK (e.g., look at stock market returns), n and g, but very few offer suggestions on how to estimate the depreciation rate: there are lots of different kinds of capital out there. Here, Mankiw presents a simple and elegant way to estimate the aggregate depreciation rate (which appears a couple of slides below). First, though, you should make sure your students know why the inequalities in the last two lines tell us whether our current steady-state is above or below the Golden Rule steady state. To see this, remember that the steady-state value of capital is inversely related to the steady state value of MPK. If we’re above the Golden Rule capital stock, then we have “too much” capital, so MPK will be smaller than in the Golden Rule steady state. If we’re below the GR capital stock, then MPK is higher than in the Golden Rule. CHAPTER 8 Economic Growth II

To estimate (MPK   ), use three facts about the U.S. economy: 1. k = 2.5 y The capital stock is about 2.5 times one year’s GDP. 2.  k = 0.1 y About 10% of GDP is used to replace depreciating capital. 3. MPK  k = 0.3 y Capital income is about 30% of GDP. The three equations appear in the top part of the next slide. Therefore, if you wish, instead of showing this slide, you could just explain verbally what appears on this slide when you show the three equations on the next slide. CHAPTER 8 Economic Growth II

1. k = 2.5 y 2.  k = 0.1 y 3. MPK  k = 0.3 y To determine  , divide 2 by 1: The actual U.S. economy has tens of thousands of different types of capital goods, all with different depreciation rates. Estimating the aggregate depreciation rate therefore might seem incomprehensibly complicated. But on this slide, we see Mankiw’s simple, clever, and elegant method of estimating the aggregate depreciation rate. Pretty neat! CHAPTER 8 Economic Growth II

1. k = 2.5 y 2.  k = 0.1 y 3. MPK  k = 0.3 y To determine MPK, divide 3 by 1: Similarly, the method of estimating the aggregate MPK shown on this slide is far simpler and more elegant than somehow measuring and aggregating the returns on all different kinds of capital. Hence, MPK   =  = 0.08 CHAPTER 8 Economic Growth II

From the last slide: MPK   = 0.08 U.S. real GDP grows an average of 3% per year, so n + g = 0.03 Thus, MPK   = 0.08 > 0.03 = n + g Conclusion: When the second bullet point displays on the screen, it might be helpful to remind students that, in the Solow model’s steady state, total output grows at rate n + g. Thus, we can estimate n + g for the U.S. simply by using the long-run average growth rate of real GDP. The U.S. is below the Golden Rule steady state: Increasing the U.S. saving rate would increase consumption per capita in the long run. CHAPTER 8 Economic Growth II

Policy issues: How to increase the saving rate
Reduce the government budget deficit (or increase the budget surplus). Increase incentives for private saving: reduce capital gains tax, corporate income tax, estate tax as they discourage saving. replace federal income tax with a consumption tax. expand tax incentives for IRAs (individual retirement accounts) and other retirement savings accounts. If you have time available in class, you might consider asking students to brainstorm a list of policies or actions the government could take to increase the national saving rate. If you’ve been reading these annotations in the “notes” area of these slides, you’ve seen my suggestions on generating classroom discussion, and hopefully have tried them. If you haven’t, now would be a great time to try, and it’s easy: Get students into pairs (they need not change seats – students sitting together can work together). Ask them to take out a sheet of paper, and give them 3-4 minutes to see if they can come up with 3 different policies to increase saving. After the 3-4 minutes are up, ask for volunteers. Write down their responses on the board, and then compare the list that the class came up with to those appearing on this slide. Having students work in pairs BEFORE discussing in class takes class-time, but yields many benefits. All students become involved (while they are working in pairs), as opposed to only a few being involved if you immediately ask for responses w/o giving them time to think first. Many students don’t have the confidence to volunteer a response when their instructor asks for responses immediately after posing the question. However, if these students are given a few moments to think of possible answers, and if they have the chance to run it by a classmate first, then they will be FAR more likely to volunteer their responses. This leads to a higher quantity and quality of class participation. CHAPTER 8 Economic Growth II

Policy issues: Allocating the economy’s investment
In the Solow model, there’s one type of capital. In the real world, there are many types, which we can divide into three categories: private capital stock public infrastructure human capital: the knowledge and skills that workers acquire through education. How should we allocate investment among these types? CHAPTER 8 Economic Growth II

Policy issues: Allocating the economy’s investment
Two viewpoints: 1. Equalize tax treatment of all types of capital in all industries, then let the market allocate investment to the type with the highest marginal product. 2. Industrial policy: Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities that private investors don’t consider. Before showing the next slide, ask your students which of the two views is closest to their own. CHAPTER 8 Economic Growth II

Possible problems with industrial policy
The govt may not have the ability to “pick winners” (choose industries with the highest return to capital or biggest externalities). Politics (e.g., campaign contributions) rather than economics may influence which industries get preferential treatment. CHAPTER 8 Economic Growth II

Policy issues: Establishing the right institutions
Creating the right institutions is important for ensuring that resources are allocated to their best use. Examples: Legal institutions, to protect property rights. Capital markets, to help financial capital flow to the best investment projects. A corruption-free government, to promote competition, enforce contracts, etc. This slide corresponds to new material for the 6th edition of the textbook – see p. 229. CHAPTER 8 Economic Growth II

Policy issues: Encouraging tech. progress
Patent laws: encourage innovation by granting temporary monopolies to inventors of new products. Tax incentives for R&D Grants to fund basic research at universities Industrial policy: encourages specific industries that are key for rapid tech. progress (subject to the preceding concerns). CHAPTER 8 Economic Growth II

CASE STUDY: The productivity slowdown
U.S. U.K. Japan Italy Germany France Canada Growth in output per person (percent per year) 2.2 2.4 8.2 4.9 5.7 4.3 2.9 1.5 1.8 2.6 2.3 2.0 1.6 (Part of) Table 8-2 on p.231. “Germany” in this table means W. Germany CHAPTER 8 Economic Growth II

Possible explanations for the productivity slowdown
Measurement problems: Productivity increases not fully measured. But: Why would measurement problems be worse after 1972 than before? Oil prices: Oil shocks occurred about when productivity slowdown began. But: Then why didn’t productivity speed up when oil prices fell in the mid-1980s? CHAPTER 8 Economic Growth II

Possible explanations for the productivity slowdown
Worker quality: 1970s - large influx of new entrants into labor force (baby boomers, women). New workers tend to be less productive than experienced workers. The depletion of ideas: Perhaps the slow growth of is normal, and the rapid growth during is the anomaly. CHAPTER 8 Economic Growth II

Which of these suspects is the culprit?
All of them are plausible, but it’s difficult to prove that any one of them is guilty. CHAPTER 8 Economic Growth II

CASE STUDY: I.T. and the “New Economy”
U.S. U.K. Japan Italy Germany France Canada Growth in output per person (percent per year) 2.2 2.4 8.2 4.9 5.7 4.3 2.9 1.5 1.8 2.6 2.3 2.0 1.6 2.2 2.5 1.2 1.5 1.7 2.4 Table 8-2 on p.231 Prior to 1995, “Germany” here refers to W. Germany. During the late 1990s into 2000, there was much talk in the business world of a “new economy” in which rapid productivity growth and high technology somehow nullified the standard rules and principles of economics (e.g., diminishing returns). CHAPTER 8 Economic Growth II

CASE STUDY: I.T. and the “New Economy”
Apparently, the computer revolution did not affect aggregate productivity until the mid-1990s. Two reasons: 1. Computer industry’s share of GDP much bigger in late 1990s than earlier. 2. Takes time for firms to determine how to utilize new technology most effectively. The big, open question: How long will I.T. remain an engine of growth? CHAPTER 8 Economic Growth II

Endogenous growth theory
Solow model: sustained growth in living standards is due to tech progress. the rate of tech progress is exogenous. Endogenous growth theory: a set of models in which the growth rate of productivity and living standards is endogenous. In the Solow model, the long-run economic growth rate equals the rate of technological progress, which is exogenous in the model. Hence, the Solow model is basically saying “all I can tell you is that growth in living standards depends on technological progress. I have no idea what drives technological progress.” Endogenous growth theory tries to explain the behavior of the rates of technological progress and/or productivity growth, rather than merely taking these rates as given. CHAPTER 8 Economic Growth II

A basic model Production function: Y = A K where A is the amount of output for each unit of capital (A is exogenous & constant) Key difference between this model & Solow: MPK is constant here, diminishes in Solow Investment: s Y Depreciation:  K Equation of motion for total capital: K = s Y   K This is an extremely simple model, yet has a powerful implication (to be developed below). CHAPTER 8 Economic Growth II

A basic model K = s Y   K Divide through by K and use Y = A K to get: If s A > , then income will grow forever, and investment is the “engine of growth.” Here, the permanent growth rate depends on s. In Solow model, it does not. Y and K grow at the same rate because A is constant. Discussion: The return to capital is the incentive to invest. If capital exhibits diminishing returns, then the incentive to invest decreases as the economy grows. Hence, investment cannot be a source of sustained growth. However, in this model, MPK does not fall as K rises, so the incentive to invest never declines, people will always find it worthwhile to save and invest over and above depreciation, so investment becomes an engine of growth. The $64,000 question: Does capital exhibit diminishing or constant marginal returns? The answer is critical, for it determines whether investment explains sustained (i.e. steady-state) growth in productivity and living standards. See the next slide for discussion. CHAPTER 8 Economic Growth II

Does capital have diminishing returns or not?
Depends on definition of “capital.” If “capital” is narrowly defined (only plant & equipment), then yes. Advocates of endogenous growth theory argue that knowledge is a type of capital. If so, then constant returns to capital is more plausible, and this model may be a good description of economic growth. CHAPTER 8 Economic Growth II

A two-sector model Two sectors:
manufacturing firms produce goods. research universities produce knowledge that increases labor efficiency in manufacturing. u = fraction of labor in research (u is exogenous) Mfg prod func: Y = F [K, (1-u )E L] Res prod func: E = g (u )E Cap accumulation: K = s Y   K Before presenting this model, it might be helpful to tell students that it is an extension of something they already know - the Solow model with tech progress. There are two differences: First, a fraction of the labor force does not produce goods & services, but rather produces “knowledge” by doing research in universities. Second, the rate of tech progress is not exogenous, but rather depends on how fast the stock of knowledge grows, which in turn depends on how much labor the economy has allocated to research. If you have a few minutes of class time after presenting the model, you should consider having your students work problem #6 on p Otherwise, assign it as a homework exercise. In regards to the specific elements of the model, Manufacturing production function: Just like in the Solow model with exogenous technological progress, output of manufactures depends on capital and the effective labor force employed in the mfg sector, (1-u)EL. Research production function: The “output” is increases in knowledge and labor efficiency. The “inputs” are labor and current knowledge. The function g() shows how changes in the amount of labor devoted to research affect the creation of new knowledge. All we need is for g( ) to be an increasing function. It does not matter whether a doubling of scientists causes the creation of knowledge to double, more than double, or less than double. Capital accumulation: Same as in the previous model -- net investment equals gross investment (sY) minus depreciation. CHAPTER 8 Economic Growth II

A two-sector model In the steady state, mfg output per worker and the standard of living grow at rate E/E = g (u ). Key variables: s: affects the level of income, but not its growth rate (same as in Solow model) u: affects level and growth rate of income Question: Would an increase in u be unambiguously good for the economy? In this model, the steady state growth rate of the standard of living equals the growth rate of labor efficiency, just like in the Solow model with tech progress, covered at the beginning of this chapter. The difference here is that the rate of tech progress, g, is not exogenous: it depends on how much labor the economy has allocated to research. Answer to the question posed on the bottom of this slide: No. On one hand, higher u means faster growth. On the other hand, higher u means less labor is devoted to the production of goods & services. If we increase u, output of goods & services per capita will fall in the near term. But, with faster growth, output per capita will eventually be higher than it would have. Of course, if we increase u to its maximum possible value, 1, then no goods and services would be produced, and you’d have a bunch of starving geniuses. Which would be kind of odd, if you think about it. This tradeoff suggests that there must be some kind of “golden rule” for u, a value of u that maximizes well-being per capita in the steady state. Well, I’m clearly babbling now. Perhaps I should let you get back to your class preparations. CHAPTER 8 Economic Growth II

Facts about R&D Patents create a stream of monopoly profits.
1. Much research is done by firms seeking profits. 2. Firms profit from research: Patents create a stream of monopoly profits. Extra profit from being first on the market with a new product. 3. Innovation produces externalities that reduce the cost of subsequent innovation. R&D = research and development An excellent quote on p.238 is relevant to fact #3: Isaac Newton once said “If I have seen farther than others, it is because I was standing on the shoulders of giants.” Much of the new endogenous growth theory attempts to incorporate these facts into models to better understand technological progress. CHAPTER 8 Economic Growth II

Is the private sector doing enough R&D?
The existence of positive externalities in the creation of knowledge suggests that the private sector is not doing enough R&D. But, there is much duplication of R&D effort among competing firms. Estimates: Social return to R&D ≥ 40% per year. Thus, many believe govt should encourage R&D. CHAPTER 8 Economic Growth II

Economic growth as “creative destruction”
Schumpeter (1942) coined term “creative destruction” to describe displacements resulting from technological progress: the introduction of a new product is good for consumers, but often bad for incumbent producers, who may be forced out of the market. Examples: Luddites ( ) destroyed machines that displaced skilled knitting workers in England. Walmart displaces many “mom and pop” stores. This slide contains material from a new case study (new to the 6th edition) on p The text provides a nice, brief summary of the story of the Luddites. CHAPTER 8 Economic Growth II

Chapter Summary 1. Key results from Solow model with tech progress
steady state growth rate of income per person depends solely on the exogenous rate of tech progress the U.S. has much less capital than the Golden Rule steady state 2. Ways to increase the saving rate increase public saving (reduce budget deficit) tax incentives for private saving CHAPTER 8 Economic Growth II slide 429

Chapter Summary 3. Productivity slowdown & “new economy”
Early 1970s: productivity growth fell in the U.S. and other countries. Mid 1990s: productivity growth increased, probably because of advances in I.T. 4. Empirical studies Solow model explains balanced growth, conditional convergence Cross-country variation in living standards is due to differences in cap. accumulation and in production efficiency CHAPTER 8 Economic Growth II slide 430

Introduction to Economic Fluctuations
9 Introduction to Economic Fluctuations This chapter has two main objectives: motivating the study of short-run fluctuations, and introducing the model of aggregate demand and aggregate supply. For this edition, Mankiw adds more data to the introduction, to give students a better feel of the economy’s behavior in the short run. Note, also, that the coverage of Okun’s law has been moved to this chapter (from Chapter 2 in previous editions). The remainder of the chapter develops a simple version of the model of aggregate demand and supply, and shows how it can be used to study the effects of shocks and policies. This introduction to AD/AS provides students with an overall context. Having this context allows students to better understand the role played by each of the more detailed pieces of the model (Keynesian Cross, IS-LM, theories of short-run aggregate supply, etc) as students learn them in the chapters that follow. This chapter is less difficult than most other chapters in the book, and all of the concepts it introduces are all developed in more detail in the following chapters of Part IV. Therefore, you might consider spending a little less class time on this chapter than on other chapters. Please note that the AD curve in this chapter is based on the Quantity Theory of Money. This simple theory, familiar to students from earlier chapters, yields a simple AD curve, which is adequate for the purposes of this chapter’s basic introduction to AD/AS. However, as a theory of aggregate demand, the Quantity Theory of Money is very incomplete: it omits interest rates, fiscal policy, and the individual components of aggregate demand – all of which will be introduced in the following chapters. Some students find it confusing, especially since they have to “unlearn” it in the following chapters, which more properly and completely cover AD and its components. So, some professors consider a more ad hoc approach: defining and drawing the AD curve without deriving it or explaining its slope. Students will learn a proper derivation in the following chapters, and they have probably already seen an aggregate demand curve if they previously took a principles course. And, the ad hoc approach saves time. This powerpoint presents the book’s approach.

facts about the business cycle how the short run differs from the long run an introduction to aggregate demand an introduction to aggregate supply in the short run and long run how the model of aggregate demand and aggregate supply can be used to analyze the short-run and long-run effects of “shocks.” CHAPTER 9 Introduction to Economic Fluctuations

Facts about the business cycle
GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run. Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. Unemployment rises during recessions and falls during expansions. Okun’s Law: the negative relationship between GDP and unemployment. The four slides that follow provide data on each of these points. If you wish, you can “hide” (omit) this slide from your presentation, and instead give students the information verbally as you display the following slides. CHAPTER 9 Introduction to Economic Fluctuations

Growth rates of real GDP, consumption
Percent change from 4 quarters earlier 10 Real GDP growth rate 8 Consumption growth rate 6 Average growth rate 4 2 Over the long run, real GDP grows about 3 percent per year. Over the short run, though, there are substantial fluctuations in GDP, as this graph clearly shows. The pink shaded vertical bars denote recessions. This graph also shows the growth rate of consumption (from Figure 9-2(a) on p.255). I have graphed both variables on the same graph to make it easier for students to see that, in most years, consumption is less volatile than income. (An exception occurs in the late 1990s, when consumption growth exceeded income growth – probably due to the stock market boom.) As Chapter 16 covers in more detail, consumers prefer smooth consumption, so they use saving as a buffer against income shocks. Source of data: See Figure 9-1, p.254 -2 -4 1970 1975 1980 1985 1990 1995 2000 2005

Growth rates of real GDP, consumption, investment
Percent change from 4 quarters earlier 40 Investment growth rate 30 20 Real GDP growth rate 10 Consumption growth rate This graph reproduces GDP and consumption growth using a larger scale. The scale accommodates the investment growth rate data. The point: investment is much more volatile than consumption or GDP in the short run. Source: See Figure 9-2, p.255 -10 -20 -30 1970 1975 1980 1985 1990 1995 2000 2005

Unemployment Percent of labor force 12 10 8 6 4 2 1970 1975 1980 1985
The unemployment rate rises during recessions and falls during expansions. The unemployment rate sometimes lags changes in GDP growth. For example, after the 1991 recession ended, unemployment continued to rise for about a year before falling. After the 2001 recession ended, unemployment did not begin to fall for a couple quarters. Source: See Figure 9-3, p.256. 2 1970 1975 1980 1985 1990 1995 2000 2005

Change in unemployment rate
Okun’s Law Percentage change in real GDP 10 1975 1982 1991 2001 1984 1951 1966 2003 1987 8 6 4 2 The green boxed equation in the upper right is the Okun’s Law equation shown on the bottom of p In this equation, “u” denotes the unemployment rate. -2 -4 -3 -2 -1 1 2 3 4 Change in unemployment rate

Index of Leading Economic Indicators
Published monthly by the Conference Board. Aims to forecast changes in economic activity 6-9 months into the future. Used in planning by businesses and govt, despite not being a perfect predictor. CHAPTER 9 Introduction to Economic Fluctuations

Components of the LEI index
Average workweek in manufacturing Initial weekly claims for unemployment insurance New orders for consumer goods and materials New orders, nondefense capital goods Vendor performance New building permits issued Index of stock prices M2 Yield spread (10-year minus 3-month) on Treasuries Index of consumer expectations I’ve abbreviated some of the names to fit more neatly on this slide. The full list of complete names appears on pp , as does a discussion of the role of each component in helping forecast economic activity. CHAPTER 9 Introduction to Economic Fluctuations

Index of Leading Economic Indicators
160 140 120 100 1996 = 100 80 60 Notice that the index turns downward a few months to a year before each recession. It also turns upward just prior to the end of almost every recession. Source: Conference Board. Note: This is proprietary data that we purchased from the Conference Board. They allow us to publish this graph on the condition that we include the source on the slide. I have tried to make the citation unobtrusive. Theoretically, it could easily be removed from this slide, though we are required to leave it. But, it wouldn’t be hard to remove. Theoretically. 40 20 Source: Conference Board 1970 1975 1980 1985 1990 1995 2000 2005

Time horizons in macroeconomics
Long run: Prices are flexible, respond to changes in supply or demand. Short run: Many prices are “sticky” at some predetermined level. The material on this slide was introduced in Chapter 1. Since it’s been a while since your students read that chapter, it’s probably worth repeating at this point, especially since the behavior of prices is so critical for understanding short-run fluctuations. It might also be worth reminding them that they (and most adults) are already aware of the concept of sticky prices. If they have a favorite beverage at Starbucks, ask if they can remember when its price was last increased. If they work, ask how long they go between wage changes. Sticky prices are a fact of everyday life, even if most adults have not heard the term “sticky prices” or studied the implications of sticky prices for short-run economic fluctuations. The economy behaves much differently when prices are sticky. CHAPTER 9 Introduction to Economic Fluctuations

Recap of classical macro theory (Chaps. 3-8)
Output is determined by the supply side: supplies of capital, labor technology. Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. Assumes complete price flexibility. Applies to the long run. Classical macroeconomic theory is what we learned in chapters This slide recaps an important lesson from classical theory, which stands in sharp contrast to what we are about to cover now. CHAPTER 9 Introduction to Economic Fluctuations

When prices are sticky…
…output and employment also depend on demand, which is affected by fiscal policy (G and T ) monetary policy (M ) other factors, like exogenous changes in C or I. Chapters 9-11 focus on the closed economy case. In an open economy, the list of things that affect aggregate demand is a bit larger. (See chapter 12.) CHAPTER 9 Introduction to Economic Fluctuations

The model of aggregate demand and supply
the paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy shows how the price level and aggregate output are determined shows how the economy’s behavior is different in the short run and long run CHAPTER 9 Introduction to Economic Fluctuations

Aggregate demand The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. For this chapter’s intro to the AD/AS model, we use a simple theory of aggregate demand based on the quantity theory of money. Chapters develop the theory of aggregate demand in more detail. CHAPTER 9 Introduction to Economic Fluctuations

The Quantity Equation as Aggregate Demand
From Chapter 4, recall the quantity equation M V = P Y For given values of M and V, this equation implies an inverse relationship between P and Y : CHAPTER 9 Introduction to Economic Fluctuations

The downward-sloping AD curve
Y P An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services. The textbook explains different ways of thinking about the AD curve’s slope. Here’s one that uses the idea of the simple money demand function introduced in chapter 4 (M/P = kY, where k = 1/V): An increase in the price level causes a fall in real money balances, and therefore a fall in the demand for goods & services (because the demand for output is proportional to real money balances according to the simple money demand function that is implied by the quantity theory of money). Here’s an explanation of the AD curve slope that doesn’t refer to the simple money demand function: A fall in P reduces real money balances. In order to buy the same amount of stuff, velocity would have to increase. But, by definition, velocity is constant along the AD curve. For simplicity, suppose V = 1. With lower real money balances (or, equivalently, the same nominal balances but higher goods prices), people demand a smaller quantity of goods and services. CHAPTER 9 Introduction to Economic Fluctuations

Shifting the AD curve AD2 AD1 Y P An increase in the money supply shifts the AD curve to the right. For future reference (a bunch of slides later in this chapter), it will be useful to see how a change in M shifts the AD curve. Pages discuss the shift. Here’s the idea: With velocity fixed, the quantity equation implies that PY is determined by M. An increase in M causes an increase in PY, which means higher Y for each value of P, or higher P for each value of Y. Or: for a given value of P, an increase in M implies higher real money balances. In the simple money demand function associated with the Quantity Theory, the demand for real balances is proportional to the demand for output, so output must rise at each P in order for real money demand to rise and equal the new, higher supply of real balances M/P. Or, if you like, just have your students take on faith that an increase in the money supply shifts the AD curve to the right for now, telling them that they will learn how this works in Chapters 10 and 11. CHAPTER 9 Introduction to Economic Fluctuations

Aggregate supply in the long run
Recall from Chapter 3: In the long run, output is determined by factor supplies and technology is the full-employment or natural level of output, the level of output at which the economy’s resources are fully employed. Some textbooks also use the term “potential GDP” to mean the full-employment level of output. “Full employment” means that unemployment equals its natural rate (not zero). CHAPTER 9 Introduction to Economic Fluctuations

The long-run aggregate supply curve
LRAS does not depend on P, so LRAS is vertical. Sometimes it takes students a little while to understand why the LRAS curve is vertical, when the supply curves they learned in their micro principles class were mostly upward-sloping. Here’s an explanation that they might find helpful: “P” on the vertical axis is the economy’s overall price level – the average price of EVERYTHING. A 10% increase in the price level means that, on average, EVERYTHING costs 10% more. Thus, a firm can get 10% more revenue for each unit it sells. But the firm also pays an average of 10% more in wages, prices of intermediate goods, advertising, and so on. Thus, the firm has no incentive to increase output. Another thought: We learn from microeconomics that a firm’s supply depends on the RELATIVE price of its output. If all prices increase by 10%, then each firm’s relative price is the same as before, hence no incentive to alter output. CHAPTER 9 Introduction to Economic Fluctuations

Long-run effects of an increase in M
AD2 AD1 Y P LRAS An increase in M shifts AD to the right. In the long run, this raises the price level… P2 P1 [The textbook does a fall in AD (Figure 9-8 on p.266); this slide does an increase.] Notice that the results in this graph are exactly as we learned in chapters 3-8: a change in the money supply affects the price level, but not the quantity of output. Here, we are seeing these results on a graph with different variables on the axes (P and Y), but it’s the same model. …but leaves output the same. CHAPTER 9 Introduction to Economic Fluctuations

Aggregate supply in the short run
Many prices are sticky in the short run. For now (and through Chap. 12), we assume all prices are stuck at a predetermined level in the short run. firms are willing to sell as much at that price level as their customers are willing to buy. Therefore, the short-run aggregate supply (SRAS) curve is horizontal: The assumption that all prices are fixed in the short run is extreme. Chapter 13 derives the SRAS curve under more realistic assumptions, and Chapter 19 (section 19-2) explores price stickiness in more detail. Yet, the extreme assumption here is worth making. The short-run response of output & employment to policies and shocks is the same (qualitatively) whether the SRAS curve is upward-sloping or horizontal. But the horizontal SRAS curve makes the analysis much simpler: a shift in AD leaves P unchanged in the short run. This greatly simplifies analysis in the IS-LM-AD model (chapters 10 and 11). (With an upward-sloping SRAS curve, a shock to the IS and AD curves would change prices in the short run in addition to changing output. The change in prices would change the real money supply, which would shift the LM curve.) CHAPTER 9 Introduction to Economic Fluctuations

The short-run aggregate supply curve
The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. SRAS CHAPTER 9 Introduction to Economic Fluctuations

Short-run effects of an increase in M
AD2 AD1 Y P In the short run when prices are sticky,… …an increase in aggregate demand… SRAS Y2 [The textbook (Figure 9-10 on p.268) does a decrease in AD, this slide does an increase.] What about the unemployment rate? Remember from chapter 2: Okun’s law says that unemployment and output are negatively related. In the graph here, in order for firms to increase output, they require more workers. Employment rises, and the unemployment rate falls. …causes output to rise. Y1 CHAPTER 9 Introduction to Economic Fluctuations

From the short run to the long run
Over time, prices gradually become “unstuck.” When they do, will they rise or fall? In the short-run equilibrium, if then over time, P will… rise fall You might want to discuss the intuition for the price adjustment in each case. First, suppose aggregate demand is higher than the full-employment level of output in the economy’s initial short-run equilibrium. Then, there is upward pressure on prices: In order for firms to produce this above-average level of output, they must pay their workers overtime and make their capital work at a high intensity, which causes more maintenance, repairs, and depreciation. For all these reasons, firms would like to raise their prices. In the short run, they cannot. But over time, prices gradually become “unstuck,” and firms can increase prices in response to these cost pressures. Instead, suppose that output is below its natural rate. Then, there is downward pressure on prices: Firms can’t sell as much output as they’d like at their current prices, so they would like to reduce prices. With lower than normal output, firms won’t need as many workers as normal, so they cut back on labor, and the unemployment rate rises above the “natural rate of unemployment.” The high unemployment rate puts downward pressure on wages. Wages and prices are “stuck” in the short run, but over time, they fall in response to these pressures. Finally: if output equals its normal (or “natural”) level, then there is no pressure for prices to rise or fall. Over time, as prices become “unstuck,” they will simply remain constant. remain constant The adjustment of prices is what moves the economy to its long-run equilibrium. CHAPTER 9 Introduction to Economic Fluctuations

The SR & LR effects of M > 0
AD2 AD1 A = initial equilibrium Y P LRAS B = new short-run eq’m after Fed increases M C P2 SRAS B A Y2 [The textbook does a decrease in agg. demand, Figure 9-12 on p This slide presents an increase in agg. demand.] This slide puts together the pieces that have been developed over the previous slides: the short-run and long-run effects, as well as the adjustment of prices over time that causes the economy to move from the short-run equilibrium at point B to the long-run equilibrium at C. The economy starts at point A; output and unemployment are at their “natural” rates. The Fed increases the money supply, shifting AD to the right. In the short run, prices are sticky, so output rises. The new short-run equilibrium is at point B in the graph. In order for firms to increase output, they hire more workers, so unemployment falls below the natural rate of unemployment, putting upward pressure on wages. The high level of demand for goods & services at point B puts upward pressure on prices. Over time, as prices become “unstuck,” they begin to rise in response to these pressures. The price level rises and the economy moves up its (new) AD curve, from point B toward point C. This process stops when the economy gets to point C: output again equals the “natural rate of output,” and unemployment again equals the natural rate of unemployment, so there is no further pressure on prices to change. C = long-run equilibrium CHAPTER 9 Introduction to Economic Fluctuations

How shocking!!! shocks: exogenous changes in agg. supply or demand
Shocks temporarily push the economy away from full employment. Example: exogenous decrease in velocity If the money supply is held constant, a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services. [The example in the textbook is an exogenous INCREASE in velocity.] The exogenous decrease in velocity corresponds to an exogenous increase in demand for real money balances (relative to income & transactions). This might occur in response to a wave of credit card fraud, which presumably would make nervous consumers more inclined to use cash in their transactions. If there’s an exogenous increase in real money demand (i.e., an increase NOT caused by an increase in Y), then M/P must increase as well; if the Fed holds M constant, then P must fall. Thus, the increase in real money demand causes a decrease in the value of P associated with each Y, and the AD curve shifts down. The velocity shock is the only AD shock we can analyze at this point, because (for this chapter only) we have derived the AD curve from the Quantity Theory of Money. However, if you have not derived the AD curve from the Quantity Theory, as discussed in the notes accompanying the title slide of this chapter, then you could pick any number of AD shocks: a stock market crash causes consumers to cut back on spending; a fall in business confidence causes a decrease in investment; a recession in a country with which we trade causes causes an exogenous decrease in their demand for our exports. CHAPTER 9 Introduction to Economic Fluctuations

The effects of a negative demand shock
AD1 AD shifts left, depressing output and employment in the short run. Y P AD2 LRAS SRAS B A Over time, prices fall and the economy moves down its demand curve toward full-employment. Y2 C P2 Note the economy’s “self-correction” mechanism: When in a recession, the economy --- left to its own devices --- “fixes” itself: the gradual adjustment of prices helps the economy recover from the shock and return to full employment. Of course, before the economy has finished self-correcting, a period of low output and high unemployment is endured. CHAPTER 9 Introduction to Economic Fluctuations

Supply shocks A supply shock alters production costs, affects the prices that firms charge. (also called price shocks) Examples of adverse supply shocks: Bad weather reduces crop yields, pushing up food prices. Workers unionize, negotiate wage increases. New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance. Favorable supply shocks lower costs and prices. CHAPTER 9 Introduction to Economic Fluctuations

CASE STUDY: The 1970s oil shocks
Early 1970s: OPEC coordinates a reduction in the supply of oil. Oil prices rose 11% in % in % in 1975 Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. Oil is required to heat the factories in which goods are produced, and to fuel the trucks that transport the goods from the factories to the warehouses to Walmart stores. A sharp increase in the price of oil, therefore, has a substantial effect on production costs. CHAPTER 9 Introduction to Economic Fluctuations

AD The oil price shock shifts SRAS up, causing output and employment to fall. Y P LRAS SRAS2 B In absence of further price shocks, prices will fall over time and economy moves back toward full employment. Y2 SRAS1 A A And, as output falls from Ybar to Y2 in the graph, we would expect to see unemployment increase above the natural rate of unemployment. (Recall from chapter 2: Okun’s law says that output and unemployment are inversely related.) Note the phrase “in absence of further price shocks.” As we will see shortly, just as the economy was recovering from the first big oil shock, a second one came along. CHAPTER 9 Introduction to Economic Fluctuations

Predicted effects of the oil shock: inflation  output  unemployment  …and then a gradual recovery. This slide first summarizes the model’s predictions from the preceding slide, and then presents data (from the text, p.274) that supports the model’s predictions. CHAPTER 9 Introduction to Economic Fluctuations

Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!! Data source: See p.274 of the textbook. This second shock was associated with the revolution in Iran. The Shah, who maintained cordial relations with the West, was deposed. The new leader, Ayatollah Khomeini, was considerably less friendly toward the West. (He even forbade his citizens from listening to Western music.) CHAPTER 9 Introduction to Economic Fluctuations

A favorable supply shock-- a significant fall in oil prices. As the model predicts, inflation and unemployment fell: A few slides back, we analyzed the effects of an adverse supply shock. It might be worth noting that the predicted effects of a favorable supply shock are just the opposite: in the short run, the price level (or inflation rate) falls, output rises, and unemployment falls. Looking at the graph: at first glance, it may seem that the fall in oil prices doesn’t occur until But remind students to look at the left-hand scale, on which 0 is in the middle, not at the bottom. Oil prices fell about 10% in 1982, and generally fell during most years between 1982 and 1986. CHAPTER 9 Introduction to Economic Fluctuations

Stabilization policy def: policy actions aimed at reducing the severity of short-run economic fluctuations. Example: Using monetary policy to combat the effects of adverse supply shocks: Chapter 14 is devoted to stabilization policy. CHAPTER 9 Introduction to Economic Fluctuations

Stabilizing output with monetary policy
AD1 Y P LRAS The adverse supply shock moves the economy to point B. SRAS2 B Y2 SRAS1 A CHAPTER 9 Introduction to Economic Fluctuations

Stabilizing output with monetary policy
AD2 AD1 Y P But the Fed accommodates the shock by raising agg. demand. LRAS SRAS2 B C Y2 A results: P is permanently higher, but Y remains at its full-employment level. Note: If the Fed correctly anticipates the sign and magnitude of the shock, then the Fed can respond as the shock occurs rather than after, and the economy never would go to point B - it would go immediately to point C. CHAPTER 9 Introduction to Economic Fluctuations

Chapter Summary 1. Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies. Short run: prices are sticky, shocks can push output and employment away from their natural rates. 2. Aggregate demand and supply: a framework to analyze economic fluctuations CHAPTER 9 Introduction to Economic Fluctuations slide 468

Chapter Summary 3. The aggregate demand curve slopes downward.
4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices. 5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels. CHAPTER 9 Introduction to Economic Fluctuations slide 469

Chapter Summary 6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run. 7. The Fed can attempt to stabilize the economy with monetary policy. CHAPTER 9 Introduction to Economic Fluctuations slide 470

Aggregate Demand I: Building the IS -LM Model
10 Aggregate Demand I: Building the IS -LM Model This chapter sets up the IS-LM model, which chapter 11 then uses extensively to analyze the effects of policies and economic shocks. This chapter also introduces students to the Keynesian Cross and Liquidity Preference models, which underlie the IS curve and LM curve, respectively. If you would like to spend less time on this chapter, you might consider omitting the Keynesian Cross, instead using the loanable funds model from Chapter 3 to derive the IS curve. Advantage: students are already familiar with the loanable funds model, so skipping the KC means one less model to learn. Additionally, the KC model is not used anywhere else in this textbook. Once it’s used to derive IS, it disappears for good. However, there are some good reasons for NOT omitting the KC model: 1) Many principles textbooks (though not Mankiw’s) cover the KC model; students who learned the KC model in their principles class may benefit from seeing it here, as a bridge to the new material on the IS curve. 2) The KC model is of historical importance. One could argue that anybody graduating from college with a degree in economics should be familiar with the KC model.

the IS curve, and its relation to the Keynesian cross the loanable funds model the LM curve, and its relation to the theory of liquidity preference how the IS-LM model determines income and the interest rate in the short run when P is fixed CHAPTER 10 Aggregate Demand I

Context Chapter 9 introduced the model of aggregate demand and aggregate supply. Long run prices flexible output determined by factors of production & technology unemployment equals its natural rate Short run prices fixed output determined by aggregate demand unemployment negatively related to output CHAPTER 10 Aggregate Demand I

Context This chapter develops the IS-LM model, the basis of the aggregate demand curve. We focus on the short run and assume the price level is fixed (so, SRAS curve is horizontal). This chapter (and chapter 11) focus on the closed-economy case. Chapter 12 presents the open-economy case. CHAPTER 10 Aggregate Demand I

The Keynesian Cross A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure = unplanned inventory investment CHAPTER 10 Aggregate Demand I

Elements of the Keynesian Cross
consumption function: govt policy variables: for now, planned investment is exogenous: planned expenditure: Stress that much of this model is very familiar to students: same consumption function as in previous chapters, same treatment of fiscal policy variables. Note: In equilibrium, there is no unplanned inventory investment. Firms are selling everything they had intended to sell. equilibrium condition: actual expenditure = planned expenditure CHAPTER 10 Aggregate Demand I

Graphing planned expenditure
E =C +I +G MPC 1 Why slope of E line equals the MPC: With I and G exogenous, the only component of (C+I+G) that changes when income changes is consumption. A one-unit increase in income causes consumption---and therefore E---to increase by the MPC. Recall from Chapter 3: the marginal propensity to consume, MPC, equals the increase in consumption resulting from a one-unit increase in disposable income. Since T is exogenous here, a one-unit increase in Y causes a one-unit increase in disposable income. income, output, Y CHAPTER 10 Aggregate Demand I

Graphing the equilibrium condition
planned expenditure E =Y 45º income, output, Y CHAPTER 10 Aggregate Demand I

The equilibrium value of income
planned expenditure E =Y E =C +I +G The equilibrium point is the value of income where the curves cross. Be sure your students understand why the equilibrium income appears on the horizontal and vertical axes. Answer: In equilibrium, E (which is measured on the vertical) equals Y (which is measured on the horizontal). Equilibrium income income, output, Y CHAPTER 10 Aggregate Demand I

An increase in government purchases
Y E E =Y At Y1, there is now an unplanned drop in inventory… E =C +I +G2 E =C +I +G1 G …so firms increase output, and income rises toward a new equilibrium. Explain why the vertical distance of the shift in the E curve equals G: At any value of Y, an increase in G by the amount G causes an increase in E by the same amount. At Y1, there is now an unplanned depletion of inventories, because people are buying more than firms are producing (E > Y). E1 = Y1 Y E2 = Y2 CHAPTER 10 Aggregate Demand I

Solving for Y equilibrium condition in changes because I exogenous
because C = MPC Y Collect terms with Y on the left side of the equals sign: Solve for Y : CHAPTER 10 Aggregate Demand I

The government purchases multiplier
Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals Example: If MPC = 0.8, then The textbook defines the multiplier as the increase in income resulting from a $1 increase in G. However, G is a real variable (as is Y ). So, if you wish to be more precise, then you might consider defining the multiplier as “the increase in income resulting from a one-unit increase in G.” An increase in G causes income to increase 5 times as much! CHAPTER 10 Aggregate Demand I

Why the multiplier is greater than 1
Initially, the increase in G causes an equal increase in Y: Y = G. But Y  C  further Y  further C So the final impact on income is much bigger than the initial G. Students are better able to understand this if given a more concrete example, which you can explain as you display the elements on this slide. For instance, Suppose the government spends an additional $100 million on defense. Then, the revenues of defense firms increase by $100 million, all of which becomes income to somebody: some of it is paid to the workers and engineers and managers, the rest is profit paid as dividends to shareholders. Hence, income rises $100 million (Y = $100 million = G ). The people whose income just rose by $100 million are also consumers, and they will spend the fraction MPC of this extra income. Suppose MPC = 0.8, so C rises by $80 million. To be concrete, suppose they buy $80 million worth of Ford Explorers. Then, Ford sees its revenues increase by $80 million, all of which becomes income to somebody - either Ford’s workers, or its shareholders (Y = $80 million). And what do these folks do with this extra income? They spend the fraction MPC (0.8) of it, causing C = $64 million (8/10 of $80 million). Suppose they spend all $64 million on Hershey’s chocolate bars, the ones with the bits of mint cookie inside. Then, Hershey Foods Corporation experiences a revenue increase of $64 million, which becomes income to somebody or other. (Y = $64 million). So far, the total impact on income is $100 million + $80 million + $64 million, which is much bigger than the government’s initial increase in spending. But this process continues, and the final impact on Y is $500 million (because the multiplier is 5). CHAPTER 10 Aggregate Demand I

An increase in taxes E C = MPC T Y Y E =C1 +I +G E =C2 +I +G
E =Y Y E Initially, the tax increase reduces consumption, and therefore E: E =C1 +I +G E =C2 +I +G At Y1, there is now an unplanned inventory buildup… C = MPC T …so firms reduce output, and income falls toward a new equilibrium Experiment: An increase in taxes (note: the book does a decrease in taxes) Suppose taxes are increased by T. Because I and G are exogenous, they do not change. However, C depends on (YT). So, at the initial value of Y, a tax increase of T causes disposable income to fall by T, which causes consumption to fall by MPC  T. Because consumption falls, the change in C is negative: C =  MPC  T C is part of planned expenditure. The fall in C causes the E line to shift down by the size of the initial drop in C. At the initial value of output, there is now unplanned inventory investment: Sales have fallen below output, so the unsold output adds to inventory. In this situation, firms will reduce production, causing total output, income, and expenditure to fall. The new equilibrium is at Y2, where planned expenditure once again equals actual expenditure/output, and unplanned inventory investment is again equal to zero. E2 = Y2 Y E1 = Y1 CHAPTER 10 Aggregate Demand I

Solving for Y eq’m condition in changes I and G exogenous
Final result: CHAPTER 10 Aggregate Demand I

The tax multiplier def: the change in income resulting from a $1 increase in T : If MPC = 0.8, then the tax multiplier equals CHAPTER 10 Aggregate Demand I

The tax multiplier …is negative: A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the govt spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. CHAPTER 10 Aggregate Demand I

Exercise: Use a graph of the Keynesian cross to show the effects of an increase in planned investment on the equilibrium level of income/output. This in-class exercise not only gives students practice with the model, it also helps them understand the next topic: the derivation of the IS curve. CHAPTER 10 Aggregate Demand I

The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is: CHAPTER 10 Aggregate Demand I

Deriving the IS curve r  I  E  Y E =C +I (r2 )+G
CHAPTER 10 Aggregate Demand I

Why the IS curve is negatively sloped
A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase. This slide simply states the intuition behind the graphs on the preceding slide. Suggestion: Omit this slide from your presentation, and just give the students this information verbally as you present the preceding slide. CHAPTER 10 Aggregate Demand I

The IS curve and the loanable funds model
(a) The L.F. model (b) The IS curve I (r ) S, I r r Y S2 S1 Y2 Y1 r2 r2 r1 The IS curve can also be derived from the (hopefully now familiar) loanable funds model from chapter 3. A decrease in income from Y1 to Y2 causes a fall in national saving. (Recall, S = Y-C-G) The fall in saving causes a reduction in the supply of loanable funds. The interest rate must rise to restore equilibrium to the loanable funds market. Now we can see where the IS curve gets its name: When the loanable funds market is in equilibrium, investment = saving. The IS curve shows all combinations of r and Y such that investment (I) equals saving (S). Hence, “IS curve.” r1 IS CHAPTER 10 Aggregate Demand I

Fiscal Policy and the IS curve
We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output. Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… CHAPTER 10 Aggregate Demand I

Shifting the IS curve: G
E =Y Y E E =C +I (r1 )+G2 At any value of r, G  E  Y E =C +I (r1 )+G1 …so the IS curve shifts to the right. The horizontal distance of the IS shift equals Y1 Y2 r Y r1 This slide has two purposes. First, to show which way the IS curve shifts when G changes. Second, to actually measure the distance of the shift. We can measure either the horizontal or vertical distance of the shift. The horizontal distance of the IS curve shift is the change in Y required to restore goods market equilibrium AT THE INITIAL INTEREST RATE when G is raised. Since the interest rate is unchanged at r1, investment will also be unchanged. This is why, in the upper panel, we write “I(r1)” in the E equation for both expenditure curves – to remind us that investment and the interest rate are not changing. Y IS2 IS1 Y1 Y2 CHAPTER 10 Aggregate Demand I

Exercise: Shifting the IS curve
Use the diagram of the Keynesian cross or loanable funds model to show how an increase in taxes shifts the IS curve. CHAPTER 10 Aggregate Demand I

The Theory of Liquidity Preference
Due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand. CHAPTER 10 Aggregate Demand I

Money supply The supply of real money balances is fixed: r M/P
interest rate The supply of real money balances is fixed: We are assuming a fixed supply of real money balances because P is fixed by assumption (short-run), and M is an exogenous policy variable. M/P real money balances CHAPTER 10 Aggregate Demand I

Money demand Demand for real money balances: L (r ) r M/P interest
rate Demand for real money balances: L (r ) As we learned in chapter 4, the nominal interest rate is the opportunity cost of holding money (instead of bonds), so money demand depends negatively on the nominal interest rate. Here, we are assuming the price level is fixed, so  = 0 and r = i. M/P real money balances CHAPTER 10 Aggregate Demand I

Equilibrium r interest rate The interest rate adjusts to equate the supply and demand for money: r1 L (r ) M/P real money balances CHAPTER 10 Aggregate Demand I

How the Fed raises the interest rate
To increase r, Fed reduces M r2 r1 L (r ) M/P real money balances CHAPTER 10 Aggregate Demand I

CASE STUDY: Monetary Tightening & Interest Rates
Late 1970s:  > 10% Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflation Aug 1979-April 1980: Fed reduces M/P 8.0% Jan 1983:  = 3.7% This and the next slide summarize the case study on p The data source is given on the next slide. At this point, students have now learned two theories about the effects of monetary policy on interest rates. This case study shows them that both theories are relevant, using a real-world example to remind students that the classical theory of chapter 4 applies in the long-run while the liquidity preference theory applies in the short run. How do you think this policy change would affect nominal interest rates? CHAPTER 10 Aggregate Demand I

Monetary Tightening & Rates, cont.
prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long run short run Liquidity preference (Keynesian) Quantity theory, Fisher effect (Classical) sticky flexible Since prices are sticky in the short run, the Liquidity Preference Theory predicts that both the nominal and real interest rates will rise in the short run. And in fact, both did. (However, the inflation rate was not zero, and in fact it increased, so the real interest rate didn’t rise as much as the nominal interest rate did during the period shown.) In the long run, the Quantity Theory of Money says that the monetary tightening should reduce inflation. The Fisher Effect says that the fall in  should cause an equal fall in i. By January of 1983 (which is “the long run” from the viewpoint of 1979), inflation and nominal interest rates had fallen. (However, they did not fall by equal amounts. This doesn’t contradict the Fisher Effect, though, as other economic changes caused movements in the real interest rate.) About the data: i = 3-month rate on Commercial Paper % change in M/P from previous slide: I computed M1/CPI (the measure used in the case study), then computed the percentage change in M1/CPI over the 8-month period beginning with the month in which Volcker became the Fed chairman, August 1979. Source: FRED database, Federal Reserve Bank of St. Louis. i > 0 i < 0 8/1979: i = 10.4% 4/1980: i = 15.8% 8/1979: i = 10.4% 1/1983: i = 8.2%

The LM curve Now let’s put Y back into the money demand function:
The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: CHAPTER 10 Aggregate Demand I

Deriving the LM curve L (r , Y2 ) L (r , Y1 ) r r LM Y1 Y2 r2 r2 r1 r1
(a) The market for real money balances (b) The LM curve L (r , Y1 ) M/P r r Y LM Y1 Y2 r2 r2 r1 r1 CHAPTER 10 Aggregate Demand I

Why the LM curve is upward sloping
An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. This slide simply states the intuition behind the graphs on the preceding slide. Suggestion: Omit this slide from your presentation, and just give the students this information verbally as you present the preceding slide. CHAPTER 10 Aggregate Demand I

How M shifts the LM curve
(a) The market for real money balances (b) The LM curve L (r , Y1 ) M/P r r Y LM2 Y1 LM1 r2 r2 r1 If you’re as anal as I am, you might consider helping your students understand the analytical difference between looking at a shift as a horizontal shift and looking at it as a vertical shift. We can think of the LM curve shift as a vertical shift: When the Fed reduces M, the vertical distance of the shift tells us what happens to the equilibrium interest rate associated with a given value of income. Or, we can think of the LM curve shifting horizontally: When the Fed reduces M, the horizontal distance of the shift tells us what would have to happen to income to restore money market equilibrium at the initial interest rate. (The graphical analysis would be a little different than what’s depicted on this slide.) r1 CHAPTER 10 Aggregate Demand I

Exercise: Shifting the LM curve
Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the liquidity preference model to show how these events shift the LM curve. Answer: This causes an increase in money demand. In the Liquidity Preference diagram, the money demand curve shifts up. Hence, at the the initial value of income, the interest rate must rise to restore equilibrium in the money market. As a result, the LM curve shifts up: each value of income (such as the initial income) is associated with a higher interest rate than before. CHAPTER 10 Aggregate Demand I

The short-run equilibrium
The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y r LM IS Equilibrium interest rate Equilibrium level of income CHAPTER 10 Aggregate Demand I

The Big Picture Keynesian Cross IS curve IS-LM model
Explanation of short-run fluctuations Theory of Liquidity Preference LM curve Agg. demand curve Model of Agg. Demand and Agg. Supply Figure 10-15, p.300. This schematic diagram shows how the different pieces of the theory of short-run fluctuations fit together. Agg. supply curve CHAPTER 10 Aggregate Demand I

Preview of Chapter 11 In Chapter 11, we will
use the IS-LM model to analyze the impact of policies and shocks. learn how the aggregate demand curve comes from IS-LM. use the IS-LM and AD-AS models together to analyze the short-run and long-run effects of shocks. use our models to learn about the Great Depression. This slide serves as a bridge between this chapter and the next one. CHAPTER 10 Aggregate Demand I

Chapter Summary basic model of income determination
Keynesian cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income. IS curve comes from Keynesian cross when planned investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services CHAPTER 10 Aggregate Demand I slide 511

Chapter Summary basic model of interest rate determination
Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rate LM curve comes from liquidity preference theory when money demand depends positively on income shows all combinations of r and Y that equate demand for real money balances with supply CHAPTER 10 Aggregate Demand I slide 512

Chapter Summary IS-LM model
Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets. CHAPTER 10 Aggregate Demand I slide 513

Aggregate Demand II: Applying the IS -LM Model
11 Aggregate Demand II: Applying the IS -LM Model This is a very substantial chapter, and among the most challenging in the text. I encourage you to go over this chapter a little more slowly than average, or at least recommend to your students that they study it extra carefully. I have included a number of in-class exercises to give students immediate reinforcement of concepts as they are covered, and also to break up the lecture. If you need to get through the material more quickly, you can omit some or all of these exercises (perhaps assigning them as homeworks, instead). A graph unfolds on slides If you create handouts of this file for your students (or create a PDF version for them to download from the web), you might consider omitting slides 30 and 32 to save paper, as they contain intermediate animations.

Context Chapter 9 introduced the model of aggregate demand and supply.
Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve. CHAPTER 11 Aggregate Demand II

how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy how to derive the aggregate demand curve from the IS-LM model several theories about what caused the Great Depression CHAPTER 11 Aggregate Demand II

Equilibrium in the IS -LM model
The IS curve represents equilibrium in the goods market. Y r LM IS r1 The LM curve represents money market equilibrium. Review/recap of the very end of Chapter 10. Y1 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. CHAPTER 11 Aggregate Demand II

Policy analysis with the IS -LM model
r LM IS We can use the IS-LM model to analyze the effects of fiscal policy: G and/or T monetary policy: M r1 Y1 CHAPTER 11 Aggregate Demand II

An increase in government purchases
1. IS curve shifts right Y r LM causing output & income to rise. IS2 IS1 r2 Y2 2. r1 Y1 2. This raises money demand, causing the interest rate to rise… 1. Chapter 10 showed that an increase in G causes the IS curve to shift to the right by (G)/(1-MPC). 3. …which reduces investment, so the final increase in Y 3. CHAPTER 11 Aggregate Demand II

A tax cut Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G… and the IS curve shifts by Y r LM IS2 IS1 r2 2. Y2 r1 Y1 1. 1. Chapter 10 used the Keynesian Cross to show that a decrease in T causes the IS curve to shift to the right by (-MPCT)/(1-MPC). If your students ask why the IS curve shifts to the right when there’s a negative sign in the expression for the shift, remind them that T < 0 for a tax cut, so the expression actually is positive. The term showing the distance of the shift in the IS curve is almost the same as in the case of a government spending increase, where the numerator of the fraction equals (1) for government spending rather than (-MPC) for the tax cut. Here’s the intuition: Every dollar of a government spending increase adds to aggregate spending. However, for tax cuts, the fraction (1-MPC) of the tax cut leaks into saving, so aggregate spending only rises by MPC times the tax cut. …so the effects on r and Y are smaller for T than for an equal G. 2. 2. CHAPTER 11 Aggregate Demand II

Monetary policy: An increase in M
1. M > 0 shifts the LM curve down (or to the right) LM1 LM2 IS r1 Y1 2. …causing the interest rate to fall r2 Y2 3. …which increases investment, causing output & income to rise. Chapter 10 showed that an increase in M shifts the LM curve to the right. Here is a richer explanation for the LM shift: The increase in M causes the interest rate to fall. [People like to keep optimal proportions of money and bonds in their portfolios; if money is increased, then people try to re-attain their optimal proportions by “exchanging” some of the money for bonds: they use some of the extra money to buy bonds. This increase in the demand for bonds drives up the price of bonds -- and causes interest rates to fall (since interest rates are inversely related to bond prices). The fall in the interest rate induces an increase in investment demand, which causes output and income to increase. The increase in income causes money demand to increase, which increases the interest rate (though doesn’t increase it all the way back to its initial value; instead, this effect simply reduces the total decrease in the interest rate). CHAPTER 11 Aggregate Demand II

Interaction between monetary & fiscal policy
Model: Monetary & fiscal policy variables (M, G, and T ) are exogenous. Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interaction may alter the impact of the original policy change. CHAPTER 11 Aggregate Demand II

The Fed’s response to G > 0
Suppose Congress increases G. Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant In each case, the effects of the G are different: CHAPTER 11 Aggregate Demand II

Response 1: Hold M constant
If Congress raises G, the IS curve shifts right. Y r LM1 IS2 IS1 If Fed holds M constant, then LM curve doesn’t shift. Results: r2 Y2 r1 Y1 CHAPTER 11 Aggregate Demand II

Response 2: Hold r constant
If Congress raises G, the IS curve shifts right. Y r LM1 IS2 LM2 IS1 To keep r constant, Fed increases M to shift LM curve right. r2 Y2 r1 Y1 Y3 Results: CHAPTER 11 Aggregate Demand II

Response 3: Hold Y constant
LM2 If Congress raises G, the IS curve shifts right. Y r LM1 Y1 IS2 r3 IS1 To keep Y constant, Fed reduces M to shift LM curve left. r2 Y2 r1 Results: CHAPTER 11 Aggregate Demand II

Estimates of fiscal policy multipliers
from the DRI macroeconometric model Estimated value of Y / G Estimated value of Y / T Assumption about monetary policy Fed holds money supply constant 0.60 0.26 The preceding slides show that the impact of fiscal policy on GDP depends on the Fed’s response (or lack thereof). This slide shows estimates of the fiscal policy multipliers under different assumptions about monetary policy; these estimates are consistent with the theoretical results on the preceding slides. First, the slide shows estimates of the government spending multiplier for the two different monetary policy scenarios. Then, the slide reveals the tax multiplier estimates. (If you wish, you can turn off the animation so that everything appearing on the slide appears at one time. Just click on the “Slide Show” pull-down menu, then on “Custom animation…”, then uncheck all of the boxes next to the elements of the screen that you do not wish to be animated. Regarding the estimates: First, note that the estimates of the fiscal policy multipliers are smaller (in absolute value) when the money supply is held constant than when the interest rate is held constant. This is consistent with the results from the IS-LM model presented in the preceding few slides. Second, notice that the tax multiplier is smaller than the government spending multiplier in each of the monetary policy scenarios. This should make sense from material presented earlier in this chapter: the government spending multiplier (for a constant money supply) is 1/(1-MPC), while the tax multiplier is only (-MPC)/(1-MPC). Fed holds nominal interest rate constant 1.93 1.19 CHAPTER 11 Aggregate Demand II

Shocks in the IS -LM model
IS shocks: exogenous changes in the demand for goods & services. Examples: stock market boom or crash  change in households’ wealth  C change in business or consumer confidence or expectations  I and/or C CHAPTER 11 Aggregate Demand II

Shocks in the IS -LM model
LM shocks: exogenous changes in the demand for money. Examples: a wave of credit card fraud increases demand for money. more ATMs or the Internet reduce money demand. CHAPTER 11 Aggregate Demand II

EXERCISE: Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of 1. a boom in the stock market that makes consumers wealthier. 2. after a wave of credit card fraud, consumers using cash more frequently in transactions. For each shock, a. use the IS-LM diagram to show the effects of the shock on Y and r. b. determine what happens to C, I, and the unemployment rate. Earlier slides showed how to use the IS-LM model to analyze fiscal and monetary policy. Now is a good time for students to get some hands-on practice with the model. Also, note that part (b) helps students learn that shocks and policies can potentially affect all of the model’s endogenous variables, not just the ones that are measured on the axes. After working this exercise, your students will better understand the case study on the 2001 U.S. recession that immediately follows. Suggestion: Instead of having students work on these exercises individually, get them into pairs. One student of each pair works on the first shock, the other student works on the second shock. Give them 5 minutes to work individually on the analysis of the shock. Then, allow 10 minutes (5 for each student) for students to present their results to their partners. This activity gives students immediate application and reinforcement of the concepts, so students learn them better and will then better understand and appreciate the remainder of your lecture on Chapter 11. Answers: 1a. The IS curve shifts to the right, because consumers feel they can afford to spend more given this exogenous increase in their wealth. This causes Y and r to rise. 1b. C rises for two reasons: the stock market boom, and the increase in income. I falls, because r is higher. u falls, because firms hire more workers to produce the extra output that is demanded. 2a. (This is a continuation of the in-class exercise at the end of the PowerPoint presentation of Chapter 10.) The increase in money demand shifts the LM curve to the left: We are assuming that all other exogenous variables, including M and P, remain unchanged, so an increase in money demand causes an increase in the value of r associated with each value of Y (this can be seen easily using the Liquidity Preference diagram). This translates to an upward (i.e. leftward) shift in the LM curve. This shift causes Y to fall and r to rise. 2b. The fall in income causes a fall in C. The increase in r causes a fall in I. The fall in Y causes an increase in u. CHAPTER 11 Aggregate Demand II

CASE STUDY: The U.S. recession of 2001
During 2001, 2.1 million people lost their jobs, as unemployment rose from 3.9% to 5.8%. GDP growth slowed to 0.8% (compared to 3.9% average annual growth during ). If you taught with the PowerPoints I did for the previous (orange) edition of this book, you will find that I have redone this case study. In addition to updating it to match the textbook, I have added two time-series graphs showing stock prices and the effects of the Fed’s policy response on short-term interest rates. CHAPTER 11 Aggregate Demand II

Causes: 1) Stock market decline  C 300 600 900 1200 1500 1995 1996 1997 1998 1999 2000 2001 2002 2003 Index (1942 = 100) Standard & Poor’s 500 Starting in mid-2000, the S&P 500 begins a downward trend. The fall in stock prices eroded the wealth of millions of U.S. consumers. They responded by reducing consumption. CHAPTER 11 Aggregate Demand II

Causes: 2) 9/11 increased uncertainty fall in consumer & business confidence result: lower spending, IS curve shifted left Causes: 3) Corporate accounting scandals Enron, WorldCom, etc. reduced stock prices, discouraged investment CHAPTER 11 Aggregate Demand II

Fiscal policy response: shifted IS curve right tax cuts in 2001 and 2003 spending increases airline industry bailout NYC reconstruction Afghanistan war The war was a response to the 9/11 attacks, not to the recession. But wars involve significant fiscal policy expansion, which increases aggregate demand and alleviates or ends recessions. CHAPTER 11 Aggregate Demand II

Monetary policy response: shifted LM curve right Three-month T-Bill Rate 1 2 3 4 5 6 7 01/01/2000 04/02/2000 07/03/2000 10/03/2000 01/03/2001 04/05/2001 07/06/2001 10/06/2001 01/06/2002 04/08/2002 07/09/2002 10/09/2002 01/09/2003 04/11/2003 Easier monetary policy shifted the LM curve to the right, causing interest rates to fall, as shown in this graph. CHAPTER 11 Aggregate Demand II

What is the Fed’s policy instrument?
The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates. In fact, the Fed targets the federal funds rate – the interest rate banks charge one another on overnight loans. The Fed changes the money supply and shifts the LM curve to achieve its target. Other short-term rates typically move with the federal funds rate. Chapter 18 discusses monetary policy in detail. CHAPTER 11 Aggregate Demand II

What is the Fed’s policy instrument?
Why does the Fed target interest rates instead of the money supply? 1) They are easier to measure than the money supply. 2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (See end-of-chapter Problem 7 on p.328.) CHAPTER 11 Aggregate Demand II

IS-LM and aggregate demand
So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed. However, a change in P would shift LM and therefore affect Y. The aggregate demand curve (introduced in Chap. 9) captures this relationship between P and Y. CHAPTER 11 Aggregate Demand II

Deriving the AD curve Intuition for slope of AD curve: P  (M/P )
Y r LM(P2) Intuition for slope of AD curve: P  (M/P )  LM shifts left  r  I  Y IS LM(P1) r2 r1 Y2 Y1 Y P P2 It might be useful to explain to students the reason why we draw P1 before drawing the LM curve: The position of the LM curve depends on the value of M/P. M is an exogenous policy variable. So, if P is low (like P1 in the lower panel of the diagram), then M/P is relatively high, so the LM curve is over toward the right in the upper diagram. If P is high, like P2, then M/P is relatively low, so the LM curve is more toward the left. Because the value of P affects the position of the LM curve, we label the LM curves in the upper panel as LM(P1) and LM(P2). P1 AD Y2 Y1 CHAPTER 11 Aggregate Demand II

Monetary policy and the AD curve
LM(M1/P1) The Fed can increase aggregate demand: M  LM shifts right IS LM(M2/P1) r1 Y1 r2 Y2  r Y P  I  Y at each value of P AD2 AD1 It’s worth taking a moment to explain why we are holding P fixed at P1: To find out whether the AD curve shifts to the left or right, we need to find out what happens to the value of Y associated with any given value of P. This is not to say that the equilibrium value of P will remain fixed after the policy change (though, in fact, we are assuming P is fixed in the short run). We just want to see what happens to the AD curve. Once we know how the AD curve shifts, we can then add the AS curves (short- or long-run) to find out what, if anything, happens to P (in the short- or long-run). P1 CHAPTER 11 Aggregate Demand II

Fiscal policy and the AD curve
Expansionary fiscal policy (G and/or T ) increases agg. demand: T  C  IS shifts right  Y at each value of P LM IS2 Y2 r2 IS1 Y1 r1 Y P AD2 AD1 P1 CHAPTER 11 Aggregate Demand II

IS-LM and AD-AS in the short run & long run
Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run equilibrium, if then over time, the price level will rise The next few slides put our IS-LM-AD in the context of the bigger picture - the AD-AS model in the short-run and long-run, which was introduced in Chapter 9. fall remain constant CHAPTER 11 Aggregate Demand II

The SR and LR effects of an IS shock
Y r LRAS LM(P1) IS1 A negative IS shock shifts IS and AD left, causing Y to fall. IS2 AD2 AD1 Y P LRAS SRAS1 P1 Abbreviation: SR = short run, LR = long run The analysis that begins on this slide continues on the following slides. CHAPTER 11 Aggregate Demand II

Y r LRAS LM(P1) IS2 In the new short-run equilibrium, IS1 Y P LRAS AD2 SRAS1 P1 AD1 CHAPTER 11 Aggregate Demand II

Y r LRAS LM(P1) IS2 In the new short-run equilibrium, IS1 Over time, P gradually falls, which causes SRAS to move down. M/P to increase, which causes LM to move down. Y P LRAS AD2 SRAS1 P1 AD1 CHAPTER 11 Aggregate Demand II

Y r LRAS LM(P1) SRAS2 P2 LM(P2) IS2 IS1 Over time, P gradually falls, which causes SRAS to move down. M/P to increase, which causes LM to move down. Y P LRAS AD2 SRAS1 P1 AD1 CHAPTER 11 Aggregate Demand II

Y r LRAS LM(P1) SRAS2 P2 LM(P2) IS2 This process continues until economy reaches a long-run equilibrium with IS1 Y P LRAS AD2 SRAS1 A good thing to do: Go back through this experiment again, and see if your students can figure out what is happening to the other endogenous variables (C, I, u) in the short run and long run. P1 AD1 CHAPTER 11 Aggregate Demand II

EXERCISE: Analyze SR & LR effects of M
Draw the IS-LM and AD-AS diagrams as shown here. Suppose Fed increases M. Show the short-run effects on your graphs. Show what happens in the transition from the short run to the long run. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y r LRAS LM(M1/P1) IS Y P AD1 LRAS This exercise has two objectives: 1. To give students immediate reinforcement of the preceding concepts. 2. To show them that money is neutral in the long run, just like in chapter 4. You might have your students try other exercises using this framework: * the short-run and long-run effects of expansionary fiscal policy. Have them compare the long-run results in this framework with the results they obtained when doing the same experiment in Chapter 3 (the loanable funds model). * Immediately after a negative shock pushes output below its natural rate, show how monetary or fiscal policy can be used to restore full-employment immediately (i.e., without waiting for prices to adjust). SRAS1 P1 CHAPTER 11 Aggregate Demand II

Unemployment (right scale)
The Great Depression 240 30 Unemployment (right scale) 220 25 200 20 billions of 1958 dollars 180 percent of labor force 15 160 10 This chart presents data from Table 11-2 on pp of the text. For data sources, see notes accompanying that table. Things to note: 1. The magnitude of the fall in output and increase in unemployment. In 1933, the unemployment rate is over 25%!! 2. There’s a very strong negative correlation between output and unemployment. Real GNP (left scale) 140 5 120 1929 1931 1933 1935 1937 1939 CHAPTER 11 Aggregate Demand II

THE SPENDING HYPOTHESIS: Shocks to the IS curve
asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IS curve. evidence: output and interest rates both fell, which is what a leftward IS shift would cause. CHAPTER 11 Aggregate Demand II

THE SPENDING HYPOTHESIS: Reasons for the IS shift
Stock market crash  exogenous C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71% Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment Contractionary fiscal policy Politicians raised tax rates and cut spending to combat increasing deficits. In item 2, I’m using the term “correction” in the stock market sense. CHAPTER 11 Aggregate Demand II

THE MONEY HYPOTHESIS: A shock to the LM curve
asserts that the Depression was largely due to huge fall in the money supply. evidence: M1 fell 25% during But, two problems with this hypothesis: P fell even more, so M/P actually rose slightly during nominal interest rates fell, which is the opposite of what a leftward LM shift would cause. CHAPTER 11 Aggregate Demand II

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices
asserts that the severity of the Depression was due to a huge deflation: P fell 25% during This deflation was probably caused by the fall in M, so perhaps money played an important role after all. In what ways does a deflation affect the economy? CHAPTER 11 Aggregate Demand II

The stabilizing effects of deflation: P  (M/P )  LM shifts right  Y Pigou effect: P  (M/P )  consumers’ wealth   C  IS shifts right  Y CHAPTER 11 Aggregate Demand II

The destabilizing effects of expected deflation:  e  r  for each value of i  I  because I = I (r )  planned expenditure & agg. demand   income & output  The textbook (starting p.322) uses an “extended” IS-LM model, which includes both the nominal interest rate (measured on the vertical axis) and the real interest rate (which equals the nominal rate less expected inflation). Because money demand depends on the nominal rate, which is measured on the vertical axis, the change in expected inflation doesn’t shift the LM curve. However, investment depends on the real interest rate, so the fall in expected inflation shifts the IS curve: each value of i is now associated with a higher value of r, which reduces investment and shifts the IS curve to the left. Results: income falls, i falls, and r rises --- which is exactly what happened from 1929 to 1931 (see table 11-2 on pp.318-9). This slide gives the basic intuition, which students often can grasp more quickly and easily than the graphical analysis. After you cover this material in your lecture, it will be easier for your students to grasp the analysis on pp CHAPTER 11 Aggregate Demand II

The destabilizing effects of unexpected deflation: debt-deflation theory P (if unexpected)  transfers purchasing power from borrowers to lenders  borrowers spend less, lenders spend more  if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls CHAPTER 11 Aggregate Demand II

Why another Depression is unlikely
Policymakers (or their advisors) now know much more about macroeconomics: The Fed knows better than to let M fall so much, especially during a contraction. Fiscal policymakers know better than to raise taxes or cut spending during a contraction. Federal deposit insurance makes widespread bank failures very unlikely. Automatic stabilizers make fiscal policy expansionary during an economic downturn. Examples of automatic stabilizers: the income tax: people pay less taxes automatically if their income falls unemployment insurance: prevents income - and hence spending - from falling as much during a downturn This topic is discussed in Chapter 14. CHAPTER 11 Aggregate Demand II

Chapter Summary 1. IS-LM model a theory of aggregate demand
exogenous: M, G, T, P exogenous in short run, Y in long run endogenous: r, Y endogenous in short run, P in long run IS curve: goods market equilibrium LM curve: money market equilibrium CHAPTER 11 Aggregate Demand II slide 558

Chapter Summary 2. AD curve
shows relation between P and the IS-LM model’s equilibrium Y. negative slope because P  (M/P )  r  I  Y expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right. expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right. IS or LM shocks shift the AD curve. CHAPTER 11 Aggregate Demand II slide 559

12 The Open Economy Revisited: the Mundell-Fleming Model and the Exchange-Rate Regime Chapter 12 covers a lot of material. First, it develops the Mundell-Fleming open-economy IS-LM model for a small open economy with perfect capital mobility. The model is used to analyze the effects of fiscal, monetary, and trade policy under floating and flexible exchange rates. Then, the chapter explores interest rate differentials, or risk premia that arise due to country risk or expected changes in exchange rates. The Mundell-Fleming model is used to analyze the effects of a change in the risk premium. The Mexican Peso Crisis is an important real-world example of this. The chapter summarizes the debate over fixed vs. floating exchange rates. Following that discussion, the Mundell-Fleming model is used to derive the aggregate demand curve for a small open economy. And finally, the chapter discusses how the results it derives would be different in a large open economy. To reinforce this material, I strongly recommend you to allow a bit of class time for a few in-class exercises (I’ve suggested several in the lecture notes accompanying some of the slides in this presentation), and that you assign a homework consisting of several of the end-of-chapter “Questions for Review” and “Problems and Applications” in the textbook.

the Mundell-Fleming model (IS-LM for the small open economy) causes and effects of interest rate differentials arguments for fixed vs. floating exchange rates how to derive the aggregate demand curve for a small open economy CHAPTER 12 The Open Economy Revisited

The Mundell-Fleming model
Key assumption: Small open economy with perfect capital mobility. r = r* Goods market equilibrium – the IS* curve: In this and the following sections (in which we analyze policies with the M-F model), we assume the price level is fixed---just as we did when we first used the closed economy IS-LM model to do policy analysis in chapter 11. As we learned in chapter 5, NX depends on the real exchange rate. However, with price levels fixed, the real & nominal exchange rates move together. So, for simplicity, we write NX as a function of the nominal exchange rate here. (At the end of this chapter, when we use M-F to derive the aggregate demand curve, we go back to writing NX as a function of the real exchange rate, because the nominal & real exchange rates may behave differently when the price level is changing.) Chapter 5 introduced the notation r* for the world interest rate, and explained why r = r* in a small open economy with perfect capital mobility. Perfect capital mobility means that there are no restrictions on the international flow of financial capital: the country’s residents can borrow or lend as much as they wish in the world financial markets; and because the country is small, the amount its residents borrow or lend in the world financial market has no impact on the world interest rate. Chapter 5 also explained why net exports depend negatively on the exchange rate. where e = nominal exchange rate = foreign currency per unit domestic currency CHAPTER 12 The Open Economy Revisited

The IS* curve: Goods market eq’m
The IS* curve is drawn for a given value of r*. Intuition for the slope: Y e IS* Again, “eq’m” is an abbreviation for “equilibrium.” The text (p.337) shows how the Keynesian Cross can be used to derive the IS* curve. Suggestion: Before continuing, ask your students to figure out what happens to this IS* curve if taxes are reduced. Answer: The IS* curve shifts rightward (i.e., upward). Explanation: Start at any point on the initial IS* curve. At this point, initially, Y = C + I + G + NX. Now cut taxes. At the initial value of Y, disposable income is higher, causing consumption to be higher. Other things equal, the goods market is out of whack: C + I + G + NX > Y. An increase in Y (of just the right amount) would restore equilibrium. Hence, each value of e is associated with a larger value of Y. OR, a decrease in NX of just the right amount would restore equilibrium at the initial value of Y. But the decrease in NX requires an increase in e. Hence, each value of Y is associated with a higher value of e. Rationale: Doing this exercise now will break up your lecture, and will prepare students for the fiscal policy experiment that is coming up in just a few slides. CHAPTER 12 The Open Economy Revisited

The LM* curve: Money market eq’m
is drawn for a given value of r*. is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e. Y e LM* The text (p.316) shows how the LM curve in (Y,r) space, together with the fixed r*, determines the value of Y at which the LM* curve here is vertical. Suggestion: Before continuing, ask your students to figure out what happens to this LM* curve if the money supply is increased. Answer: LM* shifts to the right. Explanation: The equation for the LM* curve is: M/P = L(r*, Y) P is fixed, r* is exogenous, the central bank sets M, then Y must adjust to equate money demand (L) with money supply (M/P). Now, if M is raised, then money demand must rise to restore equilibrium (remember: P is fixed). A fall in r would cause money demand to rise, but in a small open economy, r = r* is exogenous. Hence, the only way to restore equilibrium is for Y to rise. Rationale: Doing this exercise now will break up your lecture, and will prepare students for the monetary policy experiment that is coming up in just a few slides. CHAPTER 12 The Open Economy Revisited

Equilibrium in the Mundell-Fleming model
Y e LM* IS* equilibrium exchange rate equilibrium level of income CHAPTER 12 The Open Economy Revisited

Floating & fixed exchange rates
In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. Next, policy analysis – first, in a floating exchange rate system then, in a fixed exchange rate system CHAPTER 12 The Open Economy Revisited

Fiscal policy under floating exchange rates
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. e2 e1 Intuition for the shift in IS*: At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that equates planned expenditure with actual expenditure. Intuition for the results: As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s interest rate. In a small open economy with perfect capital mobility, as soon as the domestic interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference. But in order for foreigners to buy these U.S. bonds, they must first acquire U.S. dollars. Hence, the capital inflows cause an increase in foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate. This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion. How do we know that Y = 0? Because maintaining equilibrium in the money market requires that Y be unchanged: the fiscal expansion does not affect either the real money supply (M/P) or the world interest rate (because this economy is “small”). Hence, any change in income would throw the money market out of whack. So, the exchange rate has to rise until NX has fallen enough to perfectly offset the expansionary impact of the fiscal policy on output. Results: e > 0, Y = 0 Y1 CHAPTER 12 The Open Economy Revisited

Lessons about fiscal policy
In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out” closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate. CHAPTER 12 The Open Economy Revisited

Monetary policy under floating exchange rates
An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. e1 Suggestion: Treat this experiment as an in-class exercise. Display the graph with the initial equilibrium. Then give students 2-3 minutes to use the model to determine the effects of an increase in M on e and Y. Intuition for the rightward LM* shift: At the initial (r*,Y), an increase in M throws the money market out of whack. To restore equilibrium, either Y must rise or the interest rate must fall, or some combination of the two. In a small open economy, though, the interest rate cannot fall. So Y must rise to restore equilibrium in the money market. Intuition for the results: Initially, the increase in the money supply puts downward pressure on the interest rate. (In a closed economy, the interest rate would fall.) Because the economy is small and open, when the interest rate tries to fall below r*, savers send their loanable funds to the world financial market. This capital outflow causes the exchange rate to fall, which causes NX --- and hence Y --- to increase. e2 Results: e < 0, Y > 0 Y2 CHAPTER 12 The Open Economy Revisited

Lessons about monetary policy
Monetary policy affects output by affecting the components of aggregate demand: closed economy: M  r  I  Y small open economy: M  e  NX  Y Expansionary mon. policy does not raise world agg. demand, it merely shifts demand from foreign to domestic products. So, the increases in domestic income and employment are at the expense of losses abroad. Suggestion: Before revealing the text on this slide, ask students to take out a piece of paper and answer this question: “Contrast the way in which monetary policy affects output in the closed economy with the small open economy.” Or something to that effect. CHAPTER 12 The Open Economy Revisited

Trade policy under floating exchange rates
At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. e2 Intuition for results: At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to domestic goods. The reduction in their demand for foreign goods causes a corresponding reduction in the supply of the country’s currency in the foreign exchange market. This causes the exchange rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of NX. How do we know that the effect of the appreciation on NX exactly cancels out the effect of the import restriction on NX? There is only one value of Y that allows the money market to clear; since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged. Or looking at it differently: As we learned in chapter 5, the accounting identities say that NX = S - I. The import restriction does not affect S or I, so it cannot affect the equilibrium value of NX. Results: e > 0, Y = 0 CHAPTER 12 The Open Economy Revisited

Lessons about trade policy
Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade: the trade restriction reduces imports. the exchange rate appreciation reduces exports. Less trade means fewer “gains from trade.” CHAPTER 12 The Open Economy Revisited

Lessons about trade policy, cont.
Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Also, import restrictions create “sectoral shifts,” which cause frictional unemployment. Import restrictions cause a sectoral shift, a shift in demand from export-producing sectors to import-competing sectors. As we learned in chapter 6, sectoral shifts contribute to the natural rate of unemployment, because displaced workers in declining sectors take time to be matched with appropriate jobs in other sectors. CHAPTER 12 The Open Economy Revisited

Fixed exchange rates Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate. This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed. CHAPTER 12 The Open Economy Revisited

Fiscal policy under fixed exchange rates
Under floating rates, a fiscal expansion would raise e. Under floating rates, fiscal policy is ineffective at changing output. Under fixed rates, fiscal policy is very effective at changing output. Y e To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. e1 Results: e = 0, Y > 0 Y1 Y2 CHAPTER 12 The Open Economy Revisited

Monetary policy under fixed exchange rates
An increase in M would shift LM* right and reduce e. Under floating rates, monetary policy is very effective at changing output. Under fixed rates, monetary policy cannot be used to affect output. Y e Y1 e1 To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. The monetary expansion puts downward pressure on the exchange rate. To prevent it from falling, the central bank starts buying domestic currency in greater quantities to “prop up” the value of the currency in foreign exchange markets. This buying removes domestic currency from circulation, causing the money supply to fall, which shifts the LM* curve back. Another way of looking at it: To keep the exchange rate fixed, the central bank must use monetary policy to shift LM* as required so that the intersection of LM* and IS* always occurs at the desired exchange rate. Unless the IS* curve shifts right (an experiment we are not considering now), the central bank simply cannot increase the money supply. Results: e = 0, Y = 0 CHAPTER 12 The Open Economy Revisited

Trade policy under fixed exchange rates
Under floating rates, import restrictions do not affect Y or NX. Under fixed rates, import restrictions increase Y and NX. But, these gains come at the expense of other countries: the policy merely shifts demand from foreign to domestic goods. A restriction on imports puts upward pressure on e. Y e Y1 e1 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Suggestion: Assign this experiment as an in-class exercise. Give students 3 minutes to work on it before displaying the answer on the screen. Results: e = 0, Y > 0 Y2 CHAPTER 12 The Open Economy Revisited

Summary of policy effects in the Mundell-Fleming model
type of exchange rate regime: floating fixed impact on: Policy Y e NX fiscal expansion   mon. expansion import restriction Table 12-1 on p (“M-F” = “Mundell-Fleming”) This table makes it easy to see that the effects of policies depend very much on whether exchange rates are fixed or flexible. CHAPTER 12 The Open Economy Revisited

Interest-rate differentials
Two reasons why r may differ from r* country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk. expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation. CHAPTER 12 The Open Economy Revisited

Differentials in the M-F model
where  (Greek letter “theta”) is a risk premium, assumed exogenous. Substitute the expression for r into the IS* and LM* equations: The first equation says that a country’s interest rate equals the world interest rate plus a risk premium (whose size depends on investors’ perceptions of the political & economic risk of holding that country’s assets and on the expected rate of depreciation or appreciation of the country’s currency. We can now use the M-F model to analyze the effects of a change in the risk premium. The next few slides present this analysis, then discuss an important real-world example (the Mexican peso crisis). CHAPTER 12 The Open Economy Revisited

The effects of an increase in 
IS* shifts left, because   r  I Y e Y1 e1 LM* shifts right, because   r  (M/P)d, so Y must rise to restore money market eq’m. Intuition: If prospective lenders expect the country’s currency to depreciation, or if they perceive that the country’s assets are especially risky, then they will demand that borrowers in that country pay them a higher interest rate (over and above r*). The higher interest rate reduces investment and shifts the IS* curve to the left. But it also lowers money demand, so income must rise to restore money market equilibrium. Why does the exchange rate fall? The increase in the risk premium causes foreign investors to sell some of their holdings of domestic assets and pull their ‘loanable funds’ out of the country. The capital outflow causes an increase in the supply of domestic currency in the foreign exchange market, which causes the fall in the exchange rate. Or, in simpler terms, an increase in country risk or an expected depreciation makes holding the country’s currency less desirable. e2 Results: e < 0, Y > 0 Y2 CHAPTER 12 The Open Economy Revisited

The effects of an increase in 
The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive. Note: an expected depreciation is a self-fulfilling prophecy. The increase in Y occurs because the boost in NX (from the depreciation) is greater than the fall in I (from the rise in r ). CHAPTER 12 The Open Economy Revisited

Why income might not rise
The central bank may try to prevent the depreciation by reducing the money supply. The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply). Consumers might respond to the increased risk by holding more money. Each of the above would shift LM* leftward. The result that income rises when the risk premium rises seems counter-intuitive and inaccurate. This slide explains why the increase in the risk premium may cause other things to occur that prevent income from rising, and may even cause income to fall. CHAPTER 12 The Open Economy Revisited

CASE STUDY: The Mexican peso crisis
Mexico’s central bank had maintained a fixed exchange rate with the U.S. dollar at about 29 cents per peso. CHAPTER 12 The Open Economy Revisited

CASE STUDY: The Mexican peso crisis
In the week before Christmas 1994, the central bank abandoned the fixed exchange rate, allowing the peso’s value to “float.” In just one week, the peso lost nearly 40% of its value, and fell further during the following months. CHAPTER 12 The Open Economy Revisited

The Peso crisis didn’t just hurt Mexico
U.S. goods more expensive to Mexicans U.S. firms lost revenue Hundreds of bankruptcies along U.S.-Mexican border Mexican assets worth less in dollars Reduced wealth of millions of U.S. citizens The purpose of this slide is to motivate the topic. Even though this occurred in another country some years ago, it was very important for the U.S. The parents of many of your students probably held Mexican assets (indirectly through mutual funds in their 401k accounts and pension funds, which viewed Mexico very favorably prior to the crisis) and took losses when the crisis occurred. CHAPTER 12 The Open Economy Revisited

Understanding the crisis
In the early 1990s, Mexico was an attractive place for foreign investment. During 1994, political developments caused an increase in Mexico’s risk premium ( ): peasant uprising in Chiapas assassination of leading presidential candidate Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (r* > 0) When the last line displays, it might be helpful to note that, from Mexico’s viewpoint, the U.S. interest rate is r*. CHAPTER 12 The Open Economy Revisited

Understanding the crisis
These events put downward pressure on the peso. Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to “prop up” the peso exchange rate. Doing this requires that Mexico’s central bank have adequate reserves of dollars. Did it? We have already seen why an increase in a country’s risk premium causes its exchange rate to fall. One could also use the M-F model to show that an increase in r* also causes the exchange rate to fall. The intuition is as follows: An increase in foreign interest rates causes capital outflows: investors shift some of their funds out of the country to take advantage of higher returns abroad. This capital outflow causes the exchange rate to fall as it implies an increase in the supply of the country’s currency in the foreign exchange market. CHAPTER 12 The Open Economy Revisited

Dollar reserves of Mexico’s central bank
December 1993 ……………… $28 billion August 17, 1994 ……………… $17 billion December 1, 1994 …………… $ 9 billion December 15, 1994 ………… $ 7 billion Defending the peso in the face of large capital outflows was draining the reserves of Mexico’s central bank. (August 17, 1994 was the date of the presidential election.) Ask your students if they can figure out why Mexico’s central bank didn’t tell anybody it was running out of reserves. The answer: If people had known that the reserves were dwindling, then they would also have known that the central bank would soon have to devalue or abandon the fixed exchange rate altogether. They would have expected the peso to fall, which would have caused a further increase in Mexico’s risk premium, which would have put even more downward pressure on Mexico’s exchange rate and made it even harder for the central bank to “defend the peso.” Source (not only for the data on this slide, but some of the other information in this case study): Washington Post National Weekly Edition, pp8‑9, Feb 20‑ , various issues of The Economist in Jan & Feb '95. During 1994, Mexico’s central bank hid the fact that its reserves were being depleted. CHAPTER 12 The Open Economy Revisited

 the disaster  Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents) Investors are SHOCKED! – they had no idea Mexico was running out of reserves. , investors dump their Mexican assets and pull their capital out of Mexico. Dec. 22: central bank’s reserves nearly gone. It abandons the fixed rate and lets e float. In a week, e falls another 30%. CHAPTER 12 The Open Economy Revisited

The rescue package 1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt. This helped restore confidence in Mexico, reduced the risk premium. After a hard recession in 1995, Mexico began a strong recovery from the crisis. The case study on pp gives more detail on the peso crisis. CHAPTER 12 The Open Economy Revisited

CASE STUDY: The Southeast Asian crisis 1997-98
Problems in the banking system eroded international confidence in SE Asian economies. Risk premiums and interest rates rose. Stock prices fell as foreign investors sold assets and pulled their capital out. Falling stock prices reduced the value of collateral used for bank loans, increasing default rates, which exacerbated the crisis. Capital outflows depressed exchange rates. This and the following slide correspond to the case study on pp CHAPTER 12 The Open Economy Revisited

Data on the SE Asian crisis
exchange rate % change from 7/97 to 1/98 stock market % change from 7/97 to 1/98 nominal GDP % change Indonesia -59.4% -32.6% -16.2% Japan -12.0% -18.2% -4.3% Malaysia -36.4% -43.8% -6.8% Singapore -15.6% -36.0% -0.1% S. Korea -47.5% -21.9% -7.3% Taiwan -14.6% -19.7% n.a. Thailand -48.3% -25.6% -1.2% U.S. 2.7% 2.3% CHAPTER 12 The Open Economy Revisited

Floating vs. fixed exchange rates
Argument for floating rates: allows monetary policy to be used to pursue other goals (stable growth, low inflation). Arguments for fixed rates: avoids uncertainty and volatility, making international transactions easier. disciplines monetary policy to prevent excessive money growth & hyperinflation. CHAPTER 12 The Open Economy Revisited

The Impossible Trinity
A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously. A nation must choose one side of this triangle and give up the opposite corner. Free capital flows Independent monetary policy Fixed exchange rate Option 1 (U.S.) Option 2 (Hong Kong) This slide corresponds to new material in the 6th edition, on pp “Option 1” is allowing free capital flows and maintaining independent monetary policy, but giving up a fixed exchange rate. An example of a country that chooses this option is the United States. “Option 2” is allowing free capital flows keeping a fixed exchange rate, but giving up independent monetary policy. A country that chooses this option is Hong Kong. “Option 3” is keeping monetary policy independent, yet fixing the exchange rate. Doing this requires limiting capital flows. An example of a country that practices this option is China. Option 3 (China) CHAPTER 12 The Open Economy Revisited

CASE STUDY: The Chinese Currency Controversy
: China fixed its exchange rate at 8.28 yuan per dollar, and restricted capital flows. Many observers believed that the yuan was significantly undervalued, as China was accumulating large dollar reserves. U.S. producers complained that China’s cheap yuan gave Chinese producers an unfair advantage. President Bush asked China to let its currency float; Others in the U.S. wanted tariffs on Chinese goods. This slide corresponds to new material in the 6th edition, on pp CHAPTER 12 The Open Economy Revisited

CASE STUDY: The Chinese Currency Controversy
If China lets the yuan float, it may indeed appreciate. However, if China also allows greater capital mobility, then Chinese citizens may start moving their savings abroad. Such capital outflows could cause the yuan to depreciate rather than appreciate. This slide corresponds to new material in the 6th edition, on pp CHAPTER 12 The Open Economy Revisited

Mundell-Fleming and the AD curve
So far in M-F model, P has been fixed. Next: to derive the AD curve, consider the impact of a change in P in the M-F model. We now write the M-F equations as: Net exports really depend on the real exchange rate, not the nominal exchange rate. Earlier in the chapter, we wrote NX as a function of the nominal rate, because the price level was assumed fixed, so the nominal & real rates always moved together. But now, with the price level changing also, we need to write NX as a function of the real exchange rate. (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .) CHAPTER 12 The Open Economy Revisited

Deriving the AD curve Why AD curve has negative slope: P  (M/P)
 LM*(P2) LM*(P1) Why AD curve has negative slope: IS* 2 1 P  (M/P)  LM shifts left Y2 Y1 Y P   P2 Like figure on p.362, except here we are showing what happens to Y when P increases (not falls). The derivation of the open economy AD curve is very similar to that of the closed economy AD curve (see chapter 11).  NX P1  Y AD Y2 Y1 CHAPTER 12 The Open Economy Revisited

From the short run to the long run
Y  P IS* AD LRAS LM*(P2) P2 SRAS2 LM*(P1) then there is downward pressure on prices. 1 2 Over time, P will move down, causing (M/P )   NX  Y  P1 SRAS1 Figure on p.363. Suggestion: Have your students draw the two panels of the diagram on this screen, with the economy in an initial equilibrium with output equal to its natural rate. Then, have them use their diagrams to analyze the short-run and long-run effects of a negative IS* shock. CHAPTER 12 The Open Economy Revisited

Large: Between small and closed
Many countries – including the U.S. – are neither closed nor small open economies. A large open economy is between the polar cases of closed & small open. Consider a monetary expansion: Like in a closed economy, M > 0  r  I (though not as much) Like in a small open economy, M > 0    NX (though not as much) For more details, see the Appendix to chapter 12 (not included in this PowerPoint presentation). CHAPTER 12 The Open Economy Revisited

Chapter Summary the IS-LM model for a small open economy.
1. Mundell-Fleming model the IS-LM model for a small open economy. takes P as given. can show how policies and shocks affect income and the exchange rate. 2. Fiscal policy affects income under fixed exchange rates, but not under floating exchange rates. CHAPTER 12 The Open Economy Revisited slide 602

Chapter Summary affects income under floating exchange rates.
3. Monetary policy affects income under floating exchange rates. under fixed exchange rates, monetary policy is not available to affect output. 4. Interest rate differentials exist if investors require a risk premium to hold a country’s assets. An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate. CHAPTER 12 The Open Economy Revisited slide 603

Chapter Summary 5. Fixed vs. floating exchange rates Under floating rates, monetary policy is available for can purposes other than maintaining exchange rate stability. Fixed exchange rates reduce some of the uncertainty in international transactions. CHAPTER 12 The Open Economy Revisited slide 604

13 Aggregate Supply and the Short-run Tradeoff Between Inflation and Unemployment Chapter 13 has two parts. The first concerns aggregate supply. In the preceding chapters, we made the simple and extreme assumption that all prices were “stuck” in the short run. This assumption implied a horizontal short-run aggregate supply curve. More realistic models of aggregate supply imply an upward-sloping SRAS curve. Chapter 13 presents three of the most prominent models. The second half of the chapter is devoted to the Phillips curve and related issues. The section uses a few lines of algebra to derives an expression for the Phillips curve from the SRAS equation. This is followed by a discussion of adaptive and rational expectations, and the sacrifice ratio. The chapter concludes by contrasting the notion of hysteresis to the natural rate hypothesis. To help your students master the material, it would be helpful to assign homework or in-class exercises in which students use the models to analyze the effects of policies and shocks. Right before the introduction of the Phillips curve would be a good place to have students work an exercise using the IS-LM-AD-AS model with a postively-sloped SRAS curve. The key difference is that, in the short run, a shift in AD causes P to change, which changes M/P, which shifts LM a bit, which explains why the short-run change in output is smaller when SRAS is upward-sloping than when it is horizontal.

three models of aggregate supply in which output depends positively on the price level in the short run about the short-run tradeoff between inflation and unemployment known as the Phillips curve CHAPTER 13 Aggregate Supply

Three models of aggregate supply
The sticky-wage model The imperfect-information model The sticky-price model All three models imply: agg. output natural rate of output a positive parameter the actual price level the expected price level CHAPTER 13 Aggregate Supply

The sticky-wage model Assumes that firms and workers negotiate contracts and fix the nominal wage before they know what the price level will turn out to be. The nominal wage they set is the product of a target real wage and the expected price level: Target real wage At the target real wage, the labor market is in equilibrium, meaning that unemployment equals its natural rate. This implies that output equals its natural rate (aka full-employment output). CHAPTER 13 Aggregate Supply

The sticky-wage model If it turns out that then
Unemployment and output are at their natural rates. Real wage is less than its target, so firms hire more workers and output rises above its natural rate. Intuition for the positive relationship between P and Y, for a given value of the expected price level. Real wage exceeds its target, so firms hire fewer workers and output falls below its natural rate. CHAPTER 13 Aggregate Supply

The sticky-wage model Implies that the real wage should be counter-cyclical, should move in the opposite direction as output during business cycles: In booms, when P typically rises, real wage should fall. In recessions, when P typically falls, real wage should rise. This prediction does not come true in the real world: CHAPTER 13 Aggregate Supply

The cyclical behavior of the real wage
-5 -4 -3 -2 -1 1 2 3 4 5 6 7 8 1974 1979 1991 1972 2004 2001 1998 1965 1984 1980 1982 1990 Percentage change in real wage Figure 13-2, p.380 The real wage is procyclical in the U.S., contrary to the sticky wage theory. Percentage change in real GDP

The imperfect-information model
Assumptions: All wages and prices are perfectly flexible, all markets are clear. Each supplier produces one good, consumes many goods. Each supplier knows the nominal price of the good she produces, but does not know the overall price level. CHAPTER 13 Aggregate Supply

The imperfect-information model
Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level. Supplier does not know price level at the time she makes her production decision, so uses the expected price level, P e. Suppose P rises but P e does not. Supplier thinks her relative price has risen, so she produces more. With many producers thinking this way, Y will rise whenever P rises above P e. CHAPTER 13 Aggregate Supply

The sticky-price model
Reasons for sticky prices: long-term contracts between firms and customers menu costs firms not wishing to annoy customers with frequent price changes Assumption: Firms set their own prices (e.g., as in monopolistic competition). If you don’t like the appearance of the term “monopolistic competition” in this slide, just change the parenthetical comment to “(i.e. firms have some market power)” or something to that effect. CHAPTER 13 Aggregate Supply

An individual firm’s desired price is where a > 0. Suppose two types of firms: firms with flexible prices, set prices as above firms with sticky prices, must set their price before they know how P and Y will turn out: CHAPTER 13 Aggregate Supply

Assume sticky price firms expect that output will equal its natural rate. Then, To derive the aggregate supply curve, we first find an expression for the overall price level. Let s denote the fraction of firms with sticky prices. Then, we can write the overall price level as… CHAPTER 13 Aggregate Supply

price set by sticky price firms price set by flexible price firms Subtract (1s )P from both sides: Divide both sides by s : CHAPTER 13 Aggregate Supply

High P e  High P If firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices. High Y  High P When income is high, the demand for goods is high. Firms with flexible prices set high prices. The greater the fraction of flexible price firms, the smaller is s and the bigger is the effect of Y on P. CHAPTER 13 Aggregate Supply

Finally, derive AS equation by solving for Y : CHAPTER 13 Aggregate Supply

In contrast to the sticky-wage model, the sticky-price model implies a pro-cyclical real wage: Suppose aggregate output/income falls. Then, Firms see a fall in demand for their products. Firms with sticky prices reduce production, and hence reduce their demand for labor. The leftward shift in labor demand causes the real wage to fall. CHAPTER 13 Aggregate Supply

Summary & implications
Figure 13-3, p.357 Idiosyncracy alert: If  is constant, then the SRAS curve should be linear, strictly speaking. However, in the text, it is drawn with a bit of curvature (which I have reproduced here). Y P LRAS SRAS Each of the three models of agg. supply imply the relationship summarized by the SRAS curve & equation. The following is not in the text, but you and your students may find it worthwhile: There are good reasons to believe that the SRAS curve is bow-shaped in the real world; that is, the curve is steeper at high levels of output than at low levels of output. And there are good reasons why we should care about this. Why the SRAS curve is bow-shaped: At low levels of output, there are lots of unutilized and under-utilized resources available, so it is not terribly costly for firms to increase output, and therefore firms do not require a big increase in prices to make them willing to increase output by a given amount. In contrast, at very high levels of output, when unemployment is below the natural rate and capital is being used at higher than normal intensity levels, it is relatively costly for firms to increase output further. Hence, a larger increase in prices is required to make firms willing to increase their output. Why the curvature matters: When policymakers increase aggregate demand, output rises (good) and prices rise (not good). An important question arises: how much of the bad thing (price increases) must we tolerate to get some of the good thing (an increase output)? The answer depends on how steep the SRAS curve is. When President Reagan cut taxes in the early 1980s, the economy was just coming out of a severe recession, and was on the flatter part of the SRAS curve; hence, the tax cuts affected output a lot and inflation very little. In contrast, when the current President Bush proposed huge tax cuts during the 2000 election season, we were on the steeper part of the SRAS curve, so the tax cuts would likely have been inflationary. Of course, by the time they were implemented, the economy was in recession, and in any case the bulk of the tax cuts were to be spread out over 10 or 11 years, so they have not proved inflationary. CHAPTER 13 Aggregate Supply

Summary & implications
Suppose a positive AD shock moves output above its natural rate and P above the level people had expected. SRAS equation: SRAS2 Y P LRAS AD2 SRAS1 AD1 This graph has two lessons for students: First, changes in the expected price level shift the SRAS curve (this should be clear from the equation, as should the fact that a change in the natural rate of output will shift the SRAS curve). The second lesson concerns the adjustment of the economy back to full-employment output. Over time, P e rises, SRAS shifts up, and output returns to its natural rate. CHAPTER 13 Aggregate Supply

Inflation, Unemployment, and the Phillips Curve
The Phillips curve states that  depends on expected inflation,  e. cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate supply shocks,  (Greek letter “nu”).  measures the responsiveness of inflation to cyclical unemployment. where  > 0 is an exogenous constant. CHAPTER 13 Aggregate Supply

Deriving the Phillips Curve from SRAS
Explain each equation briefly before displaying the next. Here are the explanations: Equation (1) is the SRAS equation. Solve (1) for P to get (2). To get (3), add the supply shock term to (2). To get (4), subtract last year’s price level (P-1) from both sides. To get (5), write  in place of (P- P-1) and e in place of (Pe- P-1). Note that the change in the price level is not exactly the inflation rate, unless we interpret P as the natural log of the price level. Equation (6) captures the relationship between output and unemployment from Okun’s law (chapter 2): the deviation of output from its natural rate is inversely related to cyclical unemployment. Substituting (6) into (5) gives (7), the Phillips curve equation introduced on the preceding slide. CHAPTER 13 Aggregate Supply

The Phillips Curve and SRAS
SRAS curve: Output is related to unexpected movements in the price level. Phillips curve: Unemployment is related to unexpected movements in the inflation rate. CHAPTER 13 Aggregate Supply

Adaptive expectations
Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation. A simple example: Expected inflation = last year’s actual inflation Then, the P.C. becomes CHAPTER 13 Aggregate Supply

Inflation inertia In this form, the Phillips curve implies that inflation has inertia: In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate. Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set. CHAPTER 13 Aggregate Supply

Two causes of rising & falling inflation
cost-push inflation: inflation resulting from supply shocks Adverse supply shocks typically raise production costs and induce firms to raise prices, “pushing” inflation up. demand-pull inflation: inflation resulting from demand shocks Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which “pulls” the inflation rate up. Of course, a favorable supply shock that lowers production costs will “push” inflation down, and a negative demand shock which raises cyclical unemployment will “pull” inflation down. CHAPTER 13 Aggregate Supply

Graphing the Phillips curve
In the short run, policymakers face a tradeoff between  and u. u  The short-run Phillips curve Here, the “short run” is the period until people adjust their expectations of inflation. CHAPTER 13 Aggregate Supply

Shifting the Phillips curve
 People adjust their expectations over time, so the tradeoff only holds in the short run. After displaying this slide, you might consider giving your students an exercise using the P.C. curve. One possibility would be to ask them to draw a graph of the PC curve, then show what happens to it in the face of an adverse supply shock or an increase in the natural rate of unemployment, giving intuition for each. The intuition for why an increase in the natural rate shifts the PC upward (or rightward) is as follows: At any given value of actual unemployment, an increase in the natural rate implies a decrease in cyclical unemployment, which increases inflation by increasing pressures for wages to rise. Thus, each value of unemployment has a higher value of inflation than before. E.g., an increase in e shifts the short-run P.C. upward. CHAPTER 13 Aggregate Supply

The sacrifice ratio To reduce inflation, policymakers can contract agg. demand, causing unemployment to rise above the natural rate. The sacrifice ratio measures the percentage of a year’s real GDP that must be foregone to reduce inflation by 1 percentage point. A typical estimate of the ratio is 5. CHAPTER 13 Aggregate Supply

The sacrifice ratio Example: To reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year’s GDP: GDP loss = (inflation reduction) x (sacrifice ratio) = x This loss could be incurred in one year or spread over several, e.g., 5% loss for each of four years. The cost of disinflation is lost GDP. One could use Okun’s law to translate this cost into unemployment. CHAPTER 13 Aggregate Supply

Rational expectations
Ways of modeling the formation of expectations: adaptive expectations: People base their expectations of future inflation on recently observed inflation. rational expectations: People base their expectations on all available information, including information about current and prospective future policies. A good example to illustrate the difference between adaptive and rational expectations. Suppose the Fed announces a shift in priorities, from maintaining low inflation to maintaining low unemployment w/o regard to inflation; this shift will start affecting policy next week. If expectations are adaptive, then expected inflation will not change, because it is based on past inflation. The Fed’s announcement pertains to the future, and has no impact on past inflation. If expectations are rational, then expected inflation will increase right away, as people factor this announcement into their forecasts. CHAPTER 13 Aggregate Supply

Painless disinflation?
Proponents of rational expectations believe that the sacrifice ratio may be very small: Suppose u = u n and  = e = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible. If the announcement is credible, then e will fall, perhaps by the full 4 points. Then,  can fall without an increase in u. Here’s an interesting and important implication: Central banks that are politically independent are typically more credible than those that are “puppets” to elected officials. Hence, in countries with central banks that are NOT politically independent, it is usually far costlier to reduce inflation. A very worthwhile reform, therefore, would be for governments to give their central banks independence. CHAPTER 13 Aggregate Supply

Calculating the sacrifice ratio for the Volcker disinflation
1981:  = 9.7% 1985:  = 3.0% Total disinflation = 6.7% year u u n uu n 1982 9.5% 6.0% 3.5% 1983 9.5 6.0 3.5 1984 7.4 1.4 1985 7.1 1.1 The natural rate of unemployment is assumed to be 6.0% during the early 1980s. Total 9.5% CHAPTER 13 Aggregate Supply

Calculating the sacrifice ratio for the Volcker disinflation
From previous slide: Inflation fell by 6.7%, total cyclical unemployment was 9.5%. Okun’s law: 1% of unemployment = 2% of lost output. So, 9.5% cyclical unemployment = 19.0% of a year’s real GDP. Sacrifice ratio = (lost GDP)/(total disinflation) = 19/6.7 = 2.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation. CHAPTER 13 Aggregate Supply

The natural rate hypothesis
Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis: Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chaps. 3-8). The natural rate hypothesis allows us to study the long run separately from the short run. CHAPTER 13 Aggregate Supply

An alternative hypothesis: Hysteresis
Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment. Negative shocks may increase un, so economy may not fully recover. CHAPTER 13 Aggregate Supply

Hysteresis: Why negative shocks may increase the natural rate
The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends. Cyclically unemployed workers may lose their influence on wage-setting; then, insiders (employed workers) may bargain for higher wages for themselves. Result: The cyclically unemployed “outsiders” may become structurally unemployed when the recession ends. CHAPTER 13 Aggregate Supply

Chapter Summary 1. Three models of aggregate supply in the short run:
sticky-wage model imperfect-information model sticky-price model All three models imply that output rises above its natural rate when the price level rises above the expected price level. CHAPTER 13 Aggregate Supply slide 641

Chapter Summary 2. Phillips curve derived from the SRAS curve
states that inflation depends on expected inflation cyclical unemployment supply shocks presents policymakers with a short-run tradeoff between inflation and unemployment CHAPTER 13 Aggregate Supply slide 642

Chapter Summary 3. How people form expectations of inflation
adaptive expectations based on recently observed inflation implies “inertia” rational expectations based on all available information implies that disinflation may be painless CHAPTER 13 Aggregate Supply slide 643

Chapter Summary 4. The natural rate hypothesis and hysteresis
the natural rate hypotheses states that changes in aggregate demand can only affect output and employment in the short run hysteresis states that aggregate demand can have permanent effects on output and employment CHAPTER 13 Aggregate Supply slide 644

14 Stabilization Policy Chapter 14 is less difficult than the preceding chapters, and a bit shorter, so you should be able to cover it fairly quickly. Students find the material very interesting, as it deals with important real-world policy issues related to the theories they learned in the immediately preceding chapters (9-13).

…about two policy debates: 1. Should policy be active or passive? 2. Should policy be by rule or discretion? CHAPTER 14 Stabilization Policy

Should policy be active or passive?
Question 1: Should policy be active or passive? ? CHAPTER 14 Stabilization Policy

Growth rate of real GDP, 1970-2006
Percent change from 4 quarters earlier 10 8 6 Average growth rate 4 2 This graph is from Chapter 9. I include it here as it shows that GDP is very volatile. Question 1 asks whether policymakers should attempt to smooth out these fluctuations by using fiscal and monetary policy to alter aggregate demand. The pink shaded vertical bars denote recessions. Source of data: See Figure 9-1, p.254 -2 -4 1970 1975 1980 1985 1990 1995 2000 2005

Increase in unemployment during recessions
peak trough increase in no. of unemployed persons (millions) July 1953 May 1954 2.11 Aug 1957 April 1958 2.27 April 1960 February 1961 1.21 December 1969 November 1970 2.01 November 1973 March 1975 3.58 January 1980 July 1980 1.68 July 1981 November 1982 4.08 July 1990 March 1991 1.67 March 2001 November 2001 1.50 During a recession, many people lose their jobs (the average for the recessions shown in this table is 2.2 million). Advocates for activist policy believe that policymakers should use the fiscal and monetary policy tools at their disposal to try to reduce the length and severity of recessions, or prevent them if possible. Source: Business cycle dates from nber.org Increase in unemployment from U.S. Department of Labor, Bureau of Labor Statistics (via FRED, the St Louis Fed’s online database) CHAPTER 14 Stabilization Policy

Arguments for active policy
Recessions cause economic hardship for millions of people. The Employment Act of 1946: “It is the continuing policy and responsibility of the Federal Government to…promote full employment and production.” The model of aggregate demand and supply (Chaps. 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy. CHAPTER 14 Stabilization Policy

Arguments against active policy
Policies act with long & variable lags, including: inside lag: the time between the shock and the policy response. takes time to recognize shock takes time to implement policy, especially fiscal policy outside lag: the time it takes for policy to affect economy. Opponents of policy activism argue that long & variable lags hinder the effectiveness of policy. Fiscal policy requires an act of Congress. As your students may be aware, the process by which a bill becomes a law is lengthy and involved, and often fraught with political difficulty. Monetary policy has a much shorter inside lag. However, firms make their investment plans in advance, so it takes time for interest rate changes to affect investment and aggregate demand. Opponents of policy activism note that the lags are long and uncertain, making it very difficult to predict the impact of policy, which makes it difficult to determine the appropriate policy. If you have a blackboard or whiteboard handy, you might draw for students the AD/AS diagram with the economy initially in a full-employment equilibrium. Then: Show the short-run effects of a negative AD shock. From the new short-run equilibrium, illustrate how an activist policy of increasing AD can get the economy back to full-employment. Finally, repeat step 2, but assume that the policy acts with a lag, during which time the economy’s “self-correcting” mechanism is already well underway. The result should be that the AD shift actually pushes the economy over too far to the right, so that Y is greater than the full-employment level. Thus, policy meant to reduce a negative demand shock actually causes a positive shock. Of course, after this positive shock occurs, activist policymakers might try to contract aggregate demand; but again, if there’s a lag, then they might put the economy back into recession. If conditions change before policy’s impact is felt, the policy may destabilize the economy. CHAPTER 14 Stabilization Policy

Automatic stabilizers
definition: policies that stimulate or depress the economy when necessary without any deliberate policy change. Designed to reduce the lags associated with stabilization policy. Examples: income tax unemployment insurance welfare Why the income tax is an automatic stabilizer: Each person’s tax bill depends on her income. In a recession, average incomes fall, so the average person pays less taxes. It’s as if the government automatically gives people a tax cut in recessions. Why unemployment insurance is an automatic stabilizer: In a recession, people who become unemployed experience a fall in their income, and therefore reduce their spending, which further reduces aggregate demand. Unemployment insurance reduces the fall in the income of the unemployed, and so helps to reduce the drop in aggregate demand during a recession. Welfare performs a similar function. CHAPTER 14 Stabilization Policy

Forecasting the macroeconomy
Because policies act with lags, policymakers must predict future conditions. Two ways economists generate forecasts: Leading economic indicators data series that fluctuate in advance of the economy Macroeconometric models Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies The macroeconometric models are, in many cases, more elaborate versions of the IS-LM-AD-AS model that students have just learned in the preceding 5 chapters. The parameters of each equation (e.g., the MPC or the interest rate sensitivity of investment) are estimated with real-world data; then, by changing the values of the exogenous variables, or by specifying price shocks or other changes, the macroeconometric models generate forecasts of all the endogenous variables (GDP, interest rates, unemployment, inflation) at various time horizons following the shock or or policy change. CHAPTER 14 Stabilization Policy

The LEI index and real GDP, 1960s
The Index of Leading Economic Indicators includes 10 data series (see p.258 ). In the 6th edition, Chapter 9 now includes an extensive discussion of the components of the LEI index. In the PowerPoint presentation for Chapter 9, I have added a new time-series graph showing the LEI from 1970 through 2006. This and the next few slides show the annual growth rates of Real GDP and the Index of Leading Economic Indicators; there is one slide for each decade from the 1960s through the 1990s. You can ask your students to identify periods in which the LEI does a good job forecasting real GDP. One thing that becomes clear: the sign and size of the change in the LEI is a very imperfect predictor of the sign and size of the change in real GDP. Note: If you wish to save time, you can probably get the idea across with just one or two of these four slides--pick your favorite decade(s), and “hide” the slides for the other decades. source of LEI data: The Conference Board CHAPTER 14 Stabilization Policy

source of LEI data: The Conference Board CHAPTER 14 Stabilization Policy

Mistakes forecasting the 1982 recession
Unemployment rate This is Figure 14-1 on p.410 of the text. The red line is the actual unemployment rate. Each green line represents the median of 20 forecasts of the unemployment rate at the date shown. The first three forecasts all failed to predict the severity of the recession (each shows unemployment falling after a quarter or two, when in fact the unemployment rate kept rising). The last three forecasts failed to predict the speed of the recovery. The point here is that forecasts are often not accurate, which opponents of activist policy emphasize. And without accurate forecasts, policies that act with uncertain lags may end up destabilizing the economy.

Forecasting the macroeconomy
Because policies act with lags, policymakers must predict future conditions. The preceding slides show that the forecasts are often wrong. This is one reason why some economists oppose policy activism. CHAPTER 14 Stabilization Policy

The Lucas critique Due to Robert Lucas who won Nobel Prize in 1995 for rational expectations. Forecasting the effects of policy changes has often been done using models estimated with historical data. Lucas pointed out that such predictions would not be valid if the policy change alters expectations in a way that changes the fundamental relationships between variables. CHAPTER 14 Stabilization Policy

An example of the Lucas critique
Prediction (based on past experience): An increase in the money growth rate will reduce unemployment. The Lucas critique points out that increasing the money growth rate may raise expected inflation, in which case unemployment would not necessarily fall. Remember the expectations-augmented Phillips Curve from Chapter 13: An increase in money growth and inflation only reduces unemployment if expected inflation remains unchanged. Perhaps that was the case in the past. But now, if the money growth increase causes people to raise their expectations of inflation, then unemployment won’t fall. CHAPTER 14 Stabilization Policy

The Jury’s out… Looking at recent history does not clearly answer Question 1: It’s hard to identify shocks in the data. It’s hard to tell how things would have been different had actual policies not been used. Most economists agree, though, that the U.S. economy has become much more stable since the late 1980s… Greg sums it up nicely on p.412: “If the economy has experienced many large shocks to aggregate supply and aggregate demand, and if policy has successfully insulated the economy from these shocks, then the case for active policy should be clear. Conversely, if the economy has experienced few large shocks, and if the fluctuations we have observed can be traced to inept economic policy, then the case for passive policy should be clear….Yet…it is not easy to identify the sources of economic fluctuations. The historical record often permits more than one interpretation. The Great Depression is a case in point….Some economists believe that a large contractionary shock to private spending caused the depression. They assert that policymakers should have responded by stimulating aggregate demand. Other economists believe that the large fall in the money supply caused the Depression. They assert that the Depression would have been avoided if the Fed had been pursuing a passive monetary policy of increasing the money supply at a steady rate.” CHAPTER 14 Stabilization Policy

The stability of the modern economy
4.0 Volatility of GDP 3.5 Standard deviation 3.0 Volatility of Inflation 2.5 2.0 1.5 This graph presents the standard deviation of real GDP growth and of inflation. Since the late 1980s, GDP and inflation have become far less volatile than at any time in many decades. See discussion on p.413 and graphs on p.414. Data: same as in text, see p. 414. 1.0 0.5 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 14 Stabilization Policy

Should policy be conducted by rule or discretion?
Question 2: Should policy be conducted by rule or discretion? ? CHAPTER 14 Stabilization Policy

Rules and discretion: Basic concepts
Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. Policy conducted by discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time. CHAPTER 14 Stabilization Policy

Arguments for rules misinformed politicians
1. Distrust of policymakers and the political process misinformed politicians politicians’ interests sometimes not the same as the interests of society Note: these are arguments made by critics of policy by discretion. Please be clear that it is not our intention to say that politicians are misinformed or acting against society; rather, this is what is alleged by proponents of policy by rules. CHAPTER 14 Stabilization Policy

Arguments for rules 2. The time inconsistency of discretionary policy def: A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement. Destroys policymakers’ credibility, thereby reducing effectiveness of their policies. CHAPTER 14 Stabilization Policy

Examples of time inconsistency
1. To encourage investment, govt announces it will not tax income from capital. But once the factories are built, govt reneges in order to raise more tax revenue. CHAPTER 14 Stabilization Policy

2. To reduce expected inflation, the central bank announces it will tighten monetary policy. But faced with high unemployment, the central bank may be tempted to cut interest rates. CHAPTER 14 Stabilization Policy

3. Aid is given to poor countries contingent on fiscal reforms. The reforms do not occur, but aid is given anyway, because the donor countries do not want the poor countries’ citizens to starve. CHAPTER 14 Stabilization Policy

Monetary policy rules Advocated by monetarists.
a. Constant money supply growth rate Advocated by monetarists. Stabilizes aggregate demand only if velocity is stable. The preceding slides gave some arguments against discretionary policy. This and the following slides describe the alternative: policy by rule. In particular, rules for monetary policy. CHAPTER 14 Stabilization Policy

Monetary policy rules a. Constant money supply growth rate
b. Target growth rate of nominal GDP Automatically increase money growth whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target. CHAPTER 14 Stabilization Policy

b. Target growth rate of nominal GDP c. Target the inflation rate Automatically reduce money growth whenever inflation rises above the target rate. Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion. CHAPTER 14 Stabilization Policy

b. Target growth rate of nominal GDP c. Target the inflation rate d. The Taylor rule: Target the federal funds rate based on inflation rate gap between actual & full-employment GDP CHAPTER 14 Stabilization Policy

iff =  + 2 + 0.5 ( – 2) – 0.5 (GDP gap)
The Taylor Rule iff =  ( – 2) – 0.5 (GDP gap) where iff = nominal federal funds rate target GDP gap = 100 x = percent by which real GDP is below its natural rate The equation here appears on p.422. CHAPTER 14 Stabilization Policy

iff =  + 2 + 0.5 ( – 2) – 0.5 (GDP gap)
The Taylor Rule iff =  ( – 2) – 0.5 (GDP gap) If  = 2 and output is at its natural rate, then fed funds rate targeted at 4 percent. For each one-point increase in , mon. policy is automatically tightened to raise fed funds rate by 1.5. For each one percentage point that GDP falls below its natural rate, mon. policy automatically eases to reduce the fed funds rate by 0.5. CHAPTER 14 Stabilization Policy

The federal funds rate: Actual and suggested
12 Percent Actual 10 8 Taylor’s Rule 6 Figure 14-3, p. 422. The Fed never announced that it follows the Taylor Rule. But if you compare the actual fed funds rate to rate suggested by the Taylor Rule, it appears that the Fed’s behavior is roughly consistent with the Taylor Rule, whether intentionally or not. 4 2 1987 1990 1993 1996 1999 2002 2005 CHAPTER 14 Stabilization Policy

Central bank independence
A policy rule announced by central bank will work only if the announcement is credible. Credibility depends in part on degree of independence of central bank. We have seen this issue in Chapter 13: If the Fed credibly announces a new commitment to bring inflation down, then expected inflation will fall, reducing the sacrifice ratio. If the Fed’s announcement is not credible, then expected inflation will not fall, and a painful recession will be required to bring inflation down. CHAPTER 14 Stabilization Policy

Inflation and central bank independence
average inflation This figure shows a measure of the independence of various countries’ central banks (higher numbers = greater independence). One would expect higher average inflation in countries whose central banks are less independent, as monetary policy could be used for political purposes (e.g., lowering unemployment prior to elections). And the graph shows that this is the case. This graph appears on p.424 of the text as Figure 14-4 , and was originally in Alesina and Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit, and Banking, May 1993. index of central bank independence CHAPTER 14 Stabilization Policy

Chapter Summary 1. Advocates of active policy believe: frequent shocks lead to unnecessary fluctuations in output and employment fiscal and monetary policy can stabilize the economy 2. Advocates of passive policy believe: the long & variable lags associated with monetary and fiscal policy render them ineffective and possibly destabilizing inept policy increases volatility in output, employment CHAPTER 14 Stabilization Policy slide 680

Chapter Summary 3. Advocates of discretionary policy believe: discretion gives more flexibility to policymakers in responding to the unexpected 4. Advocates of policy rules believe: the political process cannot be trusted: Politicians make policy mistakes or use policy for their own interests commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility CHAPTER 14 Stabilization Policy slide 681

15 Government Debt Chapter 15 is short but fun. Lots of policy & real-world relevance, little theory (a nice breather after the analytically challenging chapters 10-13). This presentation includes a lot of data that complements the material in the chapter: To support the case study “the troubling outlook for fiscal policy,” I have included data on the proportion of the population 65+ years old, spending on Social Security and Medicare as a share of GDP, and CBO projections of the government’s debt over the next 50 years. To support the textbook’s discussion of the cyclically-adjusted budget deficit, I include a graph of CBO’s estimate of the cyclical component of the deficit, which is used to “correct” the deficit for the gap between actual and potential GDP. And finally, to support the textbook’s case study on inflation-indexed Treasury bonds, I include data on the yields on indexed and non-indexed 10-year T-bonds. The difference between these yields is a measure of expected inflation, which I also include on the graph.

about the size of the U.S. government’s debt, and how it compares to that of other countries problems measuring the budget deficit the traditional and Ricardian views of the government debt other perspectives on the debt CHAPTER 15 Government Debt

Indebtedness of the world’s governments
Country Gov Debt (% of GDP) Japan 159 U.S.A. 64 Italy 125 Sweden 62 Greece 108 Finland 53 Belgium 99 Norway 52 France 77 Denmark 50 Portugal Spain 49 Germany 70 U.K. 47 Austria 69 Ireland 30 Canada Korea 20 Netherlands Australia 15 An abbreviated version of Table 15-1 on p.432 Source: OECD Economic Outlook. Despite all the alarms sounded by politicians and some economists, the U.S. debt-to-GDP ratio is moderate when compared to other countries. (Of course, the U.S. has the largest GDP, so in absolute terms U.S. debt is a whopper when compared to other countries’ government debts.)

Ratio of U.S. govt debt to GDP
1.2 WW2 1 Iraq War 0.8 Revolutionary War WW1 0.6 Civil War 0.4 Figure 15-1, p.433. The historical pattern: the debt-GDP ratio rises during wars and falls during peace-time. The exception is the substantial rise that occurred beginning in the early 1980s. This graph suggests that the recent ( ) increase in the debt is not so horrible when viewed in the larger context of history. Nonetheless, the debt ratio was higher in the early 1990s than during any previous time, except for WW2. 0.2 1791 1815 1839 1863 1887 1911 1935 1959 1983 2007 CHAPTER 15 Government Debt

The U.S. experience in recent years
Early 1980s through early 1990s debt-GDP ratio: 25.5% in 1980, 48.9% in 1993 due to Reagan tax cuts, increases in defense spending & entitlements Early 1990s through 2000 $290b deficit in 1992, $236b surplus in 2000 debt-GDP ratio fell to 32.5% in 2000 due to rapid growth, stock market boom, tax hikes Since 2001 the return of huge deficits, due to Bush tax cuts, recession, Iraq war The stock market boom of the latter 1990s created huge capital gains, which helped bring down the budget deficit by increasing revenues. Even if the government budget had been balanced, rapid economic growth from would still have brought down the debt-GDP ratio. CHAPTER 15 Government Debt

The troubling fiscal outlook
The U.S. population is aging. Health care costs are rising. Spending on entitlements like Social Security and Medicare is growing. Deficits and the debt are projected to significantly increase… This and the next few slides correspond to the case study on pp , which has been updated and expanded for the 6th edition. If you prefer, “hide” or omit this slide from your presentation, and instead give the information verbally to students as you display the following slides. CHAPTER 15 Government Debt

Percent of U.S. population age 65+
23 Percent of pop. actual projected 20 17 14 11 Source: U.S. Census Bureau, 2004, "U.S. Interim Projections by Age, Sex, Race, and Hispanic Origin," Table 2a. < 8 5 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 CHAPTER 15 Government Debt

U.S. government spending on Medicare and Social Security
2 4 6 8 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Percent of GDP Source: Table TOTAL GOVERNMENT EXPENDITURES BY MAJOR CATEGORY OF EXPENDITURE: , page 314 of “Historical Tables, Budget of the United States Government, Fiscal Year 2007” From the Budget of the U.S., FY 2007 Online via GPO Access [wais.access.gpo.gov] CHAPTER 15 Government Debt

CBO projected U.S. federal govt debt in two scenarios
300 250 pessimistic scenario 200 Percent of GDP 150 100 Even in the optimistic scenario, the debt ratio more than doubles over the next 40 years. In the pessimistic scenario, the debt ratio increases from 40% today to over 250% in just 45 years! Source: “A CBO Study: The Long-Term Budget Outlook.” December 2005. Available at The CBO actually did projections for 6 scenarios, which differ in their assumptions regarding government spending and revenues. The report cited above explains the assumptions behind all six scenarios. I read the report and studied the six scenarios, and then picked two that I thought were reasonable for this graph. The “pessimistic scenario” on this graph is Scenario 2 in the CBO report. The “optimistic scenario” on this graph is Scenario 5 in the CBO report. For details of the CBO’s projections in the other scenarios, please see the report. optimistic scenario 50 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 CHAPTER 15 Government Debt

Problems measuring the deficit
1. Inflation 2. Capital assets 3. Uncounted liabilities 4. The business cycle Before we assess whether the debt is a problem, we first consider whether the standard measures of the debt & deficit are accurate. It turns out they are not, for these four reasons. CHAPTER 15 Government Debt

MEASUREMENT PROBLEM 1: Inflation
Suppose the real debt is constant, which implies a zero real deficit. In this case, the nominal debt D grows at the rate of inflation: D/D =  or D =  D The reported deficit (nominal) is  D even though the real deficit is zero. Hence, should subtract  D from the reported deficit to correct for inflation. CHAPTER 15 Government Debt

MEASUREMENT PROBLEM 1: Inflation
Correcting the deficit for inflation can make a huge difference, especially when inflation is high. Example: In 1979, nominal deficit = $28 billion inflation = 8.6% debt = $495 billion  D =  $495b = $43b real deficit = $28b  $43b = $15b surplus CHAPTER 15 Government Debt

MEASUREMENT PROBLEM 2: Capital Assets
Currently, deficit = change in debt Better, capital budgeting: deficit = (change in debt)  (change in assets) EX: Suppose govt sells an office building and uses the proceeds to pay down the debt. under current system, deficit would fall under capital budgeting, deficit unchanged, because fall in debt is offset by a fall in assets. Problem w/ cap budgeting: Determining which govt expenditures count as capital expenditures. CHAPTER 15 Government Debt

MEASUREMENT PROBLEM 3: Uncounted liabilities
Current measure of deficit omits important liabilities of the government: future pension payments owed to current govt workers. future Social Security payments contingent liabilities, e.g., covering federally insured deposits when banks fail (Hard to attach a dollar value to contingent liabilities, due to inherent uncertainty.) CHAPTER 15 Government Debt

MEASUREMENT PROBLEM 4: The business cycle
The deficit varies over the business cycle due to automatic stabilizers (unemployment insurance, the income tax system). These are not measurement errors, but do make it harder to judge fiscal policy stance. E.g., is an observed increase in deficit due to a downturn or an expansionary shift in fiscal policy? CHAPTER 15 Government Debt

MEASUREMENT PROBLEM 4: The business cycle
Solution: cyclically adjusted budget deficit (aka “full-employment deficit”) – based on estimates of what govt spending & revenues would be if economy were at the natural rates of output & unemployment. CHAPTER 15 Government Debt

The cyclical contribution to the U.S. Federal budget
-120 -80 -40 40 80 120 1965 1970 1975 1980 1985 1990 1995 2000 2005 billions of current dollars Source: CBO. Obtained from: CBO includes this note: “The cyclical contribution to revenues is negative when actual GDP is less than potential GDP. The cyclical contribution to mandatory spending is positive when the unemployment rate is higher than the nonaccelerating inflation rate of unemployment. The cyclical contribution to the budget surplus or deficit equals the cyclical contribution to revenues minus the cyclical contribution to mandatory spending.” In essence, the graph on this slide shows the size of the correction to the measured budget deficit due to the business cycle. The data are in billions of current dollars. The increasing magnitude of the cyclical contribution is due to inflation and economic growth, both of which increase nominal magnitudes of most macroeconomic variables. CHAPTER 15 Government Debt

We must exercise care when interpreting the reported deficit figures.
The bottom line We must exercise care when interpreting the reported deficit figures. CHAPTER 15 Government Debt

Is the govt debt really a problem?
Consider a tax cut with corresponding increase in the government debt. Two viewpoints: 1. Traditional view 2. Ricardian view CHAPTER 15 Government Debt

The traditional view Short run: Y, u Long run: Very long run:
Y and u back at their natural rates closed economy: r, I open economy: , NX (or higher trade deficit) Very long run: slower growth until economy reaches new steady state with lower income per capita The traditional view is just the viewpoint embodied in the models that students learned in chapters 3 through 13 of this textbook. This viewpoint is accepted by most mainstream economists. CHAPTER 15 Government Debt

The Ricardian view due to David Ricardo (1820), more recently advanced by Robert Barro According to Ricardian equivalence, a debt-financed tax cut has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run. CHAPTER 15 Government Debt

The logic of Ricardian Equivalence
Consumers are forward-looking, know that a debt-financed tax cut today implies an increase in future taxes that is equal – in present value – to the tax cut. The tax cut does not make consumers better off, so they do not increase consumption spending. Instead, they save the full tax cut in order to repay the future tax liability. Result: Private saving rises by the amount public saving falls, leaving national saving unchanged. CHAPTER 15 Government Debt

Problems with Ricardian Equivalence
Myopia: Not all consumers think so far ahead, some see the tax cut as a windfall. Borrowing constraints: Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut. Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending. CHAPTER 15 Government Debt

Evidence against Ricardian Equivalence?
Early 1980s: Reagan tax cuts increased deficit. National saving fell, real interest rate rose, exchange rate appreciated, and NX fell. 1992: Income tax withholding reduced to stimulate economy. This delayed taxes but didn’t make consumers better off. Almost half of consumers increased consumption. CHAPTER 15 Government Debt

Evidence against Ricardian Equivalence?
Proponents of R.E. argue that the Reagan tax cuts did not provide a fair test of R.E. Consumers may have expected the debt to be repaid with future spending cuts instead of future tax hikes. Private saving may have fallen for reasons other than the tax cut, such as optimism about the economy. Because the data is subject to different interpretations, both views of govt debt survive. CHAPTER 15 Government Debt

OTHER PERSPECTIVES: Balanced budgets vs. optimal fiscal policy
Some politicians have proposed amending the U.S. Constitution to require balanced federal govt budget every year. Many economists reject this proposal, arguing that deficit should be used to stabilize output & employment smooth taxes in the face of fluctuating income redistribute income across generations when appropriate The material on this slide is related to the material on the slide after the following one, entitled Other Perspectives: Debt and Politics. If you wish to save time, you can combine the two. CHAPTER 15 Government Debt

OTHER PERSPECTIVES: Fiscal effects on monetary policy
Govt deficits may be financed by printing money A high govt debt may be an incentive for policymakers to create inflation (to reduce real value of debt at expense of bond holders) Fortunately: little evidence that the link between fiscal and monetary policy is important most governments know the folly of creating inflation most central banks have (at least some) political independence from fiscal policymakers CHAPTER 15 Government Debt

OTHER PERSPECTIVES: Debt and politics
“Fiscal policy is not made by angels…” – Greg Mankiw, p.449 Some do not trust policymakers with deficit spending. They argue that policymakers do not worry about true costs of their spending, since burden falls on future taxpayers since future taxpayers cannot participate in the decision process, their interests may not be taken into account This is another reason for the proposals for a balanced budget amendment (discussed above). CHAPTER 15 Government Debt

OTHER PERSPECTIVES: International dimensions
Govt budget deficits can lead to trade deficits, which must be financed by borrowing from abroad. Large govt debt may increase the risk of capital flight, as foreign investors may perceive a greater risk of default. Large debt may reduce a country’s political clout in international affairs. CHAPTER 15 Government Debt

CASE STUDY: Inflation-indexed Treasury bonds
Starting in 1997, the U.S. Treasury issued bonds with returns indexed to the CPI. Benefits: Removes inflation risk, the risk that inflation – and hence real interest rate – will turn out different than expected. May encourage private sector to issue inflation-adjusted bonds. Provides a way to infer the expected rate of inflation… This slide and the next correspond to the case study “the Benefits of Indexed Bonds” that closes Chapter 15 (see pp ). It might be worth taking a moment to help your students understand why inflation risk is an undesirable thing. It’s also a good idea to help your students understand why we can infer the expected inflation rate from the difference between the yields on standard and inflation-indexed bonds of the same maturity. A simple example might help: Suppose the inflation-indexed Treasury bond pays 3 percent after inflation, while a standard Treasury bond with the same maturity pays 5 percent. We can infer that the market expects 2 percent inflation during the term of the bond. If people expected less than two percent inflation, then the non-indexed bond would have a higher real return than the indexed bond, so everyone would try to buy the non-indexed bond. But this would drive up its price, and drive down its return, until the difference between the returns on the two bonds just equals expected inflation. CHAPTER 15 Government Debt

CASE STUDY: Inflation-indexed Treasury bonds
6 rate on non-indexed bond 5 4 percent (annual rate) implied expected inflation rate 3 rate on indexed bond 2 This graph presents the yields on 10-year constant maturity non-indexed and inflation-indexed U.S. Treasury bonds. The implied expected rate of inflation is simply the difference between the non-indexed (i.e. nominal) and indexed (i.e. real) bond yields. Expected inflation was 1.51% at the beginning of 2003. It was as high as 2.7% (nearly double the 1/2003 figure) in March 2005 and again in May 2006. Source: Board of Governors of the Federal Reserve Obtained from: 1 2003- 2003- 2003- 2004- 2004- 2005- 2005- 2006- 01-03 06-27 12-19 06-11 12-03 05-27 11-18 05-12 CHAPTER 15 Government Debt

Chapter Summary are not corrected for inflation
1. Relative to GDP, the U.S. government’s debt is moderate compared to other countries 2. Standard figures on the deficit are imperfect measures of fiscal policy because they are not corrected for inflation do not account for changes in govt assets omit some liabilities (e.g., future pension payments to current workers) do not account for effects of business cycles CHAPTER 15 Government Debt slide 713

Chapter Summary 3. In the traditional view, a debt-financed tax cut increases consumption and reduces national saving. In a closed economy, this leads to higher interest rates, lower investment, and a lower long-run standard of living. In an open economy, it causes an exchange rate appreciation, a fall in net exports (or increase in the trade deficit). 4. The Ricardian view holds that debt-financed tax cuts do not affect consumption or national saving, and therefore do not affect interest rates, investment, or net exports. CHAPTER 15 Government Debt slide 714

Chapter Summary may lead to inflation
5. Most economists oppose a strict balanced budget rule, as it would hinder the use of fiscal policy to stabilize output, smooth taxes, or redistribute the tax burden across generations. 6. Government debt can have other effects: may lead to inflation politicians can shift burden of taxes from current to future generations may reduce country’s political clout in international affairs or scare foreign investors into pulling their capital out of the country CHAPTER 15 Government Debt slide 715

16 Consumption This long chapter is a survey of the most prominent work on consumption since Keynes. It is particularly useful to students who expect to continue with graduate studies in economics. After reviewing the Keynesian consumption function and its implications, the chapter presents Irving Fisher’s theory of intertemporal choice, the basis for much subsequent work on consumption. This section of the chapter uses indifference curves and budget constraints. The chapter and this PowerPoint presentation do not require or assume that students know these tools. But if they have not, then this section of the chapter is the most difficult. The chapter then presents the Life-Cycle and Permanent Income Hypotheses, and discusses Hall’s Random Walk Hypothesis. Finally, there is a brief discussion of some very recent work by Laibson and others on psychology and economics, in particular how the pull of instant gratification can cause consumers to deviate from perfect rationality. Note: if you are covering Chapter 15 on government debt, please note that you can better explain Ricardian Equivalence (a topic from Chapter 15) using the Fisher model presented in this chapter. Just show students that a debt-financed tax cut is a movement along the budget constraint, not an outward shift of the constraint, and it should be clear that the optimal bundle of current and future consumption is not affected.

an introduction to the most prominent work on consumption, including: John Maynard Keynes: consumption and current income Irving Fisher: intertemporal choice Franco Modigliani: the life-cycle hypothesis Milton Friedman: the permanent income hypothesis Robert Hall: the random-walk hypothesis David Laibson: the pull of instant gratification CHAPTER 16 Consumption

Keynes’s conjectures 1. 0 < MPC < 1
2. Average propensity to consume (APC ) falls as income rises. (APC = C/Y ) 3. Income is the main determinant of consumption. The MPC was defined in chapter 3 and used in various chapters since. CHAPTER 16 Consumption

The Keynesian consumption function
c = MPC = slope of the consumption function c 1 Interpretations of C-bar: autonomous consumption: the portion of consumption that does not depend on income the value of consumption if income were zero. a shift parameter CHAPTER 16 Consumption

The Keynesian consumption function
As income rises, consumers save a bigger fraction of their income, so APC falls. C Y Pick a point on the consumption function; that point represents a particular combination of consumption and income. Now draw a ray from the origin to that point. The slope of that ray equals the average propensity to consume at that point. (Why? The slope equals the rise over the run. The rise from zero to that point equals the value of C at that point. The run from zero to that point equals the value of Y at that point. Hence, the rise over the run equals C/Y, or the APC.) At higher values of Y, the APC (or the slope of the ray from the origin) is smaller. This is what Keynes conjectured: at higher values of income, people spend a smaller fraction of their income. slope = APC CHAPTER 16 Consumption

Early empirical successes: Results from early studies
Households with higher incomes: consume more,  MPC > 0 save more,  MPC < 1 save a larger fraction of their income,  APC  as Y  Very strong correlation between income and consumption:  income seemed to be the main determinant of consumption CHAPTER 16 Consumption

Problems for the Keynesian consumption function
Based on the Keynesian consumption function, economists predicted that C would grow more slowly than Y over time. This prediction did not come true: As incomes grew, APC did not fall, and C grew at the same rate as income. Simon Kuznets showed that C/Y was very stable in long time series data. CHAPTER 16 Consumption

The Consumption Puzzle
Consumption function from long time series data (constant APC ) C Y Consumption function from cross-sectional household data (falling APC ) CHAPTER 16 Consumption

Irving Fisher and Intertemporal Choice
The basis for much subsequent work on consumption. Assumes consumer is forward-looking and chooses consumption for the present and future to maximize lifetime satisfaction. Consumer’s choices are subject to an intertemporal budget constraint, a measure of the total resources available for present and future consumption. CHAPTER 16 Consumption

The basic two-period model
Period 1: the present Period 2: the future Notation Y1, Y2 = income in period 1, 2 C1, C2 = consumption in period 1, 2 S = Y1 - C1 = saving in period 1 (S < 0 if the consumer borrows in period 1) Note: there is no saving in period 2. Period 2 is the final period, and there are no bequests, so saving in period 2 would only reduce lifetime consumption and therefore lifetime utility/satisfaction. CHAPTER 16 Consumption

Deriving the intertemporal budget constraint
Period 2 budget constraint: Rearrange terms: Explain the intuition/interpretation of the period 2 budget constraint. If students understand it, then everything else follows nicely. Divide through by (1+r ) to get… CHAPTER 16 Consumption

The intertemporal budget constraint
present value of lifetime consumption present value of lifetime income If your students are not familiar with the present value concept, it is explained in a very nice FYI box on p.463. CHAPTER 16 Consumption

Saving Consump = income in both periods The budget constraint shows all combinations of C1 and C2 that just exhaust the consumer’s resources. Borrowing Y1 Y2 The point (Y1, Y2) is always on the budget line because C1=Y1, C2=Y2 is always possible, regardless of the real interest rate or the existence of borrowing constraints. To obtain the expression for the horizontal intercept, set C2=0 in the equation for the intertemporal budget constraint and solve for C1. Similarly, the expression for the vertical intercept is the value of C2 when C1=0. There is intuition for these expressions. Take the vertical intercept, for example. If the consumer sets C1=0, then he will be saving all of his first-period income. In the second period, he gets to consume this saving plus interest earned, (1+r)Y1, as well as his second-period income. If the consumer chooses C1<Y1, then the consumer will be saving, so his C2 will exceed his Y2. Conversely, if consumer chooses C1>Y1, then consumer is borrowing, so his second-period consumption will fall short of his second-period income (he must use some of the second-period income to repay the loan). CHAPTER 16 Consumption

The slope of the budget line equals -(1+r ) 1 (1+r ) Y1 Y2 The slope of the budget line equals -(1+r): To increase C1 by one unit, the consumer must sacrifice (1+r) units of C2. C1 CHAPTER 16 Consumption

Consumer preferences Higher indifference curves represent higher levels of happiness. C1 C2 An indifference curve shows all combinations of C1 and C2 that make the consumer equally happy. IC2 IC1 CHAPTER 16 Consumption

Consumer preferences The slope of an indifference curve at any point equals the MRS at that point. C1 C2 Marginal rate of substitution (MRS ): the amount of C2 the consumer would be willing to substitute for one unit of C1. IC1 1 MRS CHAPTER 16 Consumption

Optimization C1 C2 The optimal (C1,C2) is where the budget line just touches the highest indifference curve. At the optimal point, MRS = 1+r O All points along the budget line are affordable, including the two points where the orange indifference curve intersects the budget line. However, the consumer prefers (and can afford) point O to these points, because O is on a higher indifference curve. At the optimal point, the slope of the indifference curve (MRS) equals the slope of the budget line (1+r). CHAPTER 16 Consumption

How C responds to changes in Y
An increase in Y1 or Y2 shifts the budget line outward. Results: Provided they are both normal goods, C1 and C2 both increase, …regardless of whether the income increase occurs in period 1 or period 2. CHAPTER 16 Consumption

Keynes vs. Fisher Keynes: Current consumption depends only on current income. Fisher: Current consumption depends only on the present value of lifetime income. The timing of income is irrelevant because the consumer can borrow or lend between periods. If you covered Ricardian Equivalence in Chapter 15, you might wish to revisit it briefly at or around this point in the presentation. Draw the intertemporal budget constraint. Pick a point on it to represent (Y1–T1, Y2–T2). Now suppose the government gives each consumer a one-unit tax cut. Disposable income in period 1 rises by 1. Assume the government is not changing G1 or G2, and, just to keep things simple, assume that the government’s budget was balanced prior to the tax cut. Then, cutting taxes by one unit in period 1 requires that the government borrow one unit in period 1, which it must repay with interest in period 2. In order to retire this debt in period 2, the government must raise period-2 taxes by (1+r). Thus, disposable income rises by 1 in period 1 and falls by (1+r) in period 2. Notice that the present value of the fall in period-2 income is exactly equal to the rise in period 1 income. Thus, consumer is not any better off. What’s happened here is that the government has altered the timing of taxes (shifting some of the burden from the present to the future), but has not altered the present value of lifetime taxes. Therefore, the budget constraint does not shift out. Rather, the income point simply moves along the line toward the southeast (one unit to the right, and 1+r units downward). The combination (C1, C2) that was optimal before will still be feasible and optimal. CHAPTER 16 Consumption

How C responds to changes in r
An increase in r pivots the budget line around the point (Y1,Y2 ). As depicted here, C1 falls and C2 rises. However, it could turn out differently… A A B Y1 Y2 CHAPTER 16 Consumption

How C responds to changes in r
income effect: If consumer is a saver, the rise in r makes him better off, which tends to increase consumption in both periods. substitution effect: The rise in r increases the opportunity cost of current consumption, which tends to reduce C1 and increase C2. Both effects  C2. Whether C1 rises or falls depends on the relative size of the income & substitution effects. Note: Keynes conjectured that the interest rate matters for consumption only in theory. In Fisher’s theory, the interest rate doesn’t affect current consumption if the income and substitution effects are of equal magnitude. After you have shown and explained this slide, it would be useful to pause for a moment and ask your students (perhaps working in pairs) to do the analysis of an increase in the interest rate on the consumption choices of a borrower. In that case, the income effect tends to reduce both current and future consumption, because the interest rate hike makes the borrower worse off. The substitution effect still tends to increase future consumption while reducing current consumption. In the end, current consumption falls unambiguously; future consumption falls if the income effect dominates the substitution effect, and rises if the reverse occurs. CHAPTER 16 Consumption

Constraints on borrowing
In Fisher’s theory, the timing of income is irrelevant: Consumer can borrow and lend across periods. Example: If consumer learns that her future income will increase, she can spread the extra consumption over both periods by borrowing in the current period. However, if consumer faces borrowing constraints (aka “liquidity constraints”), then she may not be able to increase current consumption …and her consumption may behave as in the Keynesian theory even though she is rational & forward-looking. CHAPTER 16 Consumption

The budget line with no borrowing constraints Y2 Y1 CHAPTER 16 Consumption

The borrowing constraint takes the form: C1  Y1 The budget line with a borrowing constraint Y2 Similar to Figure 16-8 on p. 469. Y1 CHAPTER 16 Consumption

Consumer optimization when the borrowing constraint is not binding
The borrowing constraint is not binding if the consumer’s optimal C1 is less than Y1. (Figure 16-9, panel (a), on p.470) In this case, the consumer optimally was not going to borrow, so his inability to borrow has no impact on his choices. Y1 CHAPTER 16 Consumption

Consumer optimization when the borrowing constraint is binding
The optimal choice is at point D. But since the consumer cannot borrow, the best he can do is point E. E (Figure 16-9, panel (b), on p.470) In this case, the consumer would like to borrow to achieve his optimal consumption at point D. If he faces a borrowing constraint, though, then the best he can do is at point E. If you have a few minutes of classtime available, have your students do the following experiment: (This is especially useful if you have recently covered Chapter 15 on Government Debt) Suppose Y1 is increased by $1000 while Y2 is reduced by $1000(1+r), so that the present value of lifetime income is unchanged. Determine the impact on C1 - when consumer does not face a binding borrowing constraint - when consumer does face a binding borrowing constraint Then relate the results to the discussion of Ricardian Equivalence from Chapter 15. Note that the intertemporal redistribution of income in this exercise could be achieved by a debt-financed tax cut in period 1, followed by a tax increase in period 2 that is just sufficient to retire the debt. In the text, pages contain a case study on the high Japanese saving rate that relates to the material on borrowing constraints just covered. D Y1 CHAPTER 16 Consumption

The Life-Cycle Hypothesis
due to Franco Modigliani (1950s) Fisher’s model says that consumption depends on lifetime income, and people try to achieve smooth consumption. The LCH says that income varies systematically over the phases of the consumer’s “life cycle,” and saving allows the consumer to achieve smooth consumption. CHAPTER 16 Consumption

The basic model: W = initial wealth Y = annual income until retirement (assumed constant) R = number of years until retirement T = lifetime in years Assumptions: zero real interest rate (for simplicity) consumption-smoothing is optimal The initial wealth could be zero, or could be a gift from parents to help the consumer get started on her own. CHAPTER 16 Consumption

Lifetime resources = W + RY To achieve smooth consumption, consumer divides her resources equally over time: C = (W + RY )/T , or C = aW + bY where a = (1/T ) is the marginal propensity to consume out of wealth b = (R/T ) is the marginal propensity to consume out of income CHAPTER 16 Consumption

Implications of the Life-Cycle Hypothesis
The LCH can solve the consumption puzzle: The life-cycle consumption function implies APC = C/Y = a(W/Y ) + b Across households, income varies more than wealth, so high-income households should have a lower APC than low-income households. Over time, aggregate wealth and income grow together, causing APC to remain stable. CHAPTER 16 Consumption

Implications of the Life-Cycle Hypothesis
$ Wealth The LCH implies that saving varies systematically over a person’s lifetime. Income Saving Figure 16-12, p.474. Consumption Dissaving Retirement begins End of life CHAPTER 16 Consumption

The Permanent Income Hypothesis
due to Milton Friedman (1957) Y = Y P + Y T where Y = current income Y P = permanent income average income, which people expect to persist into the future Y T = transitory income temporary deviations from average income The middle of page 476 gives two hypothetical examples that help students understand the concepts of permanent and transitory income. CHAPTER 16 Consumption

Consumers use saving & borrowing to smooth consumption in response to transitory changes in income. The PIH consumption function: C = a Y P where a is the fraction of permanent income that people consume per year. CHAPTER 16 Consumption

The PIH can solve the consumption puzzle: The PIH implies APC = C / Y = a Y P/ Y If high-income households have higher transitory income than low-income households, APC is lower in high-income households. Over the long run, income variation is due mainly (if not solely) to variation in permanent income, which implies a stable APC. CHAPTER 16 Consumption

PIH vs. LCH Both: people try to smooth their consumption in the face of changing current income. LCH: current income changes systematically as people move through their life cycle. PIH: current income is subject to random, transitory fluctuations. Both can explain the consumption puzzle. CHAPTER 16 Consumption

The Random-Walk Hypothesis
due to Robert Hall (1978) based on Fisher’s model & PIH, in which forward-looking consumers base consumption on expected future income Hall adds the assumption of rational expectations, that people use all available information to forecast future variables like income. CHAPTER 16 Consumption

The Random-Walk Hypothesis
If PIH is correct and consumers have rational expectations, then consumption should follow a random walk: changes in consumption should be unpredictable. A change in income or wealth that was anticipated has already been factored into expected permanent income, so it will not change consumption. Only unanticipated changes in income or wealth that alter expected permanent income will change consumption. CHAPTER 16 Consumption

Implication of the R-W Hypothesis
If consumers obey the PIH and have rational expectations, then policy changes will affect consumption only if they are unanticipated. This result is important because many policies affect the economy by influencing consumption and saving. For example, a tax cut to stimulate aggregate demand only works if consumers respond to the tax cut by increasing spending. The R-W Hypothesis implies that consumption will respond only if consumers had not anticipated the tax cut. This result also implies that consumption will respond immediately to news about future changes in income. Students connect with the following example: Suppose a student is job-hunting in her senior year for a job that will begin after graduation. If the student secures a job with a higher salary than she had expected, she is likely to start spending more now in anticipation of the higher-than-expected permanent income. CHAPTER 16 Consumption

The Psychology of Instant Gratification
Theories from Fisher to Hall assume that consumers are rational and act to maximize lifetime utility. Recent studies by David Laibson and others consider the psychology of consumers. CHAPTER 16 Consumption

The Psychology of Instant Gratification
Consumers consider themselves to be imperfect decision-makers. In one survey, 76% said they were not saving enough for retirement. Laibson: The “pull of instant gratification” explains why people don’t save as much as a perfectly rational lifetime utility maximizer would save. CHAPTER 16 Consumption

Two questions and time inconsistency
1. Would you prefer (A) a candy today, or (B) two candies tomorrow? 2. Would you prefer (A) a candy in 100 days, or (B) two candies in 101 days? In studies, most people answered (A) to 1 and (B) to 2. A person confronted with question 2 may choose (B). But in 100 days, when confronted with question 1, the pull of instant gratification may induce her to change her answer to (A). The text discusses time inconsistency in this context. Time inconsistency was introduced and defined in chapter 14. CHAPTER 16 Consumption

Summing up Keynes: consumption depends primarily on current income.
Recent work: consumption also depends on expected future income wealth interest rates Economists disagree over the relative importance of these factors, borrowing constraints, and psychological factors. CHAPTER 16 Consumption

Chapter Summary 1. Keynesian consumption theory Keynes’ conjectures
MPC is between 0 and 1 APC falls as income rises current income is the main determinant of current consumption Empirical studies in household data & short time series: confirmation of Keynes’ conjectures in long-time series data: APC does not fall as income rises CHAPTER 16 Consumption slide 758

Chapter Summary 2. Fisher’s theory of intertemporal choice
Consumer chooses current & future consumption to maximize lifetime satisfaction of subject to an intertemporal budget constraint. Current consumption depends on lifetime income, not current income, provided consumer can borrow & save. CHAPTER 16 Consumption slide 759

Chapter Summary 3. Modigliani’s life-cycle hypothesis
Income varies systematically over a lifetime. Consumers use saving & borrowing to smooth consumption. Consumption depends on income & wealth. CHAPTER 16 Consumption slide 760

Chapter Summary 4. Friedman’s permanent-income hypothesis
Consumption depends mainly on permanent income. Consumers use saving & borrowing to smooth consumption in the face of transitory fluctuations in income. CHAPTER 16 Consumption slide 761

Chapter Summary 5. Hall’s random-walk hypothesis
Combines PIH with rational expectations. Main result: changes in consumption are unpredictable, occur only in response to unanticipated changes in expected permanent income. CHAPTER 16 Consumption slide 762

Chapter Summary 6. Laibson and the pull of instant gratification
Uses psychology to understand consumer behavior. The desire for instant gratification causes people to save less than they rationally know they should. CHAPTER 16 Consumption slide 763

17 Investment This chapter begins by reviewing the three components of investment, and presents a time series graph of all three components, and total investment, to show the relative size of each component and to show their behavior over business cycles. Then, the chapter presents the leading theory of each component of investment. The chapter is of average length and difficulty.

leading theories to explain each type of investment why investment is negatively related to the interest rate things that shift the investment function why investment rises during booms and falls during recessions CHAPTER 17 Investment

Three types of investment
Business fixed investment: businesses’ spending on equipment and structures for use in production. Residential investment: purchases of new housing units (either by occupants or landlords). Inventory investment: the value of the change in inventories of finished goods, materials and supplies, and work in progress. CHAPTER 17 Investment

U.S. investment and its components
Billions of dollars 2000 Total investment 1750 Business fixed investment 1500 Residential investment 1250 Change in inventories 1000 750 500 Figure 17-1, p Source: U.S. Dept of Commerce. What we learn from this graph: 1. Business fixed investment is the largest of the three types of investment 2. Investment varies with the business cycle, rising in booms and falling in recessions. 250 -250 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 17 Investment

Understanding business fixed investment
The standard model of business fixed investment: the neoclassical model of investment Shows how investment depends on MPK interest rate tax rules affecting firms CHAPTER 17 Investment

Two types of firms For simplicity, assume two types of firms:
1. Production firms rent the capital they use to produce goods and services. 2. Rental firms own capital, rent it to production firms. In this context, “investment” is the rental firms’ spending on new capital goods. Note: Many students find it easier to learn the following material by separating the investment decision from the production decision. Of course, the lessons apply to real-world firms that actually do both functions. CHAPTER 17 Investment

The capital rental market
capital stock real rental price, R/P Production firms must decide how much capital to rent. Recall from Chap. 3: Competitive firms rent capital to the point where MPK = R/P. capital supply capital demand (MPK) equilibrium rental rate The graph of the rental market for capital is review from chapter 3. As you present it to your students, it might be worthwhile to briefly review each piece (why the supply curve is vertical, why demand = MPK). CHAPTER 17 Investment

Factors that affect the rental price
For the Cobb-Douglas production function, the MPK (and hence equilibrium R/P ) is The equilibrium R/P would increase if: K (e.g., earthquake or war) L (e.g., pop. growth or immigration) A (technological improvement, or deregulation) (It might be worth reminding students that A represents the level of technology, and  is a number between 0 and 1 that equals capital’s share of national income.) We use the C-D function for two reasons: First, we can make the ideas here more concrete with a specific functional form, and second, because the C-D function will be familiar to most students from earlier chapters (the appendix to Chapter 3, and the economic growth chapters). If students are wondering where the MPK equation comes from, either refer them to the Appendix to chapter 3, or, if they are acquainted with basic calculus, take the derivative of the C-D production function with respect to K. Regarding the impact of an increase in A on R/P: We usually associate A with technology. However, A represents anything that affects the amount of output that can be produced from a given bundle of inputs. For example, firms use resources (in this context, L and/or K) to comply with regulations (some labor time is used to fill out forms; some capital is used to reduce emissions of nasty things into the air or rivers). A relaxation of regulations would allow firms to divert these resources from compliance with regulations to production, causing output to increase. Hence, a deregulation could cause A to rise. CHAPTER 17 Investment

Rental firms’ investment decisions
Rental firms invest in new capital when the benefit of doing so exceeds the cost. The benefit (per unit capital): R/P, the income that rental firms earn from renting the unit of capital to production firms. CHAPTER 17 Investment

The cost of capital Components of the cost of capital:
interest cost: i PK, where PK = nominal price of capital depreciation cost:  PK, where  = rate of depreciation capital loss:  PK (a capital gain, PK > 0, reduces cost of K ) The total cost of capital is the sum of these three parts: Notes: Interest cost-- If firms borrow in the loanable funds market (from chapter 3) to finance their purchases of capital, then they incur interest. But even if firms use their own funds, they incur an opportunity cost equal to the interest they could have earned had they purchased Pk worth of bonds instead of spending Pk to buy a piece of capital. Depreciation cost-- Remind students that  is the depreciation rate, the percentage of capital that wears out each period. If the firm starts the period with $1000 worth of capital and the depreciation rate = 0.03, then at the end of the period, the value of the firm’s capital equals (1-0.03)$1000 = $970. CHAPTER 17 Investment

Nominal cost of capital
The cost of capital Nominal cost of capital Example: car rental company (capital: cars) Suppose PK = $10,000, i = 0.10,  = 0.20, and PK/PK = 0.06 Then, interest cost = depreciation cost = capital loss = total cost = If the price of capital, Pk, falls during the period, then firm incurs a capital loss, which increases its cost of capital. In this example, the price of capital rises, so the “capital loss” is negative. (Or, there’s a capital gain which we subtract from the cost, because the increase in the price of new capital reduces the cost of capital.) $1000 $2000  $600 $2400 CHAPTER 17 Investment

The cost of capital For simplicity, assume PK/PK = .
Then, the nominal cost of capital equals PK(i +   ) = PK(r + ) and the real cost of capital equals The real cost of capital depends positively on: the relative price of capital the real interest rate the depreciation rate The assumption in the first line says that the price of capital rises as fast as the general price level. The real cost of capital equals the nominal cost divided by the price level, just as the real wage equals the nominal wage divided by P. CHAPTER 17 Investment

The rental firm’s profit rate
A firm’s net investment depends on its profit rate: If profit rate > 0, then increasing K is profitable If profit rate < 0, then the firm increases profits by reducing its capital stock. (Firm reduces K by not replacing it as it depreciates.) In plain English, the profit rate equals (the rental price of capital) minus (the user cost of capital) CHAPTER 17 Investment

Net investment & gross investment
Hence, where In[ ] is a function that shows how net investment responds to the incentive to invest. Total spending on business fixed investment equals net investment plus replacement of depreciated K: The equation in the yellow box simply states “net investment depends on the profit rate.” It might be useful to remind students that gross investment is simply net investment plus depreciation. CHAPTER 17 Investment

An increase in r raises the cost of capital reduces the profit rate and reduces investment: I r r2 Finally, we see where our familiar investment function comes from. I1 r1 I2 CHAPTER 17 Investment

An increase in MPK or decrease in PK/P increases the profit rate increases investment at any given interest rate shifts I curve to the right. I r Here’s a challenge for particularly bright students: Ask what happens to the investment curve given an increase in the depreciation rate. Tell them to justify their answer based on the investment equation we have derived. Answer: The impact on the curve is ambiguous. The depreciation rate appears in two different places in the equation. First, it appears in the expression for the profit rate, which is the argument of the net investment function. An increase in the depreciation rate would raise the cost of capital and hence reduce the profit rate and the incentive to invest (*net* investment). This would tend to shift the curve left. Second, the depreciation rate appears as a coefficient on K. An increase in the depreciation rate means that more investment (*gross* investment) is needed to replace depreciating capital and keep the total capital stock at its optimal level. This effect would shift the curve right. The net impact of the two opposing forces is ambiguous, without knowing the specific form of the In( ) function. Note: This exercise is simply for practice, and does not correspond to a real-world policy example. I1 r1 I2 CHAPTER 17 Investment

Taxes and investment Two of the most important taxes affecting investment: Corporate income tax Investment tax credit CHAPTER 17 Investment

Corporate Income Tax: A tax on profits
Impact on investment depends on definition of “profit” In our definition (rental price minus cost of capital), depreciation cost is measured using current price of capital, and the CIT would not affect investment But, the legal definition uses the historical price of capital. If PK rises over time, then the legal definition understates the true cost and overstates profit, so firms could be taxed even if their true economic profit is zero. Thus, corporate income tax discourages investment. Why the corporate income tax doesn’t affect investment when profits are defined as in the textbook: Let  be the tax rate and--for this note only--let  denote the profit rate as defined above. The after-tax profit rate equals (1). The firm’s investment decision depends on whether its profit rate is positive. As long as  < 1, then the sign of (1) equals the sign of . I.e., if an investment project is profitable without the tax, it will be profitable (though less so) with the tax. Why using the historical price to compute depreciation understates the true cost of capital: Consider the car rental example from a few slides ago. Suppose that when the car was originally purchased, the price was only $ Then, according to the government, depreciation is only $1600 = 0.2 (the depreciation rate) times $8000 (the historical price of capital). So, according to the government, the total cost of capital is only $2000, which is $400 less than the true economic cost of capital. Thus, the government is taxing the car rental firm ( + 400) instead of . (Please forgive my use of  to represent profit in this note when everywhere else we are using it to represent inflation!) CHAPTER 17 Investment

The Investment Tax Credit (ITC)
The ITC reduces a firm’s taxes by a certain amount for each dollar it spends on capital. Hence, the ITC effectively reduces PK which increases the profit rate and the incentive to invest. CHAPTER 17 Investment

Tobin’s q numerator: the stock market value of the economy’s capital stock. denominator: the actual cost to replace the capital goods that were purchased when the stock was issued. If q > 1, firms buy more capital to raise the market value of their firms. If q < 1, firms do not replace capital as it wears out. CHAPTER 17 Investment

Relation between q theory and neoclassical theory described above
The stock market value of capital depends on the current & expected future profits of capital. If MPK > cost of capital, then profit rate is high, which drives up the stock market value of the firms, which implies a high value of q. If MPK < cost of capital, then firms are incurring losses, so their stock market values fall, so q is low. CHAPTER 17 Investment

The stock market and GDP
Reasons for a relationship between the stock market and GDP: 1. A wave of pessimism about future profitability of capital would cause stock prices to fall cause Tobin’s q to fall shift the investment function down cause a negative aggregate demand shock CHAPTER 17 Investment

Reasons for a relationship between the stock market and GDP: 2. A fall in stock prices would reduce household wealth shift the consumption function down cause a negative aggregate demand shock CHAPTER 17 Investment

Reasons for a relationship between the stock market and GDP: 3. A fall in stock prices might reflect bad news about technological progress and long-run economic growth. This implies that aggregate supply and full-employment output will be expanding more slowly than people had expected. CHAPTER 17 Investment

Real GDP (right scale) Percent change from 1 year earlier 50 10 Percent change from 1 year earlier Stock prices (left scale) 40 8 30 6 20 4 10 2 Figure 17-4 on p Source: U.S. Department of Commerce and Global Financial Data. The measure of the stock market is the Dow Jones Industrial Average. The figure shows that the stock market and GDP tend to move together, but the association is far from precise. -10 -2 -20 -4 -30 -6 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 17 Investment

Alternative views of the stock market: The Efficient Markets Hypothesis
Efficient Markets Hypothesis (EMH): The market price of a company’s stock is the fully rational valuation of the company, given current information about the company’s business prospects. Stock market is informationally efficient: each stock price reflects all available information about the stock. Implies that stock prices should follow a random walk (be unpredictable), and should only change as new information arrives. This and the next two slides correspond to new material in the 6th edition, on pp CHAPTER 17 Investment

Alternative views of the stock market: Keynes’s “beauty contest”
Idea based on newspaper beauty contest in which a reader wins a prize if he/she picks the women most frequently selected by other readers as most beautiful. Keynes proposed that stock prices reflect people’s views about what other people think will happen to stock prices; the best investors could outguess mass psychology. Keynes believed stock prices reflect irrational waves of pessimism/optimism (“animal spirits”). CHAPTER 17 Investment

Alternative views of the stock market: EMH vs. Keynes’s beauty contest
Both views persist. There is evidence for the EMH and random-walk theory (see p.498). Yet, some stock market movements do not seem to rationally reflect new information. CHAPTER 17 Investment

Financing constraints
Neoclassical theory assumes firms can borrow to buy capital whenever doing so is profitable. But some firms face financing constraints: limits on the amounts they can borrow (or otherwise raise in financial markets). A recession reduces current profits. If future profits expected to be high, investment might be worthwhile. But if firm faces financing constraints and current profits are low, firm might be unable to obtain funds. CHAPTER 17 Investment

Residential investment
The flow of new residential investment, IH , depends on the relative price of housing PH /P. PH /P determined by supply and demand in the market for existing houses. CHAPTER 17 Investment

How residential investment is determined
(a) The market for housing Demand Supply Supply and demand for houses determines the equilib. price of houses. The equilibrium price of houses then determines residential investment: KH Stock of housing capital CHAPTER 17 Investment

How residential investment is determined
(a) The market for housing (b) The supply of new housing Demand Supply Supply KH IH Stock of housing capital Flow of residential investment CHAPTER 17 Investment

How residential investment responds to a fall in interest rates
(a) The market for housing (b) The supply of new housing Demand Supply Supply The main point of this slide is to establish more formally the dependence of investment (in this case, residential investment) on the interest rate. A fall in interest rates increases the demand for houses, bidding up the price of houses (relative to the general level of prices). The higher relative price of houses motivates firms to increase residential investment. KH IH Stock of housing capital Flow of residential investment CHAPTER 17 Investment

The tax treatment of housing
The tax code, in effect, subsidizes home ownership by allowing people to deduct mortgage interest. The deduction applies to the nominal mortgage rate, so this subsidy is higher when inflation and nominal mortgage rates are high than when they are low. Some economists think this subsidy causes over-investment in housing relative to other forms of capital But eliminating the mortgage interest deduction would be politically difficult. CHAPTER 17 Investment

Inventory investment is only about 1% of GDP.
Yet, in the typical recession, more than half of the fall in spending is due to a fall in inventory investment. CHAPTER 17 Investment

Motives for holding inventories
1. production smoothing Sales fluctuate, but many firms find it cheaper to produce at a steady rate. When sales < production, inventories rise. When sales > production, inventories fall. CHAPTER 17 Investment

1. production smoothing 2. inventories as a factor of production Inventories allow some firms to operate more efficiently. samples for retail sales purposes spare parts for when machines break down CHAPTER 17 Investment

1. production smoothing 2. inventories as a factor of production 3. stock-out avoidance To prevent lost sales when demand is higher than expected. CHAPTER 17 Investment

1. production smoothing 2. inventories as a factor of production 3. stock-out avoidance 4. work in process Goods not yet completed are counted in inventory. CHAPTER 17 Investment

The Accelerator Model A simple theory that explains the behavior of inventory investment, without endorsing any particular motive CHAPTER 17 Investment

The Accelerator Model Notation: N = stock of inventories N = inventory investment Assume: Firms hold a stock of inventories proportional to their output N =  Y, where  is an exogenous parameter reflecting firms’ desired stock of inventory as a proportion of output. CHAPTER 17 Investment

The Accelerator Model Result: N =  Y
Inventory investment is proportional to the change in output. When output is rising, firms increase inventories. When output is falling, firms allow their inventories to run down. CHAPTER 17 Investment

Evidence for the Accelerator Model
Inventory investment (billions of 1996 dollars) 100 1982 2001 2004 1998 1984 1978 1996 1983 1967 1974 80 60 40 20 A near-replica of Figure 17-7, p.506, except that the data Mankiw gave me to construct this graph are in 1996 dollars, whereas the data used to construct Figure 17-7 in the textbook are in 2000 dollars. This scatterplot shows that inventory investment is high in years when real GDP rises and low in years when real GDP falls, just as the accelerator model predicts. -20 -40 -200 -100 100 200 300 400 500 Change in real GDP (billions of 1996 dollars) CHAPTER 17 Investment

Inventories and the real interest rate
The opportunity cost of holding goods in inventory: the interest that could have been earned on the revenue from selling those goods. Hence, inventory investment depends on the real interest rate. Example: High interest rates in the 1980s motivated many firms to adopt just-in-time production, which is designed to reduce inventories. CHAPTER 17 Investment

Chapter Summary All types of investment depend negatively on the real interest rate. Things that shift the investment function: Technological improvements raise MPK and raise business fixed investment. Increase in population raises demand for, price of housing and raises residential investment. Economic policies (corporate income tax, investment tax credit) alter incentives to invest. CHAPTER 17 Investment slide 808

Chapter Summary Investment is the most volatile component of GDP over the business cycle. Fluctuations in employment affect the MPK and the incentive for business fixed investment. Fluctuations in income affect demand for, price of housing and the incentive for residential investment. Fluctuations in output affect planned & unplanned inventory investment. CHAPTER 17 Investment slide 809

Money Supply and Money Demand
18 Money Supply and Money Demand This chapter is particularly good for students with interests in money and banking and finance. The first half of this chapter covers money supply, including money creation in the banking system, and how the central bank controls the money supply. Much of this material is review for most students who took a macro principles course. However, this chapter presents a model of the money multiplier that is more realistic than the models found in most principles texts. The second half of the chapter presents several theories of money demand.

how the banking system “creates” money three ways the Fed can control the money supply, and why the Fed can’t control it precisely Theories of money demand a portfolio theory a transactions theory: the Baumol-Tobin model CHAPTER 18 Money Supply and Money Demand

Banks’ role in the money supply
The money supply equals currency plus demand (checking account) deposits: M = C + D Since the money supply includes demand deposits, the banking system plays an important role. CHAPTER 18 Money Supply and Money Demand

A few preliminaries Reserves (R ): the portion of deposits that banks have not lent. A bank’s liabilities include deposits, assets include reserves and outstanding loans. 100-percent-reserve banking: a system in which banks hold all deposits as reserves. Fractional-reserve banking: a system in which banks hold a fraction of their deposits as reserves. It might be worthwhile at this point to explain why deposits are liabilities and why reserves and loans are assets. CHAPTER 18 Money Supply and Money Demand

With no banks, D = 0 and M = C = $1000.
SCENARIO 1: No banks With no banks, D = 0 and M = C = $1000. In this and the following examples, we assume there is $1000 in currency circulating in the economy. We then compare the size of the money supply in different scenarios about the banking system: no banks, 100% reserve banking, and fractional reserve banking. CHAPTER 18 Money Supply and Money Demand

SCENARIO 2: 100-percent reserve banking
Initially C = $1000, D = $0, M = $1,000. Now suppose households deposit the $1,000 at “Firstbank.” After the deposit, C = $0, D = $1,000, M = $1,000. 100%-reserve banking has no impact on size of money supply. FIRSTBANK’S balance sheet Assets Liabilities reserves $1,000 deposits $1,000 CHAPTER 18 Money Supply and Money Demand

SCENARIO 3: Fractional-reserve banking
Suppose banks hold 20% of deposits in reserve, making loans with the rest. Firstbank will make $800 in loans. The money supply now equals $1,800: Depositor has $1,000 in demand deposits. Borrower holds $800 in currency. FIRSTBANK’S balance sheet Assets Liabilities reserves $1,000 deposits $1,000 reserves $200 loans $800 CHAPTER 18 Money Supply and Money Demand

Thus, in a fractional-reserve banking system, banks create money. The money supply now equals $1,800: Depositor has $1,000 in demand deposits. Borrower holds $800 in currency. FIRSTBANK’S balance sheet Assets Liabilities deposits $1,000 reserves $200 loans $800 CHAPTER 18 Money Supply and Money Demand

Suppose the borrower deposits the $800 in Secondbank. Initially, Secondbank’s balance sheet is: SECONDBANK’S balance sheet Assets Liabilities Secondbank will loan 80% of this deposit. Maybe the borrower deposits the $800 in the bank. Or maybe the borrower uses the money to buy something from someone else, who then deposits it in the bank. In either case, the $800 finds its way back into the banking system. reserves $800 loans $0 reserves $160 loans $640 deposits $800 CHAPTER 18 Money Supply and Money Demand

If this $640 is eventually deposited in Thirdbank, then Thirdbank will keep 20% of it in reserve, and loan the rest out: THIRDBANK’S balance sheet Assets Liabilities Again, the person who borrowed the $640 will either deposit it in his own checking account, or will use it to buy something from somebody who, in turn, deposits it in her checking account. In either case, the $640 winds up in a bank somewhere, and that bank can then use it to make new loans. reserves $128 loans $512 reserves $640 loans $0 deposits $640 CHAPTER 18 Money Supply and Money Demand

Finding the total amount of money:
Original deposit = $1000 + Firstbank lending = $ 800 + Secondbank lending = $ 640 + Thirdbank lending = $ 512 + other lending… Total money supply = (1/rr )  $1, where rr = ratio of reserves to deposits In our example, rr = 0.2, so M = $5,000 CHAPTER 18 Money Supply and Money Demand

Money creation in the banking system
A fractional reserve banking system creates money, but it doesn’t create wealth: Bank loans give borrowers some new money and an equal amount of new debt. CHAPTER 18 Money Supply and Money Demand

A model of the money supply
exogenous variables Monetary base, B = C + R controlled by the central bank Reserve-deposit ratio, rr = R/D depends on regulations & bank policies Currency-deposit ratio, cr = C/D depends on households’ preferences CHAPTER 18 Money Supply and Money Demand

Solving for the money supply:
where The point of all this algebra is to express the money supply in terms of the three exogenous variables described on the preceding slide. CHAPTER 18 Money Supply and Money Demand

The money multiplier where If rr < 1, then m > 1
If monetary base changes by B, then M = m  B m is the money multiplier, the increase in the money supply resulting from a one-dollar increase in the monetary base. CHAPTER 18 Money Supply and Money Demand

Exercise where Suppose households decide to hold more of their money as currency and less in the form of demand deposits. Determine impact on money supply. Explain the intuition for your result. CHAPTER 18 Money Supply and Money Demand

Solution to exercise Impact of an increase in the currency-deposit ratio cr > 0. An increase in cr increases the denominator of m proportionally more than the numerator. So m falls, causing M to fall. If households deposit less of their money, then banks can’t make as many loans, so the banking system won’t be able to “create” as much money. Note: An increase in cr raises both the numerator and denominator of the expression for m. But since rr < 1, the denominator is smaller than the numerator, so a given increase in cr will increase the denominator proportionally more than the numerator, causing a decrease in m. If your students know calculus, they can use the quotient rule to see that (dm/dcr) < 0. CHAPTER 18 Money Supply and Money Demand

Three instruments of monetary policy
1. Open-market operations 2. Reserve requirements 3. The discount rate CHAPTER 18 Money Supply and Money Demand

Open-market operations
definition: The purchase or sale of government bonds by the Federal Reserve. how it works: If Fed buys bonds from the public, it pays with new dollars, increasing B and therefore M. Why it’s called “open market operations”: The “operations” are the buying and selling. The market in which U.S. Treasury bonds are traded is “open” in the sense that anyone---you, me, your Aunt Zelda, the Fed---can buy or sell in this market. CHAPTER 18 Money Supply and Money Demand

Reserve requirements definition: Fed regulations that require banks to hold a minimum reserve-deposit ratio. how it works: Reserve requirements affect rr and m: If Fed reduces reserve requirements, then banks can make more loans and “create” more money from each deposit. CHAPTER 18 Money Supply and Money Demand

The discount rate definition: The interest rate that the Fed charges on loans it makes to banks. how it works: When banks borrow from the Fed, their reserves increase, allowing them to make more loans and “create” more money. The Fed can increase B by lowering the discount rate to induce banks to borrow more reserves from the Fed. CHAPTER 18 Money Supply and Money Demand

Which instrument is used most often?
Open-market operations: most frequently used. Changes in reserve requirements: least frequently used. Changes in the discount rate: largely symbolic. The Fed is a “lender of last resort,” does not usually make loans to banks on demand. Why not reserve requirements? Making them too low creates a risk of bank runs. Making them too high makes banking unprofitable. In addition, banking would be difficult if the Fed changed reserve requirements frequently. CHAPTER 18 Money Supply and Money Demand

Why the Fed can’t precisely control M
where Households can change cr, causing m and M to change. Banks often hold excess reserves (reserves above the reserve requirement). If banks change their excess reserves, then rr, m, and M change. CHAPTER 18 Money Supply and Money Demand

CASE STUDY: Bank failures in the 1930s
From 1929 to 1933, Over 9,000 banks closed. Money supply fell 28%. This drop in the money supply may have caused the Great Depression. It certainly contributed to the severity of the Depression. CHAPTER 18 Money Supply and Money Demand

where Loss of confidence in banks  cr  m Banks became more cautious  rr  m CHAPTER 18 Money Supply and Money Demand

August 1929 March 1933 % change 13.5 5.5 19.0 –40.3 41.0 –28.3% 22.6 D 3.9 C 26.5 M 2.9 5.5 8.4 –9.4 41.0 18.3 3.2 R 3.9 C 7.1 B Table 18-1, p.517. Source: Adapted from Milton Friedman and Anna Schwartz, A Monetary History of the United States, (Princeton, NJ: Princeton University Press, 1963), Appendix A. To the table, I have added an extra column with the percent changes. I have animated the table so that the rows appear in three groups. First group: M, C, and D, because M = C + D Second group: B, C, and R, because B = C + R Third group: m and its components, rr and cr The base rises, yet the money multiplier falls so much that the money supply falls. 0.41 0.21 2.3 141.2 50.0 –37.8 0.17 cr 0.14 rr 3.7 m CHAPTER 18 Money Supply and Money Demand

Could this happen again?
Many policies have been implemented since the 1930s to prevent such widespread bank failures. E.g., Federal Deposit Insurance, to prevent bank runs and large swings in the currency-deposit ratio. CHAPTER 18 Money Supply and Money Demand

Money Demand Two types of theories Portfolio theories
emphasize “store of value” function relevant for M2, M3 not relevant for M1. (As a store of value, M1 is dominated by other assets.) Transactions theories emphasize “medium of exchange” function also relevant for M1 Why portfolio theories are not relevant for M1: As a store of value, M1 is dominated by other assets: other assets serve the store of value function as well as M1, but offer a better risk/return profile, so there is no reason why anybody would hold M1 for a store of value. CHAPTER 18 Money Supply and Money Demand

A simple portfolio theory
where rs = expected real return on stocks rb = expected real return on bonds  e = expected inflation rate W = real wealth Intuition for the signs: Stocks and bonds are alternatives to money. An increase in their expected returns makes money less attractive, and thus reduces desired money holdings. The real return to holding money is -e. An increase in e is a decrease in the real return to holding money, which would cause a decrease in desired money balances. And finally, an increase in wealth causes an increase in the demand for all assets. CHAPTER 18 Money Supply and Money Demand

The Baumol-Tobin Model
a transactions theory of money demand notation: Y = total spending, done gradually over the year i = interest rate on savings account N = number of trips consumer makes to the bank to withdraw money from savings account F = cost of a trip to the bank (e.g., if a trip takes 15 minutes and consumer’s wage = $12/hour, then F = $3) In the Baumol-Tobin model, we assume for simplicity that the consumer’s wealth is divided between cash on hand and savings account deposits. The savings account pays interest rate i, while cash pays no nominal interest. Alternatively, we can think of “money” in the Baumol-Tobin model as representing all monetary assets, including some that pay interest. Then, i in the model would be the interest rate on non-monetary assets (e.g. stocks & bonds) minus the interest rate on monetary assets (interest-bearing checking & money market deposit accounts). F would be the cost of converting non-monetary assets into monetary ones, such as a brokerage fee. The decision about how often to pay the brokerage fee is analogous to the decision about how often to make a trip to the bank. CHAPTER 18 Money Supply and Money Demand

Money holdings over the year
Time 1 N = 1 Average = Y/ 2 Figure 18-1 on p.521. Our first step: compute average money holdings as a function of N. (Then, we will find the optimal value of N.) If N=1, then the consumer withdraws $Y from her savings account at the beginning of the year. As she spends it gradually throughout the year, her money holdings fall. CHAPTER 18 Money Supply and Money Demand

Time 1 1/2 N = 2 Y Y/ 2 Average = Y/ 4 Figure 18-1 on p.521. If N = 2, consumer makes one trip at the beginning of the year, withdraws half of the money she will spend throughout the year. She spends it gradually over the first half of the year until it runs out. Then she makes another trip, withdrawing enough money to last her the second half of the year, and spends it down gradually. CHAPTER 18 Money Supply and Money Demand

1/3 2/3 Money holdings Time 1 N = 3 Y Average = Y/ 6 Y/ 3 Figure 18-1 on p.521. CHAPTER 18 Money Supply and Money Demand

The cost of holding money
In general, average money holdings = Y/2N Foregone interest = i (Y/2N ) Cost of N trips to bank = F N Thus, Given Y, i, and F, consumer chooses N to minimize total cost CHAPTER 18 Money Supply and Money Demand

Finding the cost-minimizing N
Figure 18-2 on p.523. (For any value of N, the height of the red line equals the height of the blue line plus the height of the green line at that N.) This slide shows the graphical derivation of N*. The following slide uses basic calculus to derive an expression for N*. It is “hidden” and can be omitted without loss of continuity. If you display it, then before leaving this slide you might point out that the slope of the cost function (red line) equals zero at N*. CHAPTER 18 Money Supply and Money Demand

The cost-minimizing value of N : To obtain the money demand function, plug N* into the expression for average money holdings: If you did not show your students the slide with the calculus derivation of the expression for N*, then you can just say “it turns out that N* is equal to this expression….” Money demand depends positively on Y and F, and negatively on i. CHAPTER 18 Money Supply and Money Demand

The Baumol-Tobin money demand function: How this money demand function differs from previous chapters: B-T shows how F affects money demand. B-T implies: income elasticity of money demand = 0.5, interest rate elasticity of money demand = 0.5 Page 523 of the text contains a very nice paragraph discussing things that alter F, and hence money demand: automatic teller machines internet banking wages (higher wages increase the opportunity cost of time spent visiting the bank) bank or brokerage fees CHAPTER 18 Money Supply and Money Demand

EXERCISE: The impact of ATMs on money demand
During the 1980s, automatic teller machines became widely available. How do you think this affected N* and money demand? Explain. Answer: (From p.523) “The spread of automatic teller machines reduces F by reducing the time it takes to withdraw money.” Lower F increases N* and decreases money demand - you can see this from the expressions N* and money demand. A decrease in the cost of withdrawing money allows consumers to hold lower real money balances relative to their spending, so they can keep more of their money in interest-bearing bank accounts. Of course, they will need to make more trips to the bank now, but doing so is less costly. CHAPTER 18 Money Supply and Money Demand

Examples of financial innovation:
Financial Innovation, Near Money, and the Demise of the Monetary Aggregates Examples of financial innovation: many checking accounts now pay interest very easy to buy and sell assets mutual funds are baskets of stocks that are easy to redeem - just write a check Non-monetary assets having some of the liquidity of money are called near money. Money & near money are close substitutes, and switching from one to the other is easy. CHAPTER 18 Money Supply and Money Demand

Financial Innovation, Near Money, and the Demise of the Monetary Aggregates
The rise of near money makes money demand less stable and complicates monetary policy. 1993: the Fed switched from targeting monetary aggregates to targeting the Federal Funds rate. This change may help explain why the U.S. economy was so stable during the rest of the 1990s. CHAPTER 18 Money Supply and Money Demand

Chapter Summary 1. Fractional reserve banking creates money because each dollar of reserves generates many dollars of demand deposits. 2. The money supply depends on the monetary base currency-deposit ratio reserve ratio 3. The Fed can control the money supply with open market operations the reserve requirement the discount rate CHAPTER 18 Money Supply and Money Demand slide 851

Chapter Summary 4. Portfolio theories of money demand
stress the store of value function posit that money demand depends on risk/return of money & alternative assets 5. The Baumol-Tobin model a transactions theory of money demand, stresses “medium of exchange” function money demand depends positively on spending, negatively on the interest rate, and positively on the cost of converting non-monetary assets to money CHAPTER 18 Money Supply and Money Demand slide 852

Advances in Business Cycle Theory
19 Advances in Business Cycle Theory This brief chapter introduces the student to basic concepts in Real Business Cycle theory and New Keynesian theory. It could be covered in one class session. This chapter is especially useful for prospective doctoral students.

an overview of recent work in two areas: Real Business Cycle theory New Keynesian Economics CHAPTER 19 Advances in Business Cycle Theory

The Theory of Real Business Cycles
All prices are flexible, even in short run: thus, money is neutral, even in short run. classical dichotomy holds at all times. Fluctuations in output, employment, and other variables are the optimal responses to exogenous changes in the economic environment. Productivity shocks are the primary cause of economic fluctuations. CHAPTER 19 Advances in Business Cycle Theory

The economics of Robinson Crusoe
Economy consists of a single producer-consumer, like Robinson Crusoe on a desert island. Crusoe divides his time between leisure working catching fish (production) making fishing nets (investment) Crusoe optimizes given the constraints he faces. The real question here is: what 5 compact discs did Robinson bring to the island? Doesn’t it seem silly to ponder the “desert island disc” question? I mean, if you knew you were going to be stranded on a desert island, you’d avoid the trip altogether rather than bringing your five favorite discs. And do desert islands even have CD players? I didn’t see one in the Tom Hanks film “Castaway” or in the hit TV show “Lost”. Although, the plane-crash survivors in “Lost” did find a record player. Maybe instead of packing our five favorite CDs on flights across the ocean, we should be bringing our five favorite LPs… CHAPTER 19 Advances in Business Cycle Theory

Shocks in the Crusoe island economy
Big school of fish swims by the island. GDP rises: Crusoe’s fishing productivity is higher Crusoe’s employment rises: He decides to shift some time from leisure to fishing to take advantage of the high productivity This slide and the next one each present an example of a productivity shock, giving intuition for the responses of economic variables to that shock. The textbook also describes a third shock, an attack by the natives that spurs an increase in “defense spending” and a “wartime boom” in the economy. CHAPTER 19 Advances in Business Cycle Theory

Shocks in the Crusoe island economy
Big storm hits the island. GDP falls: The storm reduces productivity, so Crusoe spends less time fishing for consumption. Investment falls, because it’s easy to postpone making nets until storm passes. Employment falls: Since he’s not spending as much time fishing or making nets, Crusoe decides to enjoy more leisure time. CHAPTER 19 Advances in Business Cycle Theory

Economic fluctuations as optimal responses to shocks
In Real Business Cycle theory, fluctuations in our economy are similar to those in Crusoe’s economy. The shocks are not always desirable. But once they occur, fluctuations in output, employment, and other variables are the optimal responses to them. CHAPTER 19 Advances in Business Cycle Theory

The debate over RBC theory
…boils down to four issues: 1. Do changes in employment reflect voluntary changes in labor supply? 2. Does the economy experience large, exogenous productivity shocks in the short run? 3. Is money really neutral in the short run? 4. Are wages and prices flexible in the short run? Do they adjust quickly to keep supply and demand in balance in all markets? CHAPTER 19 Advances in Business Cycle Theory

1. The labor market Intertemporal substitution of labor: In RBC theory, workers are willing to reallocate labor over time in response to changes in the reward to working now versus later. The intertemporal relative wage equals Notice that the intertemporal relative wage can be expressed as: the current wage divided by the present value of the future wage. where W1 is the wage in period 1 (the present) and W2 is the wage in period 2 (the future). CHAPTER 19 Advances in Business Cycle Theory

1. The labor market In RBC theory, Critics argue that
shocks cause fluctuations in the intertemporal relative wage workers respond by adjusting labor supply this causes employment and output to fluctuate Critics argue that labor supply is not very sensitive to the intertemporal real wage high unemployment observed in recessions is mainly involuntary CHAPTER 19 Advances in Business Cycle Theory

2. Technology shocks In RBC theory, economic fluctuations are caused by productivity shocks. Solow residual: a measure of productivity shocks, shows the change in output that cannot be explained by changes in capital and labor. RBC theory implies that the Solow residual should be highly correlated with output. Is it? CHAPTER 19 Advances in Business Cycle Theory

Output growth and the Solow residual
2. Technology shocks Output growth and the Solow residual Percent per year 8 Output growth 6 4 Solow residual 2 Figure 19-1 on p.535. The Solow residual is strongly correlated with output growth. -2 -4 1960 1965 1970 1975 1980 1985 1990 1995 2000 CHAPTER 19 Advances in Business Cycle Theory

2. Technology shocks Proponents of RBC theory argue that the strong correlation between output growth and Solow residuals is evidence that productivity shocks are an important source of economic fluctuations. Critics note that the measured Solow residual is biased to appear more cyclical than the true, underlying technology. Why is the Solow residual biased? In a recession, firms cut back on their output. But because of the costs of firing workers (such as lower morale among the remaining workers) and the costs of hiring workers back when the recession ends, firms “hoard labor” rather than let go of it. They give unneeded workers tasks such as organizing the file cabinets, or let workers take more coffee breaks. In booms, firms don’t hire as many new workers as theory might suggest, instead making their existing workers work harder. As a result, observed employment appears less cyclical than firms’ true use of labor in production, and the Solow residual then appears to move more closely with output. CHAPTER 19 Advances in Business Cycle Theory

3. The neutrality of money
RBC critics note that reductions in money growth and inflation are almost always associated with periods of high unemployment and low output. RBC proponents respond by claiming that the money supply is endogenous: Suppose output is expected to fall. Central bank reduces money supply in response to an expected fall in money demand. CHAPTER 19 Advances in Business Cycle Theory

4. Wage and price flexibility
RBC theory assumes that wages and prices are completely flexible, so markets always clear. RBC proponents argue that the degree of price stickiness occurring in the real world is not important for understanding economic fluctuations. RBC proponents also assume flexible prices to be consistent with microeconomic theory. Critics believe that wage and price stickiness explains involuntary unemployment and the non-neutrality of money. CHAPTER 19 Advances in Business Cycle Theory

New Keynesian Economics
Most economists believe that short-run fluctuations in output and employment represent deviations from the natural rate, and that these deviations occur because wages and prices are sticky. New Keynesian research attempts to explain the stickiness of wages and prices by examining the microeconomics of price adjustment. CHAPTER 19 Advances in Business Cycle Theory

Small menu costs and aggregate-demand externalities
There are externalities to price adjustment: A price reduction by one firm causes the overall price level to fall (albeit slightly). This raises real money balances and increases aggregate demand, which benefits other firms. Menu costs are the costs of changing prices (e.g., costs of printing new menus, mailing new catalogs) In the presence of menu costs, sticky prices may be optimal for the firms setting them even though they are undesirable for the economy as a whole. CHAPTER 19 Advances in Business Cycle Theory

CASE STUDY: How large are menu costs?
A 1997 study using data from supermarket chains. costs of changing prices include: labor cost of changing shelf tags costs of printing, delivering new tags cost of supervising this process results: menu costs = 0.7% of revenue, 35% of net profits This case study appears in the textbook on p It is new to the 6th edition. See p.539 for more information about this research. CHAPTER 19 Advances in Business Cycle Theory

Recessions as coordination failure
In recessions, output is low, workers are unemployed, and factories sit idle. If all firms and workers would reduce their prices, then economy would return to full employment. But no individual firm or worker would be willing to cut his price without knowing that others will cut their prices. Hence, prices remain high and the recession continues. The textbook (Fig. 19-2, p.540) shows a game between two firms in which both would be better off if both cut prices, but each is unwilling to cut price first. In the equilibrium, neither cuts its price. CHAPTER 19 Advances in Business Cycle Theory

The staggering of wages and prices
All wages and prices do not adjust at the same time. This staggering of wage & price adjustment causes the overall price level to move slowly in response to demand changes. Each firm and worker knows that when it reduces its nominal price, its relative price will be low for a time. This makes firms reluctant to reduce their prices. The text does not discuss contracts, but contracts may also explain price stickiness: The cost of negotiating may be sufficiently high that buyers and sellers agree to a contract that fixes the price for the duration of the contract’s life. However, we are trying to explain the stickiness of nominal prices. One wonders why contracts do not specify a real price (i.e., index the nominal price to a measure of the price level), as the elimination of inflation uncertainty would make buyer and seller better off (provided both are risk averse). CHAPTER 19 Advances in Business Cycle Theory

Top reasons for sticky prices: Results from surveys of managers
1. Coordination failure: firms hold back on price changes, waiting for others to go first 2. Firms delay raising prices until costs rise 3. Firms prefer to vary other product attributes, such as quality, service, or delivery lags 4. Implicit contracts: firms tacitly agree to stabilize prices, perhaps out of ‘fairness’ to customers 5. Explicit contracts that fix nominal prices 6. Menu costs See Table 19-2 on p.543 for more information. This slide lists theories of price stickiness in the order in which they were most frequently cited by managers. The survey considered 12 theories; this slide lists the top 6, all of which were accepted by 30% or more of the managers that responded to the survey. CHAPTER 19 Advances in Business Cycle Theory

CONCLUSION: The frontiers of research
This chapter has explored two distinct approaches to the study of business cycles: - Real Business Cycle theory - New Keynesian theory Not all economists fall entirely into one camp or the other. An increasing amount of research incorporates insights from both schools of thought to advance our understanding of economic fluctuations. CHAPTER 19 Advances in Business Cycle Theory

Chapter Summary 1. Real Business Cycle Theory
assumes perfect flexibility of wages and prices shows how fluctuations arise in response to productivity shocks suggests that the fluctuations are optimal given the shocks 2. Points of controversy in RBC theory intertemporal substitution of labor the importance of technology shocks the neutrality of money the flexibility of prices and wages CHAPTER 19 Advances in Business Cycle Theory slide 875

Chapter Summary 3. New Keynesian Economics
accepts the traditional model of aggregate demand and supply attempts to explain the stickiness of wages and prices with microeconomic analysis, including menu costs coordination failure staggering of wages and prices CHAPTER 19 Advances in Business Cycle Theory slide 876

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