SENIOR

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SENIOR OUTCOMES SEMINAR (BU385) ECONOMICS (cont)
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BASIC CONCEPTS IN ECONOMICS II

• Nominal, real, and potential GDP
• Recessions
• Types of unemployment
• Standard stabilization policy versus
• Supply-side Economics
• Growth policy
• Equilibrium of aggregate demand and supply

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BASIC CONCEPTS IN ECONOMICS II

• Real interest rate and real wage
• Inflation
• Presence and absence of trade-offs
• between inflation and unemployment
• Fiscal policy
• Monetary policy

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• Gross Domestic Product (GDP)
• Final goods and services
• Nominal and real
• Domestic economy
• Produced over a year

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Gross National Product (GNP)

• GDP - GNP

Final goods services produced by
American producers abroad
Final goods services produced by foreign
producers
For the U.S. economy, GDP GNP
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Deflators of GDP
Consumer Price Index (CPI) Nominal GDP/Real GDP
More comprehensive deflator Consumer Price
Index (CPI) Producer Price Index (PPI)
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Logic of Computing Real GDP
Step 1. Compute Nominal GDP based on statistics
of sales of final goods and services in market
(current) prices Step 2. Compute a
deflator Step 3. Compute Real GDP
Nominal GDP/ Deflator
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Logic of Computing Real GDP
The essence of the logic Only Nominal GDP is
a directly observable variable. Deflators and
Real GDP are not directly observable variables.
They are constructed based on the statistics of
Nominal GDP.
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Difficulties with understanding deflators and
real GDP
stem from the fact that elements of deflators and
real GDP are not physically observable. They are
economic models fitted by real-life statistics.
In sharp contrast, elements of nominal GDP are
physically observable. A new edition of the old
textbook, published in 2007, is a part of 2007
nominal GDP. However, one cannot physically
observe this new edition when it is transformed
through deflation into a part of 2007 real GDP
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Potential GDP
is a hypothetical real GDP produced under 4
unemployment and about 85 utilization of
production capacities.
Potential GDP ? Actual real GDP
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The idea behind potential GDP

• It is believed that the 4 unemployment rate is
  neutral towards inflation and recession
• it is high enough to prevent inflation
• it is low enough to prevent recession.
• Neutrality means that under 4 unemployment rate
  chances of inflation and recession are 5050.

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The idea behind potential GDP

• Neutrality means that under 4 unemployment rate
  chances of inflation and recession are 5050.
• Employment at 4 unemployment rate is called full
  employment

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Recessions

• Units of measurement real GDP
• Time units quarters
• Dynamics reduction of absolute
• value of real GDP during a quarter

Definition Recession is reduction of absolute
value of real GDP during three consecutive
quarters
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Interpretation of recessions

• Negative growth of real GDP.
• This negative growth can coexist
• with positive growth of nominal GDP.
• Elimination of surplus production
• capacities. These capacities are surplus
• relative to existing demand.

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Interpretation of recessions (cont)

• Elimination of surplus capacities tends to
• produce cyclical unemployment.
• In the U.S. economy, recessions tend to
• be progressively less harmful.
• Recessions happen in spite of all-out
• efforts to prevent them.

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Types of unemployment
Frictional people who are fired/left on their
own possess marketable skills, which make finding
their new employment virtually assured.
At any moment of time (except recessions),
approximately 50 of unemployed Americans are
frictionally unemployed. Frictional
unemployment is a major vehicle of mobility on
the labor market.
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Types of unemployment
Structural people who are fired because their
functions are either eliminated or fulfilled
through automated processes. Their skills are
not marketable, and finding new employment is
extremely difficult. Due to their age, most of
structurally unemployed experience major
difficulties with acquisition of new skills.
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Structural unemployment
At any moment of time, structurally unemployed
comprise between 25 and 40 of unemployed
Americans. Structural unemployment is an
important positive sign of economic development.
However, on a family/personal level, structural
unemployment is close to a tragedy.
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Cyclical unemployment
results from elimination of surplus capacities
during recessions. For people with marketable
skills, it could take a form of frictional
unemp-loyment. For people without marketable
skills, it could take a form of structural
unemploy-ment.
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Stabilization policy

• represents government programs whose goals are
• to keep inflation at bay
• to soften recessions.
• Standard stabilization policy is implemented
  through increase/decrease in aggregate demand due
  to increasing/decreasing government expenditures.

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Standard stabilization policy for fighting
inflation
P
AD, AS
P is absolute price level deflator of GDP
index of inflation
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Standard stabilization policy for softening
recession
P
AD, AS
P is absolute price level deflator of GDP
index of inflation
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Trade-off between inflation and unemployment in
the short run when AS curve is relatively flat
Increase in inflation P1 to P2 Increase in
employment G1 to G2
P
P2 P1
AD, AS (real GDPG)
G1 G2
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Trade-off between inflation and unemployment in
the long run when AS curve is steep
Increase in inflation P1 to P2 Increase in
employment G1 to G2
P
P2 P1
AD, AS (real GDPG)
G1G2
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Trade-off between inflation and unemployment is

• Favorable in the short run when
• the AS curve is relatively flat
• Unfavorable in the long run when
• the AS curve is steep.

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Reagans supply-side alternative to standard
stabilization policy
Decrease in inflation P1 to P2 Increase in
employment G1 to G2
P
P1 P2
AD, AS (real GDPG)
G1 G2
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Reagans supply-side alternative to standard
stabilization policy (cont)

• Rightforward shift of AS curve is achieved
  through accelerated investments

• Accelerated investments are achieved through
  decrease in taxes and accelerated depreciation

• Supply-side alternative is based on the idea
  that changes in fiscal policy strongly influence
  economic behavior

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Final results of Reagans supply-side
alternative increased employment increased
incomes shift of AD curve rightward
P
Increase in inflation P2 to P1 Increase in
employment G2 to G3
P1 P2
AD, AS (real GDPG)
G1 G2 G3
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Final results of supply-side alternative
inflation remains on the previous level,
employment significantly increases
P
Increase in inflation P2 to P1 Increase in
employment G2 to G3
P1 P2
AD, AS (real GDPG)
G1 G2 G3
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Growth policy
An elementary description of the process of
economic growth is given by production function
YtF (Kt, Lt, ?t), where Yt real GDP at year
t, Kt fixed capital, Lt hours worked, ?t
technological progress (residual),
tconsecutive years.
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Growth policy
stimulates accumulation of Kt, increase in Lt,
and acceleration of Ht such that Yt in
production function YtF (Kt, Lt, ?t) grows
on average about 4 per year.
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Equilibrium of aggregate demand and supply
P
P
AD, AS (real GDP)
AD(P)AS(P)
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Real interest rate

• iR iN EInf,
• where iRreal interest rate,
• iNnominal interest rate,
• EInf expected inflation

Real interest rate is a price of credit adjusted
for expected inflation
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Real wage rate
wNnominal wage rate (i.e. wage per
hour) wRreal wage rate wR wN/CPI
Real wage measures the purchasing power of
nominal wage
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Inflation
Inflation is a persistent increase in the
absolute price level

• Main causes
• Excess demand (demand inflation)
• Excessive increase (wage inflation)
• in wages

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Inflation

• Main consequences
• Introduces arbitrariness into movements of
  relative prices deformations in
  investment processes arbitrariness in
  distribution of income from investments
• Very quickly becomes unmanageable and explosive

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Inflation

• Main consequences (cont)
• Unmanageable and explosive inflation creates
  different expectations of the strength of
  inco-ming inflation between borrows (investors)
  and lenders (institutions of the saving system).
• These different expectations prevent signing of
  contracts between borrows and lenders b/c they
  cannot agree on a fair amount of nomi-nal
  interest rate charged for a loan.

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Inflation

• Main consequences (cont)
• If the lending process by the U.S. saving system
  to the U.S. businesses is interrupted, the
  further development of the American industry is
  most seriously jeopardized. Reason loans are the
  cheapest form of financing
• the most popular form of financing of Ameri-can
  businesses (up to 45-50 of all new financing).

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Inflation

• Main consequences (cont)
• People on fixed income without adjustment to
  inflation suffer the most. This alone is a shame
  for any nation.

• Purchasing power ( exchange rate) of national
  currency is sharply reduced.
• Falling inflows of new capital to the country
  further reduce financing of businesses.

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Fiscal policy deals with taxation of businesses
population
Major goals

• Secure financing of the government budget.
  Expenses from this budget finance rightward
  shifts of AD curve (stabilization policy).
• Redistribute income in pursuit of some ideal of
  fairness. Currently, upper 50 of American
  households contribute around 90 of all tax
  recites. Upper 5 contribute around 30.

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Monetary policy deals with regulation of the
quantity of money in the domestic economy
Two major factors of the quantity of money in the
economy

• Emission of new banknotes by the government
• Issuance of new loans by banks through the
  creation of additional deposits

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Issuance of new loans by banks through the
creation of additional deposits
Open-market operations are the most powerful
levers Fed uses to induce banks to increase
lending during recessions and decrease lending
during booms
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Equilibria on the market for money
iN
iinitial equilibrium I1 equilibrium after Fed
induced banks to contract lending I2 equilibrium
after Fed induced banks to increase lending
i1
i
i2
MS, MD