ECONOMICS%20why%20should%20we%20study%20it?

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ECONOMICSwhy should we study it?
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Economic development quality of life

• Life expectancy is strongly correlated with
  economic activity (GDP per capita, based on PPP)
• Using WDI data for 2004, the correlation
  coefficient between the life expectancy at birth
  and the GDP per capita, PPP method 0.63
• The statistical relationship can be approximated
  by the following expression (click here for the
  source file)

This suggests that 1319 in GDP per capita
translates into 1 year difference in expected
lifespan
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Economics

• Defining Economics
• Social Science
• Unlimited Wants
• Scarce Resources
• Efficiency
• What to Produce (allocative efficiency)
• How to Produce (productive efficiency)
• For Whom to Produce (allocative efficiency)

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Economic Resources

• Agricultural Economy (Feudalism)
• Labor
• Immigration, population growth
• Land
• Inclusive of natural resources
• Industrialization (Capitalism)
• Capital
• Encouragement of saving and capital formation
  (IRA)
• Advanced Industrialization and Post Industrial
• Human Capital
• Subsidized education
• Entrepreneurship
• Establishing favorable business environment

5
Economic systems

• Capitalism
• Socialism
• Communism
• These systems differ in the allocation of the
  ownership of productive resources
• The differences in these systems can also be
  formulated in terms of how they address the
  fundamental questions (e.g. command economy
  versus market economy)
• Feudalism
• Mercantilism

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Capitalism

• Natural emergence
• Adam Smiths invisible hand concept
• Simplified role of the government
• Institutional support for economic activity
• Property rights laws
• Stable political system
• Well defined legal system
• Transparent business regulations
• System of checks and balances for govt officials

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Socialism

• Philosophical Foundation
• Socialist Movement of the mid XIX century
• Role of the government
• Includes economic decisions in terms of
  allocation of resources and output, and possibly
  production

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Modern Economies

• Mixed system (capitalism socialism)
• EU versus US versus RU versus China

General government final consumption expenditure ( of GDP) in 2001 General government final consumption expenditure ( of GDP) in 2001
Switzerland 13.31
China 13.69
United States 14.23
Russian Federation 14.32
Italy 18.47
Germany 19.06
France 23.27
Sweden 26.66
Source World Bank, WDI 2003
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Unemployment rate comparison
Unemployment, total ( of total labor force), 2000 Unemployment, total ( of total labor force), 2000
Switzerland 2.7
China 3.1
United States 4.1
Sweden 5.1
Germany 8.1
France 10.0
Italy 10.8
Russian Federation 11.4
Source World Bank, WDI 2003
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The Concept of Cost in Economics

• Every undertaken activity has a foregone
  sacrifice associated with it
• Opportunity Cost
• The value of the next BEST (highest valued)
  alternative (the value of the sacrifice that
  would have become the next choice)
• E.g. opportunity cost of this class
• E.g. Opportunity cost of the Colanders book
  (relative price)
• E.g. Opportunity cost of physical capital

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The world of trade-offs

• Budget Constraint and Relative Price
• Production Possibilities Frontier

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Gains from Trade

• Specialization and increased output
• Two-country two-product world
• Absolute advantage principle
• Why specialize in the production of something
  that is cheaper to purchase from abroad?
• Comparative advantage principle
• Specialize in the production of those products in
  which you have the lowest relative (opportunity)
  cost of production
• Shape of PPF and lack of complete specialization
• US trade data available on BEA website at
  http//www.bea.gov/bea/di/home/trade.htm

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Trade ( of GDP) Trade ( of GDP)
2003

World 47.84
Upper middle income 68.53
Middle income 61.98
High income 45.29
Lower middle income 57.10
Low income 44.61
Sub-Saharan Africa 64.28
South Asia 33.33
Middle East North Africa 58.16
Latin America Caribbean 45.53
European Monetary Union 68.25
East Asia Pacific 74.17
United States 23.66

Definition
Trade is the sum of exports and imports of goods and services measured as a share of gross domestic product. Trade is the sum of exports and imports of goods and services measured as a share of gross domestic product.
For the US see BEA
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Globalization and International Risks

• Globalization economic integration
• Trade
• Investment
• Labor mobility
• Economic union (EU)
• Globalization and spread of economic recessions

Correlation in economic growth (GDP growth rates
1990-2005) between the US and some of its major
trading partners)
  China Canada Mexico United States
China 1
Canada 0.038296 1
Mexico -0.21368 0.126047 1
United States 0.174459 0.759405 0.391163 1
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Markets

• Defining a market
• Product definition (and competition)
• Geographical boundaries (internet, shipping cost
  reduction globalization and outsourcing)
• Market forces Buyers (demand) versus Sellers
  (supply)
• Price and quantity as the outcome

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demand

• Quantity f (price, other factors)
• Price and the Law of Demand
• Other factors
• Income (normal versus inferior)
• Related in consumption goods
• Substitutes
• Complements
• Expectations about the future
• OTHER FACTORS

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supply

• Quantity f ( price, other factors)
• Price and the Law of Supply
• Other factors
• Costs of Production (MC, and price as MB)
• Goods related in production
• Substitutes (agricultural products)
• Note, identical to costs of production since is
  based on opportunity cost concept
• Complements (like gold and silver)
• Producer expectations of future prices
• Other factors

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Market equilibrium

• Qs Qd
• Shortage and surplus as unstable states and the
  stability property of the equilibrium
• Market efficiency
• Shifts in demand and supply
• Is the equilibrium really efficient?
• Productive and allocative efficiency

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Market example ForEx

• How can the US run a trade deficit consistently?
  Or, differently put, can one live on credit
  forever?

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Does Dollar Matter?
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Should We Be Concerned With The Fluctuating
Dollar?

• TRADE and Currency Fluctuations
• Price Changes
• Standard of Living
• Commodity Prices

Date USD per EURO USD Price of OIL Euro Price of OIL
March 1, 2002 0.8652 22.40 25.89
March 3, 2003 1.0835 35.88 33.11
March 1, 2004 1.2431 36.86 29.65
March 1, 2005 1.3189 51.68 39.18
change over the period 52.44 130.71 51.35
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The ForEx market

• Demand for the USD
• US Exports
• Goods
• Services (tourism)
• Foreign Investment into US
• US Financial markets
• Direct investment
• Central Banks
• Speculation

• Supply of the USD
• Imports to the US
• Goods (trade)
• Services (tourism)
• US investment abroad
• Foreign Financial Markets
• Direct investment abroad
• Central Banks
• Speculation

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The Interesting 90s

• 1991-92 Collapse of the USSR Block, beginning of
  the Transitional Recession in Eastern Europe
• 1994 Mexican Currency Crisis
• 1991(2)-95 The Balkan Wars
• 1998 Recession in Japan
• 1997 (July) Beginning of the Asian Financial
  Crisis
• 1998 major Rouble Crisis

US ECONOMY US ECONOMY US ECONOMY
  average rates average rates
  1992-2000 2001-2004
Real GDP 3.7 2.5
Gross Domestic Private Investment 8.7 1.8
Non-Residential Investment 9.1 0.2
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The market for USD in the 90s
P of USD
Influx of investment stimulated Demand

D
S
Increase in imports stimulated Supply
Demand Effect Dominated (thus positively
effecting consumers standard of living)
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The post 90s era

• United Europe
• 10 New Countries Entered the Union on May 1st of
  2004, bringing the total number of member states
  to 25, with combined population of over 430
  million (US population is 293 million).
• Strong Growth in Russia and China
• Emerging Economies of Brazil and India
• Threat of Terrorism to the US
• Continuous Growth in US Trade Deficit
• More Recently, the French and Dutch Referendums
  on the EU Constitution

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The BIG picture

• Rise in Imports ? Increase in Supply ?
  Depreciation
• Rise in Exports ? Increase in Demand ?
  Appreciation
• Influx of Investment ? Increase in Demand ?
  Appreciation
• Outflow of Investment ? Increase in Supply ?
  Depreciation
• BALANCE OF PAYMENTS An Economys International
  Balance Sheet (www.bea.gov)

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• Demand for the dollar
• different economic agents that purchase the
  dollar
• Foreigners who wish to purchase US goods or
  services, foreign
• tourists who wish to travel to the US (US
  exports)
• Foreigners who wish to invest in the US (higher
  US interest rate, attractive US stock market
  returns)
• Supply of the dollar
• different economic agents that sell the dollar
• US consumers/firms that want to purchase foreign
  goods or services, US tourists who wish to travel
  abroad (US imports)
• US residents who wish to invest abroad (higher
  interest rates abroad, etc.)
• The dollar will appreciate if demand exceeds
  supply at the current exchange rate. The increase
  in the demand creates a temporary shortage, but
  that shortage disappears due to the increase in
  the price. The price adjustment is the markets
  correction mechanism to the changing conditions.
• Note that when you purchase a foreign made
  product, the cost of the production of that
  product is paid in foreign currency, hence
  somewhere between the production process and your
  purchase someone would have to convert your
  currency into that foreign currency in order to
  pay for the production.

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Measuring Economic Activity

• OUTPUT
• EMPLOYMENT
• INFLATION

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• Gross Domestic Product
• the total market value of all final goods and
  services produced by factors of production
  located within a nations borders over a period
  of time (usually one year)
• Gross National Product
• the total market value of all final goods and
  services produced by factors of production owned
  by a nation over a period of time (usually one
  year)

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Output

• Measuring production
• Time period
• Final goods and services (value added)
• Market prices
• Defining an economy (geographical boundaries
  versus resource ownership)
• Gross Domestic Product
• Gross National Product
• www.bea.gov Table 1.7.5
• http//www.bea.gov/bea/dn/nipaweb/TableView.asp?Se
  lectedTable43FirstYear2003LastYear2005FreqQ
  tr

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GDP per capita in 2005 (using 2000 USD)
Greater than 9910 (2445, 9910) (1172,
2445) (430, 1172) less than 430 no data
available
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The World Economy in 2004
Source WDI 2006, World Bank
34
2003 Health expenditures per capita (current USD) 2004 cases of TB per 100,000 2004 Internet Users per 1000 Life expectancy at birth Mobile phone subscribers per 1000 Infant mortality rate per 1000 PCs per 1000 people
World 587.79 139.47 139.93 67.32 279.34 54.09 129.77
Upper middle income 279.96 112.15 159.33 69.15 484.18 23.36 121.75
Middle income 116.29 113.63 91.83 70.22 293.61 30.02 60.86
High income 3449.40 17.11 544.93 78.74 771.72 6.12 574.14
Lower middle income 77.49 113.97 75.91 70.47 248.86 31.58 46.20
Low income 29.62 223.99 24.34 58.68 42.15 79.45 11.29
Sub-Saharan Africa 36.42 363.14 19.44 46.22 74.08 100.47 15.05
South Asia 23.78 177.21 26.14 63.41 41.31 66.41 12.14
Middle East North Africa 92.41 53.91 58.00 69.35 128.61 44.09 48.55
Latin America Caribbean 221.68 63.51 114.53 72.19 318.36 26.52 92.40
European Monetary Union 2552.10 13.00 443.22 79.38 904.19 4.11 420.84
East Asia Pacific 64.11 137.75 73.79 70.28 243.47 29.16 38.19
United States 5711.00 4.70 629.99 77.43 616.73 6.70 749.18
Correlation between life expectancy and the
standard of living as measured by the GDP per
capita (PPP) is positive 0.65, see the stats
table correlation between GDP per capita and
life expectancy is 0.57 (based on the 2005 data
from WDI of 2007
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The planet Earth in the darkness of the night
Image source NASA (http//antwrp.gsfc.nasa.gov/
apod/ap001127.html)
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Issues in GDP computation/comparison

• Survey of economic activity
• Self-employed/small businesses
• Market prices and the government sector
• Illegal activities
• Underground economy (shadow sector)
• Tax compliance
• Defining legal vs illegal
• Labor force participation/wages
• Household vs market setting

37
Equivalence between expenditure and income
approaches in GDP computation

• Circular flaw concept
• Production of output creates income
• Income finances consumption of output

Input markets
Wages, interest, profits
Labor, capital
Businesses
Households
prices
output
Output markets
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Income output

• GDP GNP NET FOREIGN INCOME
• NI GNP depreciation indirect business taxes
• PI NI - (Transfer payments from Govt, net
  non-business interest income) (Social Insurance
  tax, corporate retained earnings)
• DI PI Personal Taxes
• See Table 1.7.5 (www.bea.gov)

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Income approach

• Disposable Income (in 2004 8,646.9 billion )
• Income that households actually receive
• Available for consumption and saving
• Personal Income (in 2004 9,689.6 billion )
• Household income prior to personal taxes and
  transfers
• PI DI Personal Taxes
• National Income
• Summation of factor payments
• Employment compensation
• Interest received from private business
• Profits
• Rental income
• NI PI (Transfer payments from Govt, net
  non-business interest income) (Social Insurance
  tax, corporate retained earnings)
• Gross National Product
• GNP NI Dep.Allowance Indirect Business
  Taxes
• GDP GNP - Net Foreign Income

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Expenditures Approach

• Personal Consumption
• Goods
• Durable
• Non-durable
• Services
• Gross Private Domestic Investment
• Fixed Investment
• Non-residential
• Structure
• Equipment and software
• Residential
• Business
• Government Spending (all levels)
• Exports of goods and services
• Imports of goods and services
• http//www.bea.gov/bea/dn/nipaweb/TableView.asp?Se
  lectedTable35FirstYear2003LastYear2005FreqQ
  tr Table 1.5.5

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employment

• Labor force
• Labor force participation rate
• Unemployment
• Unemployment rate
• BLS www.bls.gov US statistics
• Industry data ftp//ftp.bls.gov/pub/suppl/empsit.
  ceseeb3.txt
• Categorizing unemployment
• Cyclical
• Structural
• Seasonal
• Frictional

42
More on unemployment

• Accuracy of unemployment statistics
• Discouraged worker phenomenon
• Two surveys

Statistics for the US economy For March-July 2003
(seasonally adjusted). Source BLS
Discouraged Worker Phenomenon
43
Historical unemployment rate in the US
44
inflation

• Rate of growth of the average of all prices
• Average price weighted price
• Weight represents relative importance of the good
• Average price converted into index price index
• Measuring inflation
• Consumer Price Index (CPI)
• www.bls.gov (http//www.bls.gov/news.release/cpi.t
  01.htm)
• Producer Price Index (PPI)
• www.bls.gov

45
Real versus Nominal Measures
US Real and Nominal GDP. Source BEA
46
Costs of (unanticipated) Inflation

• Menu Cost
• Redistribution of Wealth
• Changes in Standard of Living
• Inflation and relative prices
• High inflation tends to be more volatile
• Increased Uncertainty in Forward Looking
  Financial Arraignments
• Impact on the Exchange Rate (Purchasing Price
  Parity for internationally traded goods)

47
Growth in Real GDP
Recessions in Recent US history 2000-2001 QIII
00 QI01 QIII01 1990-1991 QIV90 QI91 19
81-1982 QIV81 QI82 (QIII82) 1980 QII
QIII 1974-1975 QIII74 QIV74 QI75
48
Real Business Cycle - US Real GDP 1974-2006
49
Unemployment Rate 1974-2006
Source BLS
50
Core Consumer Prices
Source BLS
51
The Business Cycle

• Glut of goods and subsequent reduction in
  production

Real GDP (per capita)
time
Recession a period of two or more consecutive
quarters of decline in real output
52
Business Cycle

• Relationship between Output, Employment, and
  Inflation
• Causes of inflation
• Natural unemployment
• Other sources monetary policy, currency
  depreciation, decreases in the supply of
  resources oil .
• Business Inventories and start of recession
• Deflation in the costs of production
• Foreign economy effect
• Change in confidence

53
business cycle, unemployment and inflation
This slide merely provides you with
some definitions and a basic discussion (for your
reading)

• Inflation and unemployment are related. Inflation
  will decline, and even deflation may begin when
  unemployment rate is above the natural rate of
  unemployment. In fact, the natural rate of
  unemployment is defined as the rate of
  unemployment at which the inflation rate remains
  constant. Another way of defining the natural
  rate of unemployment is to simply tie it to the
  level of real GDP. Natural rate of unemployment
  is the rate of unemployment that occurs when the
  real GDP is at its long term trend. Note that at
  the start of a recession the unemployment rate
  may still be above the natural rate of
  unemployment and hence the rate of inflation may
  continue to increase. Similarly, early in the
  recovery, unemployment rate remains higher than
  the natural rate of unemployment which may
  further reduce inflation.
• Inflation is dependent on unemployment. If
  unemployment is high then there is little
  pressure on prices to go up, but if unemployment
  is low, then people can bid up prices because
  they have disposable incomes. There are some
  additional factors that can change inflation,
  including currency fluctuations, but that topic
  will be covered later in the semester when we get
  to the international finance section.

54
Can future be predicted? Magical art of
forecasting

• Examples of Leading Indicators
• Average work hours in manufacturing
• Business inventories
• New orders for non-defense capital goods
• Sales tax receipts
• Stock index (index futures)
• Construction Employment
• Residential permits
• Examples of Coincident Indicators
• Total Tax Receipts
• Corporate Income Tax Receipts
• Average weekly claims for unemployment insurance
• Examples of Lagging Indicators
• Unemployment Rate

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1994 Mexican currency crisis
1997 - Asian financial crisis
1998 Russian currency
crisis Recession in Japan Slow Growth in Europe
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59
Average Growth Rates by Component, 1996-2000
8
4
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Growth in components of Real GDP,
2000-2003 Seasonally adjusted at annual rates
62
Jobless Recovery
Seasonally adjusted US unemployment rate Source
BEA
63
Economy of Atlanta in the recession and jobless
recovery
Source BLS
64
A side-note Job recovery in Atlanta
65
Aggregate Framework

• GDP C I G X M
• Relationship between income (GDP), expenditures
  and saving
• Y C S
• Consumption function C a mpc (Y)
• Autonomous versus induced expenditures
• a f (wealth, expectations, real interest,
  subsistence needs..)
• Incorporating income and non-income taxes into
  consumption function
• Solving for the GDP
• Multiplier and its role

66
Autonomous Expenditures Induced Expenditures
Independent of current income Autonomous Consumption Consumption that does not depend on current income but depends on other factors (like future income, confidence, subsistence needs) Domestic Investment Is not a function of current income, but may be a function of future income, expected profitability, relative profitability, interest rate Government Spending Function of policy, and hence should not be considered as induced spending Exports Exports tend to be a function of economic condition of the importing country. The wealthier it is, the more likely it is to purchase more Function of current income Induced Consumption Consumption that is driven by current income Imports note that imports do depend on the current income level. We will buy more of all goods, domestic or foreign in our incomes increase. Thus, it is an induced expenditure, but we will ignore this in our class and treat it as autonomous! There are also other factors (other than income) that influence imports relative prices, and hence the exchange rate, preferences)
67
More on the multiplier simple example

• Consider the following case
• The level of private consumption spending is 500
  million
• The level of investment is 100 million
• Current government spending is 100 million
• Exports 100 million Imports 50 million
• Given this information we can conclude that the
  level of the GDP is 750 million. Now imagine that
  the government wants to increase that level to
  800 million. What can the government do?
• Natural conclusion is to increase the government
  spending by 50 million to close the gap between
  the actual and targeted GDP, but that actually is
  wrong. This ignores the multiplier effect. Assume
  that the MPC is 0.8, in other words, 80 of the
  marginal dollar earned is directed into
  consumption, and hence becomes an income to
  someone else. In this case, using the math from
  our previous slides, the multiplier is 1/0.25.
  Thus, an increase in government spending
  (autonomous expenditures component) will increase
  the GDP by 5 times the initial change through
  the multiplication effect. In this case, an
  increase in government spending of only 10
  million to 110 million would suffice.

68
More on the previous example

• Now consider the example from the previous slide,
  but assume that the investment level declines by
  5 million what will the implication to the GDP
  will be and what should the government do?
• Note that investment is an autonomous component,
  and hence its decline will create a
  multiplication effect. The total decline will be
  25 million, hence the GDP declines to 725 million
• If the government selects to offset this change
  in investment spending through government
  spending, the change would have to be exactly
  equal to the drop in investment, i.e. 5 million.
  Note that although this policy will cure the
  recession caused by the investment decline, it
  will create another problem, the size of the
  government sector relative to the private sector
  has just increased

69
Further complication note this slide will not
appear on the exam

• Now, lets introduce income taxes.
• C a mpc (Y t Y)
• Here t represents the income tax rate, the rest
  of the function is the same
• The new multiplier is 1/(1-mpc1-t)
• Note that income tax tends to reduce the
  multiplier effect as it increases the flow out of
  the consumption cycle.
• Income taxes also present a second fiscal policy
  instrument change in taxes
• More complications can be introduced into the
  model, but as you can see their introduction does
  not complicate the math of the model

70
Multiplier

• Dollar spent on domestic consumption becomes an
  income of domestic workers/capital owners
• Marginal propensity to consume fraction of the
  next dollar earned that will be directed into
  consumption
• Multiplier 1 / marginal leakage rate from the
  consumption stream

71
Through the so called wealth effect, recent
stock market gains have tended to foster
increases in aggregate demand beyond the
increases in supply. It is this imbalance that
contains the potential seeds of rising
inflationary pressures that could undermine the
current expansion. Our goal is to extend the
expansion by containing its imbalances and
avoiding the very recession that would complete
the business cycle. -Alan Greenspan,
January 13, 2000

• Extending the demand-supply framework to the
  economy as a whole Aggregate Demand Aggregate
  Supply Model

Last two US recessions Recession of 2001
Decline in the Aggregate Demand Recession of
2007-2010 Decline in the Aggregate Demand
72
Stock Market and the Wealth Effect
WFE - YTD Monthly
How do such fluctuations in wealth effect the
economy? Can the effects be modeled and
understood?
73
Aggregate Demand

• Demand for domestically produced goods and
  services aggregate across all sectors of the
  economy (the demand for the Real GDP)
• AD C I G x m
• U.S. Department of Commerce. Bureau of Economic
  Analysis - Real GDP

74
Constructing AD
Framework
U.S. Department of Commerce. Bureau of Economic
Analysis - Price Level
75
Constructing AD continued
Slope
76
Determinants of ADfactors that shift AD

• Anything (other than the price level) that will
  cause changes in the expenditure components of
  the GDP

77
Examples of Determinants of AD
78

• Why do we have a jobless recovery today?
• Need for non-residential investment in job
  creation
• U.S. Department of Commerce. Bureau of Economic
  Analysis - GDP growth
• How can you explain what is going on with the
  investment function?
• How would you incorporate the minimum wage
  increase into the model at this point?

79
Supply Side
Profit Function of a small perfectly competitive
firm (self-employed) versus a large firm with
labor contracts.
Profit Price x Output Wage x Labor
What is the real wage? How does it change?
3
1
P10
2
P2
8 hr 16 output
4 hr 8 output
80
Inflation does not matter in the long run (do we
take into consideration the inflation rates of
the 70s and 80s in our decisions today?) In
the long term, recessionary pressure translates
into deflation In the short term CPI
inflation/deflation causes real output changes
81
Long-Run Aggregate Supply

• Capacity Based
• Full employment (cyclical zero)
• Long Run Equilibrium
• Corresponds to the expansion path in the business
  cycle
• Shifts
• Economic development

82
Short-Run Aggregate Supply

• Fixed input prices
• Short Run Equilibrium
• Corresponds to the actual business cycle
• We are always in the short run equilibrium
• Shift factors
• Changes in input costs
• Changes in input productivities

83
Supply Driven Recession

• The Oil Crisis of the 1970s
• Supply side threat with the rising oil prices in
  2008
• Supply driven recessions are induced by rising
  input costs or reduced productivity
• Consequences
• Stagflation
• Correction
• Time cures all
• Will redistribute wealth shares of output value
  will shift between the input suppliers
• Rising price of fuel and Deltas labor
  negotiations in 2007.
• Government Stabilization Policy

84
Demand Driven Recession

• Recession of 2001 pull back in investment
  spending
• Recession of 2007-2010 pull back in
  investment/consumption spending
• The recessions of 2001 and 2007-2010 underscore
  the importance of asset bubbles

The wealth effect of a bubble burst
WFE - YTD Monthly
Recessions can be contagious Canada tends to
follow the US business cycle 2000 2009
Correlation between the US and Canadian GDP is
0.55
Consequences Deflation
85
Real GDP growth rate in 2000 World Bank
Development Indicators 2003
Less than 0.6 -0.6 lt . lt 0.8 0.8 lt / lt2.1
2.1 lt . lt 4.2 Over 4.2 No data available
86
Real GDP growth rate in 2001 World Bank
Development Indicators 2003
Less than 0.6 -0.6 lt . lt 0.8 0.8 lt / lt2.1
2.1 lt . lt 4.2 Over 4.2 No data available
87
Overheating

• Short-run equilibrium above the capacity level
• Demand rise
• Usually induced by a bubble
• Aggregate Demand rise in 2000

Through the so called wealth effect, recent
stock market gains have tended to foster
increases in aggregate demand beyond the
increases in supply. It is this imbalance that
contains the potential seeds of rising
inflationary pressures that could undermine the
current expansion. Our goal is to extend the
expansion by containing its imbalances and
avoiding the very recession that would complete
the business cycle. -Alan Greenspan,
January 13, 2000
88
How will each of the following affect the AD-AS
diagram?

• Stock market growth
• Fiscal expansionary policy
• Increase in taxes
• Capital investment

89
Classical View

• The Invisible Hand logic
• Flexible Economy
• Dominated by small firms
• Recessionary pressure translates into deflation
• Price mechanism as a corrective tool
• Rapid price adjustments
• Says Law Supply Creates Its Own Demand

90
Keynesian Points

• Price flexibility is too strong of an assumption
• Non-flexible input prices in the short-run
  leading to output adjustments
• Decline in Expenditures Components of the GDP
  (Aggregate Demand)
• The Thrift Paradox
• Consumption spending and other factors
• Under-Production as an equilibrium in the
  short-run

91
Aggregate Supply

• Long-Run
• Classical view
• Capacity level
• Long-term Growth
• Short-Run
• Fixed input prices
• Relationship between the price level and the
  output CPI and Q

92
equilibrium

• Long-Run and Short-Run
• Demand Driven Recession
• Deflationary pressure
• Long-run input cost adjustment
• Possible need for government intervention in the
  short-run
• Supply Driven Recession
• Input cost rise
• Inflationary pressure
• Eliminating Recession through Demand Side Policy

93
Fiscal Stabilization Policy

• Instruments
• Government Spending
• Taxes
• Transfers
• Budget
• Ability to be targeted
• State level
• Municipality level

94
Drawbacks of Fiscal Expansionnote that this is
in chapter 30

• crowding-out effects these refer to the
  replacement of one sector by another, in the case
  of expansionary fiscal policy, the public sector
  displaces the private sector
• direct direct provision. GSU reduces the demand
  for Emory
• indirect this works through the interest rate
  mechanism, expansionary fiscal policy results in
  government borrowing, the current tax cut and
  budget deficit is a perfect example of that,
  government borrowing may lead to an increase in
  the interest rates and hence higher costs for
  private sector investment
• open-economy effect an increase in the interest
  rate due to government borrowing may cause an
  influx of foreign investment and therefore drive
  up the value of domestic currency
• Time lags (decision, recognition, effect)

Ideally the second exam will be here
95
Monetary Side

• MONEY
• Functions of money
• Medium of exchange
• Unit of account
• Store of value
• Measuring the supply of money (liquidity and
  transaction principles)
• M1
• Cash, checking accounts, travelers checks
• M2
• M1savings accounts, CD accounts, money market
  accounts

96
Money Creation by Banks

• Creation of money balances by banks
• Fractional reserve system and lending
• Money multiplier
• Potential
• Actual
• Regulatory institutions
• Federal Reserve Bank
• FDIC

97
Monetary Policy

• Federal Reserve Bank of the US (Central Bank)
• Goal of the Policy
• Influence consumption and investment spending
• Change the exchange rate ? side effect more than
  a goal
• Policy Instruments
• Open Market Operations
• Discount Rate
• Reserve Requirements
• Policy Operating Targets
• Federal Funds Rate
• Weaknesses of the Policy
• Liquidity trap
• Recognition/time lags

98
Economic Policy and the Exchange Rate Regime

• Float
• Monetary
• Fiscal
• Fixed
• Monetary
• Fiscal

99
Currency Trade and Exchange Regime

• (History optional)
• Floating Exchange Rate Regime
• Currency Trade by Central Banks
• (Forward looking instruments optional)
• Fixed Exchange Rate Regime
• Does Recent Dollar Depreciation Impact the Trade
  Deficit with CHINA?
• Price Stabilization and Fixed Exchange Rate
  Regime
• Risk to CB