GDP – Total quantity of final goods and services produced in a country over a period of time measured in constant prices.
- What’s wrong with inflation?
o Creditor/debtor income redistribution
o Shoe leather costs:the cost of running back and forth to the bank in order to make financial transactions. Transaction cost
o Unit-of-Account Costs: Reduce quality of economic decisions, less likely to enter long-term contracts b/c of uncertainty.
- Uncertainty about price information, this creates uncertainty in anything involving long-term contracting. Having stable prices is important.
o Menu Costs: Costs arising from having to print prices.
- A recession is 6 moths or 2 quarters of falling real output. In the US the NBER makes a judgment call based on economic indicators about recessions.
- Calculating GDP: Y = C + I + G + X – IM (Expenditure Approach):
o The value of domestic production of final goods.
1. Value added approach: Revenue– payments to factors of production and for intermediate goods.
2. Income approach: Income earned by factors of production, wages and salaries, rents, interest, and profits (payments for capital services).
3. Expenditure approach: Total value of final sales (includes investment and inventory goods)
o Gross GDP includes government expenditures on goods and service. Government outlays are public goods includes transfer payments.
o Investments are current production that wind up as capital goods, not private investment such as machinery.
Calculating CPI:
o 100 * Cost of market basket in current period/ cost of market basket in base period
o Two good basket: Base period: 100 * (Quantities in year 1 x Prices in year 1 / Quantities year 1 x Prices in year 1)
o 2nd Period: 100 * (Quantities in year 1 x Prices in year 1 / Quantities year 2 x Prices in year 2)
o Inflation rate: CPI year 2 – CPI year 1/100
o However, choosing base period matters because of the substitution effect. Goods that have high/negative inflation, and therefore reduced/increased demand, must be factored. Use 1st year as comparison: CPI 2 = 100 x ( Year 2 Quantities x Year 1 Prices / Year 2 Quantities x Year 2 Prices)
o 2nd year as base year: CPI 1 = 100 x ( Year 2 Quantities x Year 2 Prices / Year 2 Quantities x Year 2 Prices). Inflation rate: CPI 1 – CPI 2 / CPI 2
Headline Inflation Rate: % Change from last month or % change from same month last year in CPI and seasonally adjusted. Annualized rate, r/12 * 4 = per quarter change.
Y = AF(K,N) -> Full employment output is given as the output that results from equilibrium in the labor market. Assuming Cobb-Douglas, equal increases in K and N that result in an unequal increase in Y must necessitate a change in A equal to the difference between the other two changes.
- When labor demand = labor supply; wage and employment level are set:
This level of employment plugged into production function yields full employment output.
- Adverse supply shock reduces full employment output directly, reducing quantity of output that can be produced with fixed amounts of capital and labor (reduction in A)
- Reduces full employment indirectly, lowers N thereby lowering Y.
Labor force: All employed and unemployed workers.
- Employed: over 16, employed part or full time in the past week
- Unemployed – Didn’t work for the past week but look for work during the past 4 weeks.
- Not in labor force – didn’t work during the past week and didn’t look for work during the past 4 weeks. Discouraged workers leave the labor force.
- Unemployment rate: unemployed/labor force
- Participation rate: Labor Force/Adult Population
- Employment ratio: Employed/population.
- Frictional unemployment – Unemployment created by searching, firms for workers and workers for firms.
- Structural Unemployment –Can’t be attributed to matching process. Exists even when economy is not in recession. Unskilled workers are unable to obtain desirable, long term jobs. Reallocation pains from labor in contracting industries moving into expanding industries. unemployment that results when there are more people seeking jobs in a labor market than there are jobs available at the current wage rate.
o Sources of Structural Unemployment:
o Limited geographic mobility
o Limited mobility of job types, contracting to expanding industry
o Inability to acquire better skill sets.
o Cultural/sociological barriers to new markets
o Culture of unemployment – People who spend a long time unemployed have a reduced flexibility. (Older unemployed workers)
- Natural rate of unemployment – Unemployment rate is never zero, even when economy is at full employment output. Reflects structural and frictional forces.
- The natural rate of unemployment changes over time, and it can be affected by economic policies.
- Cyclical unemployment: Actual unemployment – natural unemployment.
Say’s Law: Market stays in equilibrium b/c if output is produced, income is created or earned in production. Output = Income, Y = I
- Leakages out of income: Tax payments, savings, and imports. Not spent on consumption.
- Injections (not earned from consumption): investment, government expenditure, exports.
- Current Account: Measure of foreign assets. NX + Net factor income (interests + dividends) + net transfer payments (aid). If deficit, R.O.W holds more assets if surplus holds more assets from the R.O.W.
- Saving Investment Identity: T + S + M = I + G + X
o I = S + (T-G) – (X-M)
o T-G = Government Surplus if T > G
o X-M = Capital Inflow if M > X
o NX = Y – (C+I+T-G), when output exceeds absorption, an economy will send its goods abroad and have a current account surplus.
- Capital Inflow: As other nations sell us goods, they accumulate our currency and use that money to buy our investment goods. Thereby providing their purchasing power via our investment goods.
- Physical Capital: Stock of investment goods
- Human capital: Labor force stock of skills
- Financial capital: Funds available for investment expenditures from either private savings or capital inflow.
Loanable funds market (interest rate equilibrates):
- Loanble funds market tells us nothing about full employment and output.
- Factors that cause shift of demand curve: changes in perceived business opportunities, changes in government borrowing.
- Government deficit reduces capital available to private sector b/c it increases the interest rate, pushes the demand curve out.
- Govt. needs diff b/t D1 and D2 but the change in loanable funds (F2-F1) is less than this amount; business are CROWDED out of loanable funds.
- Savings curve can shift b/c of changes in private savings behavior (substitution or income effect) and change in capital inflows. More exports means more holders of our currency, buying more investment goods.
- Investment curve shifts can be a result of expected future MPK (higher MPK means desired capital stock increases) and the tax rate.
Income-Expenditure Model:
- When inventory grows at a faster rate than desired expenditure than inventory accumulates b/c no one buys it and when inventory grows slower, inventory declines.
- Expenditure model is a model of quantity adjustments, ignores capacity, interest rates, and prices.
- Y = C + Ip + G + NX only in equilibrium, Ip being planned investment otherwise Y = C + I + G + NX
- I = Ip + unplanned inventory; so equilibrium when unplanned inventory = 0
- Consumption function = a + MPC*Income
o A + MPC*yd = Consumer spending, A = wealth, yd = disposable income
- MPC*Y + Ip + G = AE, AE = Ip + C, Assume no govt. outlays
- The slope of the AE curve is MPC because it demonstrates the relationship between Y and Aggregate Expenditure.
- 45 degree line is the level of output b/c output = income
- When AE line is above output GDP rises b/c unplanned inventory is < 0, people expend more than there is output. AE line below GDP, unplanned inventory > 0.
- Prices do not change b/c prices do not respond to difference between AE and output. Prices are sticky, firms adjust output constantly but rarely change prices.
Keynes -> Equilibrium in expenditure model is not necessarily at full employment.
- Short run expenditure equilibrium involves cyclical unemployment.
- AE is low, economy can be stuck for temporarily in underemployment equilibrium. B/c people do not spend, people do not have jobs.
AD-AS Model:
AD Curve slopes up because:
Interest rate effect:
- As aggregate price level increases people need to hold larger amounts of money (cash and equivalents) to make purchases so demand for funds increases the interest rate.
Wealth Effect
- As aggregate price level rises, people’s purchasing power falls. As a result spending on final goods and services fall.
Shifts
- Increases in the money supply push out the AD curve.
- Exogenous changes not resulting from the price level shift AD
AS Curve slopes down because:
- Increase in output raises unit costs, thereby raising input costs and making firms raise their own prices to protect markups, making the overall price level increase
- Wages are sticky in the short run, higher price level means higher profits so firms increase output in the short run.
Shifts of the supply curves
- occur when input prices change (commodity prices, nominal wages, and productivity).
- LRAS is vertical b/c potential output does not depend on price level. Long run growth, driven by productivity, physical capital, and human capital push LRAS:
- In the short run a positive supply shock pushes SRAS out but a rise in nominal wages shifts SRAS back. A negative demand shock means that nominal wages fall and eventually firms supply more, pushing SRAS out and into LRAS.
- Long run growth: Rule of 70, 70/r = time to double r
Fiscal Policy
- Discretionary Fiscal Policy: Use of government spending, transfer payments, or tax policy to influence aggregate demand
- Supply side influences as well as deficit and government debt (crowding out)
- Lags, multiplier process takes time (AE curve shifts out equilibrium output further than the shift in the AE curve).
- Magnitude of multiplier is uncertain, temporary cuts might make people just save but permanent cuts are an income effect but can create unsustainable deficits.
- Economy is ALWAYS self-correcting in the long run. Years of lost output: idle resources and unemployment problems
- . Stabilization policy is one that offsets shocks and maintains full employment
- Automatic stabilizers: Tax revenues tend to fall in recession and transfer payments increase, thereby running a deficit. The opposite is true in boom times.
- Government saving = Tax revenue – Transfer payments – Expenditure
- Expansionary policy increase Tr and G while reducing T
- Contractionary policy decreases Tr and G while increasing T
- When deficits are cyclically adjusted (w/o automatic stablizers) they are smaller
- US is more often than not in deficit rather than surplus
- Deficits are a problem b/c they make the Debt/GDP ratio rise, meaning future interest payments must rise.
- Large public debt -> bonds are safe and crowd out private sector borrowing, eventually there will be an unwillingness to hold debt b/c of concerns about stability of public sector meaning interest rates will rise. A gov.t that can’t sell debt can print money, but this means inflation.
- Hidden debt in addition to Debt/GDP ratio: Future liabilities, social security, medicare, and Medicaid. Unfunded obligations.
- Marginal tax rates increase employment because it reduces the tax wedge, effectively an increase in marginal returns to labor.
