Macroeconomics, 14th Edition Michael Parkin Solution Manual by Ace Test Banks

Macroeconomics, 14th edition By Andrew B. Abel

Email: Richard@qwconsultancy.com

Table of Contents

Preface Perspective Flexibility  Part 1 Chapter 1 Chapter 2 Chapter 3  Part 2 Chapter 4 Chapter 5  Part 3 Chapter 6 Chapter 7 Chapter 8 Chapter 9  Part 4 Chapter 10 Chapter 11 Chapter 12  Part 5 Chapter 13 Chapter 14 Chapter 15

MyLab Economics How to Assemble Your Course

iii vii ix

Introduction What is Economics? The Economic Problem Demand and Supply

1 9 21

Monitoring Macroeconomic Performance Measuring the Value of Production: GDP Monitoring Jobs and Inflation

35 47

Macroeconomic Trends Economic Growth Finance, Saving, and Investment Money, the Price Level, and Inflation The Exchange Rate and the Balance of Payments

57 67 77 89

Macroeconomic Fluctuations Aggregate Supply and Aggregate Demand Expenditure Multipliers The Business Cycle, Inflation, and Deflation

101 113 123

Macroeconomic Policy Fiscal Policy Monetary Policy International Trade Policy

135 145 155

P r e f a c e

Introduction At no time in history has teaching the principles of economics been either more challenging or more important. Your decision to adopt the fourteenth edition of my textbook brings to your task a set of teaching and learning tools that are unmatched in their clarity, relevance, and currency. It is my hope that with the help of these tools, you will enable your students to become as excited about economics as you are. Whether you’re teaching the principles course for the first time or are an experienced teacher at this level, I hope you will find this manual helpful. Each chapter in the manual consists of five parts: 1. The Big Picture: This part provides a discussion of “Where we are going” and “Where we have been.” In other words it helps you fit this particular chapter into the context of what has come before and what will come later. This Big Picture information can help you provide the Big Picture to your students. 2. New in the Fourteenth Edition: Both the major and the minor changes in this thirteenth edition of the textbook are described in this section. The changes noted are especially those that might affect your lecture, so if you are an experienced Parkin user, glance at these to see what’s different in this edition of the textbook. 3. Lecture Notes: We have created a set of ready-to-use lecture notes for each chapter. You will be able to glance over these notes before class, take them into class, and deliver from them your polished lecture. These notes have been heavily revised from the last edition to reflect all the latest changes. These notes provide: • Concise (bullet point) statements of all the key material • Tables and figures that differ from those in the book so that you can use new examples in your lectures • Key terms in bold print and the definitions from the textbook so that you can be sure that you don’t confuse your students by defining a term differently than the book • Highlighted boxes with teaching suggestions that reinforce a key concept, provide an additional anecdote, or suggest how to handle a difficult idea 4. Additional Problems: We present some additional problems that reflect the problems in the textbook. Some of these problems are carried over from the previous edition’s Solutions Manual; others are new for this edition. Solutions for all the additional problems are provided. 5. Additional Discussion Questions: Additional discussion questions have been created for each chapter. Some of these questions are suitable for essay exams; others, more open-ended, are probably best used for classroom discussion. All of them are designed to make your students think and use the material you have been teaching them. Do not forget that the answers and solutions to all the Review Quizzes and the Problems at the end of each chapter are provided in a separate book, the Solutions Manual. The Solutions Manual has both the questions from the textbook and complete answers all in one handy source. You can use these answers .

PREFACE

and solutions to help you grade problems you have assigned to the students or else you can copy them and hand them out directly to the students.

The Electronic Classroom The next Perspective features a special essay designed to assist your teaching in another way by discussing MyEconLab, an incredibly powerful Internet site that is a source of “one-stop shopping” for both your students and you. This essay can help you see all that is available to you—and your students!— on MyEconLab.

Acknowledgments Teaching the principles of economics is a “work in progress.” As new insights are uncovered, as new knowledge emerges, the principles of economics course changes and evolves. So, too, are Parkin’s Microeconomics and Macroeconomics always changing and evolving to remain the best books available for you and your students’ use. Undoubtedly, there remains room for improvement in the text and (says Mark) in this manual. Any corrections, suggestions, or comments that you have will be greatly appreciated. Send your comments on this manual to Mark (markrush@ufl.edu) and your comments on the text to me (michael.parkin@uwo.ca). Michael Parkin University of Western Ontario

P e r s p e c t i v e

MYLAB ECONOMICS

It’s About Time What if you could spend less time grading, and more time teaching? And what if, at the same time, you could strengthen the incentives for your students to do their homework and come to class better prepared? With MyLab Economics, what sounds like a free lunch is now an achievable goal! MyLab Economics is a turn-key, online solution for your economics course. Using a new and powerful graphing tool and question bank, students can self-test and generate a study plan, and instructors can assign homework and capture grades. With a tight, everything-in-one-place organization around the new testing tool, questions include true-false, multiple choice, fill-ins, numerical, and complete the graph. Many of the questions are generated algorithmically, a feature that rewards understanding and penalizes rote learning. Previous users of The Economics Place and Economics in Action will find MyLab Economics an exciting and powerful resource. Practice tests for each section of the textbook enable students to test their ability and identify the areas in which they need further work. Based on a student’s performance on a practice test, a personalized study plan shows where further study is needed. Once students have received their study plan, additional practice exercises, keyed to the textbook, provide extensive practice and link directly to the eText with animated graphs, an electronic tutorial, and other resources. Users of MyLab Economics will revel in the powerful graphing tool integrated into both the practice tests and practice exercises. This tool enables students to manipulate graphs and see how the concepts, numbers, and graphs are connected. Questions that use the graphing tool (like all other questions) can be submitted and graded online. MyLab Economics saves your students time because it identifies what they have not yet mastered and creates a Personalized Study Plan. This study plan consists of a series of additional practice exercises. Using tutorial instruction launched directly from practice exercises, students can follow step-by-step solutions and tutorials that promote self-discovery. With an abundant collection of interactive resources, students will come to class better prepared. MyLab Economics saves instructors time in answering questions, tracking performance, and giving practice tests. Instructors can customize the practice tests or leave students to use the supplied pre-built tests. Additional MyLab Economics tools include: • eText •

Animated figures

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Electronic tutorials

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Glossary

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Glossary Flashcards

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Office Hours

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Daily Economics in the News updates and archives

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Links to the most useful economic data and information sources on the Internet .

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MYLAB ECONOMICS

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Research Navigator—extensive help on the research process and four exclusive databases of credible and reliable source material including the New York Times, the Financial Times, and peer-reviewed journals

Registration for MyLab Economics To learn more, and to register for MyLab Economics, please go to www.myconlab.com and click on the link to request an access code. Your Pearson sales representative will then be in touch to help you get started.

Flexibility

HOW TO ASSEMBLE YOUR COURSE

Introduction Instructors who have already used Michael Parkin’s Macroeconomics are aware of its flexibility: There are many ways to teach from this book, depending on your preferences. Because there is no necessarily right or wrong way to teach a principles of macroeconomics class, the macroeconomic part can be used in a variety of ways. The most obvious one is the order in which the chapters are printed. Others are summarized below. Macroeconomics At both the professional and the principles level, macroeconomics is unsettled: Economists range from Keynesian to monetarist to rational expectations new classicalists to new Keynesians to real business cycle advocates. Instructors disagree whether to teach economic growth or business cycles first. My text recognizes these perspectives and provides a vehicle through which you can place the approach on your choosing on your course. It is possible to teach a course that emphasizes a Keynesian perspective or one that takes a monetarist point of view. If you want to teach economic growth before business cycles, you can do so; if you want to cover business cycles first, you are equally free to do so. You can adapt the macroeconomic chapters to be the type of course you want and still be assured of a high quality of presentation. Table 1 presents all the chapters. It shows the two necessary foundation chapters and then the large array of chapters that you can cover next. It also shows the necessary prerequisite chapters for the concluding three final chapters. Table 1 illustrates how you can emphasize precisely the points you think most important. The choice is up to you because you can shape the course you want to teach.

HOW TO ASSEMBLE YOUR COURSE

Table 1

C h a p t e r

WHAT IS ECONOMICS?

The Big Picture Where we are going: After completing Chapter 1, the student will have a good sense for the range of questions that economics addresses and will be on the path towards an economic way of thinking. The students will begin to think of cost as a forgone alternative— an opportunity cost—and also about making choices by balancing marginal costs and marginal benefits. Chapter 2 reinforces the central themes of Chapter 1 by laying out a core economic model, the production possibilities frontier (PPF), and using it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 also provides a deeper explanation, again with a model, of the concepts of marginal cost and marginal benefit, beginning with the concept of efficiency, and concluding with a review of the source of the gains from specialization and exchange.

New in the Fourteenth Edition

When discussing the social interest and four major issues, the issue of financial instability has been replaced with a discussion of social interest issues surrounding the COVID pandemic. The emphasis in this discussion is that often self-interested decisions are not in the social interest (for example, whether to socially distance) so that rules governing behavior may need to be established. The last topic, dealing with Economists in the Economy, now includes a section covering the diversity challenge in economics. It points out that fewer women and minorities receive bachelor’s PhD degrees in economics than in STEM majors in general. It also discusses efforts being made to overcome this lack of diversity. The Economics in the News presenting Mark Zuckerberg’s vision to have the Internet available to the whole world has been eliminated to make room for the coverage of diversity in the profession. This important chapter is not one to gloss over as it lays down an important foundation that can be drawn from as you move through more specific applications later. Students relate well to the section on self and social interest which calls out issues of both efficiency and fairness and is great for class discussion. .

CHAPTER 1

WHAT IS ECONOMICS?

Lecture Notes

What Is Economics? I. Definition of Economics • •

Economic questions arise because we always want more than we can get, so we face scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can satisfy all of his or her wants. Scarcity forces us to make choices over the available alternative. The choices we make depend on incentives, a reward that encourages a choice or a penalty that discourages a choice.

Forbes lists Bill Gates and Warren Buffet among some of the wealthiest Americans. Do these two men face scarcity? According to The Wall Street Journal, both men are ardent bridge players, yet they have never won one of the many national bridge tournaments they have entered as a team. These two men can easily afford the best bridge coaches in the world and but other duties keep them from practicing as much as they would need to in order to win. So even the wealthiest two Americans face scarcity (of time) and must choose how to spend their time. Economics • Economics is the social science that studies the choices that individuals, businesses, governments and entire societies make when they cope with scarcity and the incentives that influence and reconcile those choices. • Economists work to understand when the pursuit of self-interest advances the social interest • Economics is divided into microeconomics and macroeconomics: • Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments.

•

Macroeconomics is the study of the performance of the national economy and the global economy.

On the first day do a “pop quiz.” Have your students write on paper the answer to “What is Economics?” Reassure them that this is their opinion since it is the first day. You will find most of the answers focused around money and/or business. Stress that Economics is a social science, a study of human behavior given the scarcity problem. All too often first-time students (especially business students) think that Economics is just about making money. Certainly, the discipline can and does outline reasons why workers work longer hours to increase their wage earnings, or why firms seek profit as their incentive. But Economics also explains why a terminally ill cancer patient might opt for pain medication as opposed to continued chemotherapy/radiation, or why someone no longer in the workforce wants to go to college and attain a Bachelor’s degree, in their sheer pleasure of learning and understanding. Stressing the social part of our science now will help later when relating details to the overall bigger picture (especially when time later in the semester seems scarce, no pun intended!). The definition in the text: “Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity and the incentives that influence and reconcile these choices,” is a modern language version of Lionel .

CHAPTER 1

Robbins famous definition, “Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.” Other definitions include those of Keynes and Marshall: John Maynard Keynes: “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions.” Alfred Marshall: “Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.” A “shorthand” definition that resonates with students is: “Economics is the study of trying to satisfy unlimited wants with limited resources.” Students can—and do—easily abbreviate this definition to “unlimited wants and limited resources,” which captures an essential economic insight. II. Two Big Economic Questions How do choices wind up determining what, how, and for whom goods and services are produced? What, How and For Whom? • Goods and services are the objects that people value and produce to satisfy human wants. What we produce changes over time—today we produce more streaming music than 5 years ago. • Goods and services are produced using the productive resources called factors of production. These are land (the “gifts of nature”, natural resources), labor (the work time and work effort people devote to production), capital (the tools, instruments, machines, buildings, and other constructions now used to produce goods and services), and entrepreneurship (the human resource that organizes labor, land, and capital). • The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, work experience, and on-the-job training. • Owners of the factors of production earn income by selling the services of their factors. Land earns rent, labor earns wages, capital earns interest, and entrepreneurship earns profit. Do Choices Made in the Pursuit of Self-Interest also promote the social interest? • You make a choice in your self-interest if you think that choice is the best one available for you. • An outcome is in the social interest if it is best for society as a whole. • A major question economists explore is “Could it be possible that when each of us makes choices in our self-interest, these choices are in the social interest?’ Students (and others!) often take the answers to the what, how, and for whom questions for granted. For instance, most of the time we do not bother to wonder “How does our economy determine how many light bulbs, automobiles, and pizzas to produce?” (what), or “Why does harvesting wheat from a plot of land in India occur with hundreds of laborers toiling with oxen pulling threshing machines, while in the United States, a single farmer streaming music and sitting in an air-conditioned cab of a $500,000 machine harvests the same quantity of wheat from the same sized plot of land?” (how), or “Why is the annual income of an inspiring and effective grade school teacher much less than that of an average major-league baseball player?” .

WHAT IS ECONOMICS?

(for whom). Explaining the answers to these types of questions and determining whether the answers are in the social interest is a major part of microeconomics. Figure 1.1 in the textbook “What Three Countries Produce” ties in nicely with Chapter 2’s later discussion on the PPF. Figure 1.1 also links the three questions of what, how and for whom nicely to the component parts of those questions: goods and services, factors of production (land, labor, capital, entrepreneurship), and incomes economic agents earn (rent, wages, interest and profit). •

We can examine whether the self-interested choices serve the social interest for a variety topics: • Globalization: Buying an iPod allows workers overseas to earn a wage and provide for family • Information-Age Monopolies: A firm producing popular software leads to format standards • Climate Change: Carbon dioxide emissions led to higher global temperatures and climate change

•

The Covid pandemic: Covid-19 spreads through social contact, so a person who socially isolates avoids infection and avoids infecting others, but people may not choose the optimal degree of isolation

III.

Economic Way of Thinking Scarcity requires choices and choices create tradeoffs.

What is the difference between scarcity and poverty? Ask the students why they haven’t yet attained all of their personal goals. One reason will be that they lack sufficient money. Ask them if they could attain all of their goals if they were as rich as Bill Gates. They quickly realize that time is a big constraint—and the great leveler: we all have only 24 hours in a day. They have stumbled on the fact that scarcity, which even Bill Gates faces, is not poverty. A Choice is a Tradeoff • A tradeoff is an exchange—giving up one thing to get another. • Whatever choice you make, you could have chosen something else. Virtually every choice that can be thought of involves a tradeoff. Presenting a few of the following as examples can help your class better appreciate this key point: • Consumption and savings: If someone decides to save more of his or her income, savings can be funneled through the financial system to finance businesses new capital purchases. As a society, we trade off current consumption for economic growth and higher future consumption. • Education and training: A student remaining in school for another two years to complete a degree will need to forgo a significant amount of leisure time. But by doing so, he or she will be better educated and will be more productive. As a society, we trade off current production for greater future production. • Research and development: Factory automation brings greater productivity in the future, but means smaller current production. As a society, we trade off current production for greater future production.

CHAPTER 1

Making a Rational Choice • A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice. • But how do people choose rationally? Why do more people choose to stream movies rather than buy blu-rays? Why has the U.S. government chosen to build an interstate highway system and not an interstate high-speed railroad system? The answers turn on comparing benefits and costs. Benefit: What you Gain • The benefit of something is the gain or pleasure that it brings and is determined by preferences—by what a person likes and dislikes and the intensity of those feelings. • Some benefits are large and easy to identify, such as the benefit that you get from being in school. Much of that benefit is the additional goods and services that you will be able to enjoy with the boost to your earning power when you graduate. • Some benefits are small, such as the benefit you get from a slice of pizza. That benefit is just the pleasure and nutrition that you get from your pizza. Cost: What You Must Give Up Seeing choices as tradeoffs shows there is an opportunity cost of a choice. The opportunity cost of something is the highest-valued alternative that must be given up to get it. So, for instance, the opportunity cost of being in school is all the good things that you can’t afford and don’t have the spare time to enjoy. What is the Opportunity Cost of Getting a College Degree? When the students calculate their opportunity cost of being in school, be sure they place a value on their leisure time lost to studying on weekends and evenings. Most students are shaken when they realize that when lost leisure time and income is included in their calculations, the opportunity cost of a college degree approaches $200,000 or more. Don’t leave them hanging here though. Mention that a college education does yield a high rate of financial return over. To ensure that people do not die of any serious side effects, the Food and Drug Administration (FDA) requires all drug companies to thoroughly test newly developed medicines before allowing them to be sold in the United States. However, it takes many years to perform these tests and many people suffering from the terminal diseases these new medicines are designed to cure will die before good new medicines are eventually approved for use. Yet, if the FDA were to abandon this testing process, many others would die from the serious side effects of those bad medicines that made it to market. People’s lives will be at risk under either policy alternative. This stark example of a tradeoff reveals the idea that choices have opportunity costs. How Much? Choosing at the Margin • Making choices at the margin means looking at the trade-offs that arise from making small changes in an activity. People make choices at the margin by comparing the benefit from a small change in an activity (which is the marginal benefit) to the cost of making a small change in an activity (which is the marginal cost). • Changes in marginal benefits and marginal costs alter the incentives that we face when making choices. When incentives change, people’s decisions change. • For example, if homework assignments are weighed more heavily in a class’s final grade, .

WHAT IS ECONOMICS?

the marginal benefit of completing homework assignments has increased and more students will do the homework. Choices Respond to Incentives • Economists take human nature as given and view people acting in their self-interest. • Self-interest actions are not necessarily selfish actions. IV. Economics as Social Science and Policy Tool Economist as Social Scientist • Economists distinguish between positive statements and normative statements. A positive statement is about “what is” and is testable. A normative statement is about “what ought to be” and is an opinion and so is inherently not testable. A positive statement is “Raising the tax on a gallon of gasoline will raise the price of gasoline and lead more people to buy smaller cars” while a normative statement is “The tax on a gallon of gasoline should be raised.” • Economists tend to agree on positive statements, though they might disagree on normative statements. • An economic model describes some aspect of the economic world that includes only those features needed for the purpose at hand. Economic models describe the economic world in the same way that a road map explains the road system: Both focus on only what is important and both are abstract depictions of the real world. • Testing an economic model can be difficult, given we observe the outcomes of the simultaneous operation of many factors. So, economists use the following to copy with the problem: • Natural experiment: A situation that arises in the ordinary course of economic life in which • •

the one factor of interest is different and other things are equal or similar. Statistical Investigation: A statistical investigation might look for the correlation of two variables, to see if there is some tendency for the two variables to move in a predictable and related way (e.g. cigarette smoking and lung cancer). Economic Experiment: Putting people in a decision-making situation and varying the influence of one factor at a time to see how they respond.

Economist as Policy Adviser • Economics is useful. It is a toolkit for advising governments and businesses and for making personal decisions. • For a given goal, economics provides a method of evaluating alternative solutions— comparing marginal benefits and marginal costs and finding the solution that makes the best use of the available resources. The success of a model is judged by its ability to predict. Help your student’s appreciate that no matter how appealing or “realistic looking” a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable. Milton Friedman’s Pool Hall example illustrates the point nicely. Imagine a physicist’s model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It certainly wouldn’t depict what we actually see—a pool stick striking a pool cue on a .

CHAPTER 1

rectangular patch of green felt. It wouldn’t even reflect the thought processes of the pool shark that relies on years of experience and the right “touch.” Yet, constructed correctly, this mathematical model would predict exactly where the cue ball would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can easily invent analogous examples from any sport.) V. Economists in the Economy Jobs for an Economics Major • Economists work for private firms, governments, and international organizations. Some have a bachelor’s degree, while others have a master’s degree or a PhD. • On their jobs, economists often collect and analyze data on production and use of resources, goods, and services in order to predict future trends or devise ways to use resources more efficiently. • Economists have jobs as market research analysts, financial analysts, and, less often, budget analysts. There were about 1,300,000 of these jobs in the United States in 2020. Will Jobs for Economics Majors Grow? • The Bureau of Labor Statistics (BLS) forecasts that from 20194 to 2029, jobs for PhD economists will grow 14 percent; jobs for budget analysts will grow by only 3 percent; but jobs for financial analysts will grow by 5 percent; and jobs for market research analysts will grow by 18 percent. Earnings of Economics Majors • The Web resource payscale.com reports the earnings of economics majors range between $48,000 to $133,000 with a median of $108,000. • Pay in analyst jobs is lower, with an average of $65,800 for market research analysts and $83,700 for financial research analysts. Skills Needed for Economics Jobs • Five skills are needed for an economics related job: • Critical-Thinking Skills: The ability to clarify and solve problems using logic and relevant evidence. • • • •

Analytical Skills: The use of economic ideas and tools to examine data, notice patterns, and reach a logical conclusion. Math Skills: The ability to use mathematical and statistical tools to analyze data and reach valid conclusions. Writing Skills: The ability to present ideas, conclusions, and reasons in succinct written reports appropriate for the target audience. Oral Communication Skills: The ability to explain ideas, conclusions, and reasons to people with a limited background in economics.

A Diversity Challenge in the Economics Profession • Minorities and women are under-represented in the economics profession. • The American Economic Association has introduced prizes and grants to give minorities and women more incentive to pursue economics as a career.

WHAT IS ECONOMICS?

Additional Problems 1.

You plan a major adventure trip for the summer. You won’t be able to take your usual summer job that pays $6,000, and you won’t be able to live at home for free. The cost of your travel accomodations on the trip will be $3,000, gasoline will cost you $200, and your food will cost $1,400. What is the opportunity cost of taking this trip?

The university has built a new parking garage. There is always an available parking spot, but it costs $1 per day. Before the new garage was built, it usually took 15 minutes of cruising to find a parking space. Compare the opportunity cost of parking in the new garage with that in the old parking lot. Which is less costly and by how much?

Solutions to Additional Problems 1.

The opportunity cost of taking this trip is $10,600. The opportunity cost of taking the trip is the highest-valued activity that you will give up so that you can go on the trip. In taking the trip, you will forgo all the goods and services that you could have bought with the income from your summer job ($6,000) plus the expenditure on travel accommodations ($3,000), gasoline ($200), and food ($1,400). The opportunity cost of parking before the building of the new parking garage is the highest-valued activity that you forgo by spending 15 minutes parking your car. The opportunity cost of parking in the new parking garage is $1 that you could have spent elsewhere. If the opportunity cost of 15 minutes spent parking your car is greater than the opportunity cost of $1, then the new parking garage is less costly.

Additional Discussion Questions 1. Why are economists so concerned about the material aspects of life? Explain that this is a myth! Economists are often criticized for focusing on material wellbeing because of the general public’s view that economics is about money. Explain that there are economists that research social and emotional (or spiritual) aspects of life. You may also add that these parts of life often depend heavily on attaining material well-being. You may want to reference the Economic Freedom Index (www.freetheworld.com) and its explanatory power on issues of world hunger and poverty. Ask them to consider the need for life-enhancing goods and services such as health care or education to support spiritual or emotional well-being. Ask how protestors would be able to voice their opinions without low-cost air travel and the power of the Internet to coordinate the activities of hundreds of protesters. (Be careful not to seem to be either condoning or condemning these activities.) Most students will begin to see that the more efficient we are at producing material prosperity, the more time and opportunity everyone has to promote emotional (or spiritual) goals.

CHAPTER 1

Chapter 1 Appendix, Graphs in Economics Lecture Notes Goggle Theory Explain to students that you are going to ask them to use three sets of goggles to view math in the course. I have found this to be a great tool for students to understand why we present data in different ways. 1. Equation Goggles: Write an equation in slope-intercept form and explain that this is one way to show relationships between two variables. I like to use X and Y for this one and then quickly explain that economics is much more fun than math because we may be talking about X-rays and Yo-Yo’s. This helps some students break the barrier early on what “variable” means. 2. Graphing Goggles: Work through a graph of the equation you wrote highlighting slope and intercept. Indicate that this may be a Demand or Supply curve for instance. 3. Now you can explain that they will see all three of these forms of math at different times during the course and it is important for them to understand that you can move between all three anytime. We usually have it shown just one way for convenience. It is also fun during lecture to say, “I need you to pull out your graphing goggles.” I. Graphing Data • •

Graphs are valuable tools that clarify what otherwise might be obscure relationships. Graphs represent “quantity” as a distance. Two-variable graphs use two perpendicular scale lines. The vertical line is the y-axis. The horizontal line is the x-axis. The zero point in common to both axes is the origin. • Scatter diagram—a graph that plots the value of one variable on the x-axis and the value of the associated variable on the y-axis. A scatter diagram can make clear the relationship between two variables. II. Graphs Used in Economic Models •

III. •

• •

Graphs are used to show the relationship between variables. Graphs can immediately convey the relationship between the variables: • A positive relationship (or direct relationship)—when the variable on the x-axis increases the variable on the y-axis increases. A straight line is a linear relationship. • A negative relationship (or inverse relationship)—when the variable on the x-axis increases, the variable on the y-axis decreases. • A maximum or a minimum—when the variable has a highest or lowest value. The Slope of a Relationship The slope of a curve equals the change in the value of the variable on the vertical axis at the point where the slope is being calculated divided by the change in the value of the variable on the horizontal axis at the relevant point. • In terms of symbols, the slope equals y/x, with  standing for “change in.” The slope of a straight line is constant. The slope is positive if the variables are positively related and negative if the variables are negatively related. The slope of a curved line at a point equals the slope of the straight line that is tangent to .

WHAT IS ECONOMICS?

• IV. •

the curved line at the point. The slope of a curved line across an arc equals the slope of a straight line between the two points on the curved line. Graphing Relationships Among More Than Two Variables When a relationship involves more than two variables, we can plot the relationship between two of the variables by holding other variables constant.

C h a p t e r

THE ECONOMIC PROBLEM

The Big Picture Where we have been: Chapter 1 introduced the economic reality that wants exceed the resources available to satisfy them—we face scarcity. Chapter 2 reinforces these central themes by laying out the core economic model, the Production Possibilities Frontier, or PPF, and uses it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 further details the concepts of marginal cost and marginal benefit, presenting a first look at the concept of efficiency. The second half of the chapter begins with a model of exchange between two people that shows the “win-win” situation created through specialization and free trade. The next sections show how those individual gains scale up to economy wide gains. Lastly the traditional circular flow model highlights transformation of resources into final goods and services along with the money used in those markets Where we are going: The key concept of opportunity cost and the widespread tendency for the opportunity cost of a good to increase as the quantity produced of that good increases returns in Chapter 3 when we explain the supply curve. For Micro classes, we see it again in Chapters 10 and 11 when we study a firm’s costs and cost curves. Preferences return and are treated more rigorously when we explain marginal utility theory in Chapter 8 and indifference curves in Chapter 9. Efficiency returns in Chapter 5 when we study the efficiency of markets and first preview the impediments to efficiency. The gains from trade are explored more completely in the context of international trade in Chapter 7 in Microeconomics and Chapter 15 of Macroeconomics. Finally, the role of markets and prices in allocating resources and coordinating activity is an ongoing theme throughout most of the rest of the text. The next task, in Chapter 3, is to develop the central demand and supply model.

New in the Fourteenth Edition

In Chapter 2 the introduction includes some teaser comments about Covid-19 and how it led to empty airports and how vaccines brought recovery. Related, the “Economics in the News” has a new article on “Production Possibilities in and after Covid-19” and uses the PPF to analyze issues surrounding government infrastructure expenditure.

CHAPTER 2

Lecture Notes

The Economic Problem • • •

Scarcity creates the need to make choices. Economic choices can be evaluated in terms of their efficiency. We can expand possible choices through capital accumulation and specialization and trade.

I. Production Possibilities and Opportunity Cost • The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot given available resources and technology. • Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure showing the PPF is to the right. A B C D • • •

Books 0 200 400 600

Movies 600 500 300 0

Production points beyond the PPF are not attainable without increases in resources or technology (these factors shift the PPF); Production points on and within the PPF are attainable, but production points within the PPF, such as point Z, are inefficient. It is possible to get more of one good without giving up any of the other. The PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books.

Using the PPF above, make a point outside the PPF and ask the students about it. Once they state it is not possible, ask them how we could get there. After they highlight a few shifters, summarize for them that the resources and technology we held constant when we drew the PPF now relocate it when they change. Now give them an example of a new movie camera invention and ask them if this will help us get more books? You will likely get an immediate round of “NO.” Reply, “Are you sure?” and you should be able to find a student who sees that the new resource frees up other resources that can now be used for more books. Show them graphically a shift that is pinned at the book axis and it will open their eyes to how technology and resource growth in any sector can make more of all goods! Production Efficiency Production is efficient only on the frontier. • We achieve production efficiency if we cannot produce more of one good without .

THE ECONOMIC PROBLEM

•

producing less of some other good. Inside the frontier (point Z), production is inefficient. Resources could be better employed to increase production of both books and movies.

Tradeoff Along the PPF • Moving along the PPF, there is always a tradeoff involved in diverting resources from the production of one thing to another. We gain one thing but at the opportunity cost of losing something else. The key here is to make sure the student understands that given scarcity, because we produce one thing, we cannot produce something else. Some students will see the tradeoff immediately as a cost (giving up something), but they will incorrectly interpret that cost as only that valued in money units. To eliminate this ambiguity (better now than later), ask them to think about a meal they purchased recently. Now ask them what the money cost was as well as what else they might have picked for a meal? Most students pick up on this concept quickly with one or two more examples. And since this is a consumption example, tell them to put themselves in the place of an office manager, who must produce a service but can do so only given tradeoffs. While money costs are measurable and useful, propose to the students that opportunity costs are indeed even more useful in identifying the tradeoffs made in production. Opportunity Cost • The opportunity cost of an action is the highest valued alternative forgone. • Opportunity cost is a ratio; it is the cost of an additional unit of a good measured in terms of what was given up to obtain that additional unit. The formula to calculate opportunity cost is decrease in the quantity produced of one good divided by the increase in the quantity produced of a another good. • Efficiency means that the opportunity cost of producing more books or movies is the tradeoff along the frontier. Increasing Opportunity Cost • The “bowed-out” shape of the PPF reflects the principle of increasing opportunity cost. • Not all resources are the same, which is why the PPF bows out. Publishers are better at producing books and Hollywood studios are better at producing movies. Moving along the frontier and producing more movies inevitably means that more and more publishers must produce movies. As this happens, the increase in movies becomes smaller and the decrease in books becomes larger. • Emphasize the intercepts where the PPF crosses the axes. Take the vertical intercept in the figure. At this point all resources are used to produce movies. Basically, to get to that point the economy has crammed and slammed every resource into movie production. Now when the economy moves down the PPF to produce the first book, that book is really inexpensive—has very low opportunity cost—because the economy uses resources better suited for book production first rather than movies. • As more resources are diverted from production of one good to another, the smaller the additional increase in the production of the one good will be and the larger the decrease in the production of the other good. You can bring in the relationship of slope and opportunity cost here if you want. OPTION 1: A soft way to bring in slope is to offer it as a double check on calculating marginal cost: “The .

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opportunity cost of whatever is being measured on the horizontal axis is equal to the magnitude of the slope of the PPF.” OPTION 2: You can also introduce the slope of a curve as the slope of a tangent line to the curve, that is, the slope of the line that is “just kissing” the curve at a single point. The bowed-out shape is a key feature of typical PPFs, often overlooked by the student (and too often not accentuated by the instructor). The key here is to link the ever increasing opportunity cost exhibited by the shape of a bowed out PPF with that of the marginal cost curve, which is upward sloping. Simply stated, some resources are better suited for the production of one good or the other. To make the PPF model useful, it was necessary to simplify. By considering the case where production of all goods other than two remain fixed, we can use a relatively simple picture to see how concepts apply to the real world. With three goods, we would have a 3-D frontier surface. With more than 3 goods, it would be impossible to represent the frontier using a graph. The cool thing is that all relevant results of the 2-D model are true in the N-good model.

THE ECONOMIC PROBLEM

II. Using Resources Efficiently Which point on the PPF best serves the public interest? To answer this question, we must measure and compare costs and benefits of different points. The PPF and Marginal Cost • Marginal cost is the opportunity cost of producing one more unit of a good. • As more books are produced, the marginal cost of a book increases. The table shows the marginal cost of producing books from the PPF data presented before and the figure shows the upward sloping marginal cost curve.

Books A

200

400

Marginal cost of a book (movies per book) 0.5 1.0 1.5

600

Preferences and Marginal Benefit • Preferences are a description of a person’s likes and dislikes. • The marginal benefit of a good or services is the benefit received from consuming one more unit of it. • The principle of decreasing marginal benefits is why the marginal benefit curve in the figure above slopes downward. You might have some students that have had a microeconomics course in their past, and have already been introduced to the concept of marginal cost and marginal benefit. And, they might inquire if the marginal benefit curve is linked to the Law of Diminishing Marginal Utility. While this might be adequate discussion for an advanced undergraduate course, and certainly a graduate micro seminar, pass it up in your principles course. Let the student know that the goal is to employ demand side concepts, in a marginal sense. As such, key in on the fact that the marginal benefit curve can be characterized as a willingness to pay curve. Keep the discussion of marginal cost and marginal benefit separate and distinct, making sure that the student realizes these are in essence the foundation of market forces (supply and demand, respectively). While the PPF can tell us the opportunity costs in production, and the tradeoffs therein, it is the market that allows us to determine the allocatively efficient point. Allocative efficiency only occurs with a balance between benefits and costs, at the margin. Allocative Efficiency Allocative efficiency occurs only when marginal benefit equals marginal cost. • In the figure, when 100 books per month are produced, the marginal benefit from another .

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book exceeds its marginal cost, which means that people prefer another book more than the movies they must give up. When the allocatively efficient number of books, 200 per month, is produced, the PPF in the previous figure shows that the allocatively efficient number of movies is 500 movies per month. When marginal cost equals marginal benefit it is impossible to make people better off by reallocating resources.

THE ECONOMIC PROBLEM

III. Gains from Trade Specialization and trade expand consumption possibilities Comparative Advantage and Absolute Advantage • A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. • The PPF shows opportunity cost. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers. • A person has an absolute advantage if that person is more productive than others in that activity or activities. A person (or country) can have an absolute advantage in all activities but that person (or country) will not have a comparative advantage in all activities. An easy way for students to remember the difference between comparative and absolute advantages is that with comparative advantage, the opportunity costs comparison matters. If one has a comparative advantage in producing something, they should specialize in production of that good or service. An absolute advantage can be characterized by being able to “absolutely out-produce” the other economic agent. Even though a country might have absolute advantages, it should not produce everything, and should focus on identifying its comparative advantages. Achieving the Gains from Trade • When countries specialize by producing the good in which each country has a comparative advantage more goods in total can be produced. If without trade Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, Japan produces at point B* and Canada produces at point B for a combined total of 12 computers and 24 bushels of wheat. • Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own. For example, suppose that the market price of wheat is ½ computer per 1 bushel of wheat. As illustrated, each country can now be consuming at point C along the trade line. Note that each country’s consumption point lies beyond its own PPF. .

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The gains from trade can now be easily seen in terms of Japan and Canada each gaining 2 computers and 4 bushels of wheat compared to their initial, no-trade consumption points. Note that it is more likely that point C for each country will be on a different point on the trade line according to preferences. In the end, the sum of consumption among the two countries must equal the sum of production (imports=exports). For simplicity, this example has points A and C equal for both countries.

To show the gains from trade you can use candy or any kind of small trinkets. Make sure that each person initially gets Then: 1. Create several countries with approximately even student populations. Give each country at least 3 or 4 items such as different types of candy. You can have some fun and add in a few entertaining items. For example: a can of spam, sticks of beef jerky, bubbles, etc. 2. Students record individual happiness value from 1-10 on initial allocation (I use an Excel spreadsheet to easily aggregate data at the end but keeping track on paper is fine). 3. Allow the countries to trade with each other 4. Have the students record their new happiness level after trade. 5. Compare the “happiness” level after trade with that before trade. Here are the key points that come from the experiment: • Both parties become better off when they engage in voluntary trade. • Even without production, trade creates value. IV. Economic Growth Economic growth expands production possibilities and shifts the PPF outward. • Technological change (the development of new goods and of better ways of producing goods and services) and capital accumulation (the growth of capital resources, which includes human capital) lead to economic growth. You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2017, income per person in the United States was about $133 a day. In 1808 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2208 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $10 million!). Encourage a discussion of why scarcity is still present even at these large incomes. The Cost of Economic Growth • Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth. A Nation’s Economic Growth • Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster. • Some nations, such as Hong Kong, have chosen faster capital accumulation at the expense of current consumption and so have experienced faster economic growth. .

THE ECONOMIC PROBLEM

Running through the above example can really help students catch on to how economic growth is linked to choices (less consumption now for more later). You may wish to demonstrate more consumption or more capital biased shifts of the PPF, to demonstrate changes in opportunity costs. Changes in What We Produce • In a low-income country, just producing enough food is a high priority, and the marginal benefit from food is high. So, in Ethiopia, agriculture accounts for a large 35 percent of total production. • In China, where production per person is 7 times that of Ethiopia, agriculture shrinks to 8 percent of total production and industry expands to 41 percent. • Further investment in capital and in advanced robot technologies expand production possibilities to the level in the United States, which today is 4 times (per person) its level in China.

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V. Economic Coordination Firms and Markets • A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services. • A market is any arrangement that enables buyers and sellers to get information and to do business with each other. Property Rights and Money • The social arrangements that govern the ownership, use, and disposal of resources, goods, and services are called property rights. Types of property include real (buildings and land), financial (stocks and bonds) and intellectual (ideas and technology). • Money is anything generally accepted as a means of payment. Money’s main purpose is to facilitate trade. Students are usually fixated on money, but ask them to dig deeper. It is what we can do or buy with money that brings us happiness not the actual bills themselves. Our focus on money creates a “veil” that hides the real economic engine of capitalism. Circular Flows Through Markets • Firms and households interact in markets and it is this interaction that determines what will be produced, how it will be produced, and who will get it. Coordinating Decisions • Prices within markets coordinate firms’ and households’ decisions. Everyone knows what prices are. But not everyone knows why prices rise or fall. The point is that no one needs to know why a price has changed when making the choice to buy or sell. All that someone needs to know is what the price is relative to what he or she believes the item to be worth. •

Enforced property rights ensure that exchange is voluntary (not theft). Property rights and prices help insure that production takes place efficiently without waste because the owner of a firm has the property right to any profit the firm can earn.

Willingness to pay affects production and production affects willingness to pay. It would appear that we have the classic “which came first, the chicken or the egg” conundrum. However, in the next chapter, we will discuss the most powerful model in economics, Demand and Supply, which allows us to think clearly about the behavior of markets.

THE ECONOMIC PROBLEM

Additional Problems 1.

Jane’s Island’s production possibilities are given in the table to the right. a. Draw a graph of the production possibility possibilities frontier on Jane’s Island. b. What are Jane’s opportunity costs of producing corn and cloth at each output in the table?

In problem 1, Jane is willing to give up 0.75 pounds of corn per yard of cloth if she has 2 yards of cloth; 0.50 pounds of corn per yard of cloth if she has 4 yards of cloth; and 0.25 pound of corn per yard of cloth if she has 6 yards of cloth. a. Draw a graph of Jane’s marginal benefit from corn. b. What is Jane’s efficient quantity of corn?

Joe’s production possibilities are given in the table to the right. What are Joe’s opportunity costs of producing corn and cloth at each output in the table?

In problems 1 and 2, Jane’s Island produces and consumes 2 pounds of corn and 2 yards of cloth. Joe’s Island produces and consumes 2 pounds of corn and 2 yard of cloth. Now the islands begin to trade. a. What good does Jane sell to Joe and what good does Jane buy from Joe? b. If Jane and Joe divide the total output of corn and cloth equally, what are the gains from trade?

Corn (pounds per month) 3.0 2.0 1.0 0

and and and and

Cloth (yards per month ) 0 1.0 2.0 3.0

Corn (pound s per month)

Solutions to Additional Problems 1. a. Jane’s Island’s PPF is a straight line. To make a graph of Jane’s Island’s PPF measure the quantity of one good on the x-axis and the quantity of the other good on the y-axis. Plot the quantities in each row of the table. Figure 2.1 illustrates Jane’s Island’s PPF. b. The opportunity cost of 1 pound of corn is 2 yards of cloth. The opportunity cost of the first pound of corn is 2 yards of cloth. To find the opportunity cost of the first pound of corn, increase the quantity of corn from 0 pounds to 1 pound. In doing so, Jane’s Island’s production of cloth decreases from 6 yards to 4 yards. The opportunity cost of the first pound of corn is 2 yards of cloth. Similarly, the opportunity costs of producing the second pound and the third pound of corn are 2 yards of cloth.

and and and and

Cloth (yards per month) 0 2 4 6

6 4 2 0

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The opportunity cost of 1 yard of cloth is 0.5 pound of corn. The opportunity cost of producing the first 2 yards of cloth is 1 pound of corn. To calculate this opportunity cost, increase the quantity of cloth from 0 yards to 2 yards. Jane’s Island’s production of corn decreases from 3 pounds to 2 pounds. Similarly, the opportunity cost of producing the second 2 yards and the third 2 yards of cloth are 1 pound of corn. 2. a. The marginal benefit curve slopes downward. To draw the marginal benefit curve from cloth, plot the quantity of cloth on the x-axis and the willingness to pay for cloth (that is, the number of pounds of corn that Jane is willing to give up to get a yard of cloth) on the y-axis, as illustrated in Figure 2.2. b. The efficient quantity is 4 yards a month. The efficient quantity to produce is such that the marginal benefit from the last yard equals the opportunity cost of producing it. The opportunity cost of a yard of cloth is 0.5 pound of corn. The marginal benefit of the fourth yard of cloth is 0.5 pound of corn. And the marginal cost of the fourth yard of cloth is 0.5 pound of corn.

Joe’s Island’s opportunity cost of a pound of corn is 1/2 yard of cloth, and its opportunity cost of a yard of cloth is 2 pounds of corn. When Joe’s Island increases the corn it produces by 2 pounds a month, it produces 1 yard of cloth less. The opportunity cost of 1 pound of corn is 1/2 yard of cloth. Similarly, when Joe’s Island increases the cloth it produces by 1 yard a month, it produces 2 pounds of corn less. The opportunity cost of 1 yard of cloth is 2 pound of corn. 4. a. Jane’s Island sells cloth and buys corn. Jane’s Island sells the good in which it has a comparative advantage and buys the other good from Joe’s Island. Jane’s Island’s opportunity cost of 1 yard of cloth is 1/2 pound of corn, while Joe’s Island’s opportunity cost of 1 yard of cloth is 2 pounds of corn. Jane’s Island’s opportunity cost of cloth is less than Joe’s Island’s, so Jane’s Island has a comparative advantage in producing cloth. Jane’s Island’s opportunity cost of 1 pound of corn is 2 yards of cloth, while Joe’s Island’s opportunity cost of 1 pound of corn is 1/2 yard of cloth. Joe’s Island’s opportunity cost of corn is less than Jane’s Island’s, so Joe’s Island has a comparative advantage in producing corn. b. With specialization and trade, together they can produce 6 pounds of corn and 6 yards of cloth and each will get 3 pounds of corn and 3 yards of cloth—an additional 1 pound of corn each and an additional 1 yard of cloth each. Hence the total gains from trade are 2 yards of cloth and 2 pounds of corn. .

THE ECONOMIC PROBLEM

Additional Discussion Questions

1. Use the PPF model to analyze an “Arms Race” between nations. You might like to get the students to realize how useful even a simple economic model (such as the PPF model) is for helping us understand and interpret important political events in history. Draw a PPF for military goods and civilian goods production (or, simply, the traditional example of “guns versus butter”). Then draw another PPF for a country that is about twice the size of the first, but with the same degree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly “arms race.” Each country picks a point on the PPF that produces an equal level of military output (in absolute terms). What would happen if the larger country decided to increase military production? Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the government of the small country by forcing the small country to match the increase in military production. The PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country. What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post–Viet Nam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy contributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R. What are the implications for the next 50 years? China is currently the world’s second largest economy. It could become the biggest by mid-century. How does this development influence the strategic balance and the position of the United States? 12. Using the PPF model to analyze global environmental agreements between nations. This application of the PPF is a more “green” perspective that uses the same logic as the “Arms Race” on a timely international policy issue. Compare a rich economy PPF to a poor economy PPF, each with the same degree of concavity. (Production levels are now measured as output per person.) The goods are now “cleaner air” and “other goods and services.” What if the citizens of each country were required to make equal reductions in per-person greenhouse gas emissions? Show an equal quantity increase in per person output on the clean air axis for both countries’ PPF curves. Show how the opportunity cost of requiring additional pollution reduction (cleaner air) of equal amounts per person is much greater for the citizens of a poorer country than for the citizens of the richer country. This fact has been used to persuade developed countries (like the United States) to accept larger pollution reduction targets than developing countries (like China, India, and African nations). .

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3. Why do some of the brightest students Recreation Marginal cost not get a 4.0 GPA? The answer—because it (hours per day) (GPA points per hour) doesn’t achieve allocative efficiency—can 0.5 0.1 now be approached. The first conceptual 1.5 0.2 step is to derive the marginal cost curve 2.5 0.3 from the PPF. The table provides eight 3.5 0.4 points on the MC curve. Tell the students 4.5 0.5 that this table is from a PPF between hours 5.5 0.6 spent at recreation and GPA. Use this 6.5 0.7 opportunity to explain why we plot 7.5 0.8 marginal values at the midpoints of changes because the marginal cost at the midpoint approximately equals the average of the opportunity costs across the interval. The students must now think about preferences for recreation and study. You’ll be surprised how many students want to derive preferences from the PPF! Explain that the PPF provides the constraint—what is feasible—and preferences provide the objective—what is desirable in the opinion of the chooser. Each additional hour of recreation likely Willingness yields a smaller marginal benefit to the Recreation to pay student. Translate this to the proposition that (hours per day) (GPA points per hour) the student’s willingness to give up GPA 0.5 0.7 points for additional hours of recreation 1.5 0.6 decreases and provide a table similar to that 2.5 0.5 in Figure 2.3 that captures this observation. 3.5 0.4 The table has a preference schedule. Stress 4.5 0.3 once again that this table did not come from 5.5 0.2 the PPF. 6.5 0.1 To determine the efficient amount of 7.5 0 recreation and hence study time, the student must ask “Do I study a little bit longer?” That is the question. Walk the student through the thought experiment: 1. If I study for 8 hours a day I get a 4.0, but I am willing to pay much more than I will pay if a take a bit of time off studying and have some fun. So I will be better off if study less and take more recreation time. 2. If I don’t study at all I get a 0.4, and I am paying much more in lost GPA than I am willing to pay for the last bit of fun. So I will be better off if I study more and take less recreation time. 3. The only allocation at which I can’t become better off by studying a little bit more or a little bit less is where I am just willing to pay what the last bit of recreation costs—where marginal cost equals marginal benefit. In this example, the student studies for 4.5 hours and takes 3.5 hours a week of recreation time. Explain that there is nothing strange or wrong with the fact that the student gets no net benefit from the last seconds-worth of recreation time. He or she is just willing to pay what it costs him or her. .

THE ECONOMIC PROBLEM

4. Gains from Trade The gain from trade is a real eye-opener for students. Their first reaction is one of skepticism. Convincing students of the power of trade to raise living standards and the costs of trade restriction is one of the most productive things we will ever do. Here are some questions to drive home the idea of comparative advantage: Why didn’t Billy Sunday do his own typing? Billy Sunday, an evangelist in the 1930s, was reputed to be the world’s fastest typist. Nonetheless, he employed a secretary who was a slower typist than he. Why? Because in one hour of preaching, Billy could raise several times the revenue that he could raise by typing for an hour. So, Billy plays to his comparative advantage. Why doesn’t Martha Stewart bake her own bread? Martha Stewart is probably a better cook than most people, but she is an even better writer and TV performer on the subject of food. So Martha plays to her comparative advantage and writes about baking bread but buys her bread. Why doesn’t Vinnie Jones play soccer? Vinnie Jones was one of the world’s best soccer players. But he stopped playing soccer and started making movies some years ago. Why? Because, as he once said, “You go to the bank more often when you’re in movies.” Vinnie’s comparative advantage turned out to be in acting.

C h a p t e r

DEMAND AND SUPPLY

The Big Picture Where we have been: In Chapter 3, the students have their first encounter with demand and supply and the powerful forces that determine price and quantity in a competitive market. Chapter 3 builds on Chapter 2, which provides the simplest rigorous description of the economic problem and the implications of the pursuit of an efficient use of resources. If you have time, it is worth forging links between Chapters 2 and 3. Chapter 2 explains why we trade in markets. Chapter 3 shows how trade in markets through the interaction of supply and demand determines where on the PPF the economy operates. Where we are going: Demand and supply lie at the heart of the principles course. Eventually in the microeconomics class we derive the demand curve and the supply curve from deeper views of the choices that people and firms make. And in the macroeconomic class, the lessons learned here apply, albeit with subtle differences, to the aggregate supply-aggregate demand model.

New in the Fourteenth Edition

The content of this chapter is largely the same except for the opener, which poses teaser questions about how Covid-19 changed the use of scarce resources, and the Economics in the News sections. The first now looks at why the price of chocolate has risen (an increase in demand), which is a nice contrast to the second, which looks at why the price of vanilla has risen (a decrease in supply). The last Economics in the News section looks at the market for hand sanitizers during the pandemic. The Review Quizzes also feature questions asking about the effects of the Covid-19 pandemic on various markets. Previous editions used the phrase the “price of productive resources” as a factor that shifts the supply curve. This edition changes to the phrase the “price of factors of production.”

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Lecture Notes

Demand and Supply I. Markets and Prices • In our market-based economy, the interaction of demand and supply in markets determines the prices of goods and services and the quantity produced and consumed. • Changes in demand and/or supply lead to changes in the price of the good or service and in the quantity produced and consumed. • Markets vary in the intensity of competition. This chapter studies a competitive market, which is a market that has many buyers and sellers, so no single buyer or seller can influence price. • The money price of a good or service is the number of dollars that must be given up for it. The ratio of one (money) price to another is called a relative price. A relative price is an opportunity cost. The theory of demand and supply determines relative prices and so when we use the word “price” we mean “relative price.” To show the importance of relative prices, ask your students if turkey at 40¢ a pound is a good buy. Tell them that is all they know—turkey is 40¢ a pound. Generally most students respond that turkey at this price is cheap and a good buy. Then tell them that steak is 8¢ a pound. Now is turkey such a good buy? Students realize that the relative price of turkey is 5 pounds of steak per pound of turkey and so turkey is actually expensive. These money prices are actual prices from circa 1800. At that time, turkey was relatively quite expensive because turkeys could fly and needed to be hunted rather than harvested! Mention the unimportance of the money price and the importance of the relative price. II. Demand • •

The price of a good or service affects the quantity people plan to buy. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price. The law of demand states that other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater the quantity demanded. The law of demand occurs for two reasons: • Substitution Effect: When the relative price of good changes, the opportunity cost of the good •

changes. An increase in the price increases the opportunity cost of buying the good and people respond by buying less of the good and buying more of its substitutes. Income Effect: A change the price of a good changes the amount that a person can afford to buy. When the price rises, people cannot afford to buy the same quantities that they purchased before, so the quantities bought of some goods and services must decrease. Normally the good whose price rises is one of the goods for which less is purchased.

DEMAND AND SUPPLY

Demand Curve and Demand Schedule • The demand for a good •

•

refers to the entire relationship Price Quantity between the price of the good and the quantity demanded (dollars demanded of the good. The table gives a demand schedule. per (units) A demand curve shows the relationship between unit) the quantity demanded of a good and its price when all other influences on consumers’ planned purchases 1 50 remain the same. The figure illustrates the demand 2 40 curve resulting from the demand schedule. 3 30 The demand curve is a willingness-to-pay curve—for 4 20 each quantity, the price along the demand curve is the 5 10 highest price a consumer is willing to pay for that unit of output which means that a demand curve is a marginal benefit curve.

Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct. The classic demand-revealing experiment is one of the most productive and worthwhile ones. Bring to class two bottles of ice-cold, ready-to-drink Mt. Dew, bottled water, or sports drink. (If your class is very large, bring six bottles). Tell the students that you have these drinks and ask them to indicate if they would like one. Most hands will go up. Tell the class that you are going to sell them to the high bidder. Tell them that this auction is real. The winner will get the drink and will pay. Ask for a show of hands of those who have some cash and can afford to buy a drink. Explain that these indicate an ability to buy but not a definite plan to buy. Now begin the auction. Appoint a student to count hands (more than one for a big class). Begin at a low price: say 10¢ a bottle and count the number willing to buy. Raise the price in 10¢ increments and keep the tally of the number who are willing to buy at each price. When the number willing to buy equals the number of bottles you have for sale, do the transactions. (If you make a profit, and you might do so, tell the students that the profit, small though it is, will go the department fund for undergraduate activities—and deliver on that promise.) Now use the data to make a demand curve for Mt. Dew (or other drink) in your classroom today. You can easily emphasize the law of demand. And, now that you have a demand curve, you can do some thought experiments that will shift it. Ask: How would this demand curve have been different if the temperature in the classroom was 10 degrees higher/lower? How would this demand curve have been different if half the class was sick and absent today? How would this demand curve have been different if there was a Coke machine right in the classroom? A Change in Demand (Demand Shifters) •

When any factor that influences buying plans other than the price of the good changes, there is a change in demand and the demand curve shifts. An increase in demand shifts the demand curve rightward and a decrease in demand shifts the demand curve leftward. Six factors change demand: • Prices of Related Goods: A substitute is a good that can be used in place of another good (tea and coffee) and a complement is a good that is used in conjunction with another good (sugar and coffee). A rise in the price of a substitute or a fall in the price of a complement • • •

increases the demand for the good. Expected Future Prices: If the price of a good is expected to rise in the future, the demand for the good today increases. Income: A normal good is one for which demand increases as income increases; an inferior good is one for which demand decreases as income increases. Expected Future Income and Credit: When expected future income increases, demand today .

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• •

increases. When credit becomes easier to obtain, demand increases. Population: The larger the (relevant) population, the greater the demand. Preferences: Preferences are an individual’s attitudes toward goods and services. If people “like” a good more, the demand for it increases.

A Change in the Quantity Demanded Versus a Change in Demand •

•

III. •

•

A change in price results in a movement along the demand curve, which is change in the quantity demanded. A change in other factors shifts the demand curve, which is a change in demand. In the figure, the movement along demand curve D0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity demanded. The shift of the demand curve from D0 to the new demand curve D1 is a change in demand.

Supply The price of a good or service affects the quantity firms plan to sell. The quantity supplied of a good or service is the amount that firms plan to sell during a given time period at a particular price. The law of supply states that other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller the quantity supplied. The law of supply occurs because an increase in the quantity of a good produced results in an increase in its marginal cost. So, the price must rise in order to induce firms to increase the quantity they produce.

Supply Curve and Supply Schedule • The supply of a good

•

Price

Quantity

refers to the entire (dollars supplied relationship between per (units) the price of the good unit) and the quantity 1 10 supplied of the good. 2 20 The table gives a 3 30 supply schedule. 4 40 A supply curve shows the relationship 5 50 between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same. The figure illustrates the supply curve resulting from the supply schedule. The supply curve is a minimum-supply-price curve— for each quantity, the price along the supply curve is the lowest price a producer must receive in order to produce that unit of output which means that a supply curve is a marginal cost curve.

A Change in Supply (Supply Shifters) •

When any factor that influences selling plans other than the price of the good changes, there is a change in supply and the supply curve shifts. An increase in supply shifts the supply curve rightward and a decrease in supply shifts the supply curve leftward. Six factors change supply: .

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• •

• • • •

Prices of Factors of Production: If the price of a factor of production used to produce the good rises, the supply of the good decreases. Prices of Related Goods Produced: A substitute in production is a good that can be produced using the same resources and a complement in production is a good that must be produced with the initial good. A fall in the price of a substitute in production or a rise in the price

of a complement in production increases the supply of the good. Expected Future Prices: If the price of a good is expected to rise in the future, the supply of the good today decreases. Number of Suppliers: If the number of suppliers increases, the supply increases. Technology: Technology refers to the ways in which factors of production are used to produce a good. A technological advance increases the supply of a good. The State of Nature: The state of nature includes all natural forces that influence supply. Bad weather or an earthquake decreases the supply of a good.

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A Change in the Quantity Supplied Versus a Change in Supply •

•

A change in price results in a movement along the supply curve, which is change in the quantity supplied. A change in other factors shifts the supply curve, which is a change in supply. In the top figure, the movement along supply curve S0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity supplied. The shift of the supply curve from S0 to the new supply curve S1 is a change in supply.

IV. Market Equilibrium • An equilibrium is a situation in which opposing •

forces balance. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. In the figure, the equilibrium price is $3 and the equilibrium quantity is 30 per week.

Price as a Regulator and Price Adjustments • •

•

The price of a good regulates the quantities demanded and supplied. Shortage: If the price is below the equilibrium price, consumers plan to buy more than firms plan to sell. A shortage results, which forces the price higher, toward the equilibrium price. In the figure, there is a shortage at any price below $3 and so the price is forced higher, toward the equilibrium price. Surplus: If price is above the equilibrium, firms plan to sell more than consumers plan to buy. A surplus results, which forces the price lower, toward the equilibrium price. In the figure, there is a surplus at any price above $3 and so the price is forced lower, toward the equilibrium price. The price continues to adjust until the quantity supplied equals quantity demanded.

To help students have a base of knowledge from which build tell them to memorize “Home Base”—the basic Supply and Demand curves showing an initial starting position with proper labels on the axis’ and an initial equilibrium, P0 and Q0 on the axis at the intersection of the two curves. “Home Base” provides them a starting place for every story problem they face. Then as you work through examples, be sure to ask them what “shifter” is changing. This procedure will keep them using the economic tool rather than just going with a gut feeling.

The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve already used the demand experiment outlined above, with hard evidence in the form of the class activity. Using the experiment is straightforward. Start by explaining that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class. The equilibrium occurred where the market demand curve (demand by the students) intersected your supply .

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curve. Point out that the trades you made in your little economy made both buyers and sellers better off. Back in the dim mists of time, circa 1870 or so, economists struggled to understand if it was the supply or the demand that determined the price and quantity of a good. Nowadays we know that these efforts were misguided. To borrow from the great economist Alfred Marshall, demand and supply curves are like the blades on a pair of scissors. It does not make sense to ask which blade does the cutting because the cutting takes both blades and occurs at the intersection of the two blades. Likewise, it takes both the demand and supply to determine the price and quantity and the price and quantity are determined at the intersection of the demand and supply curves.

V. Predicting Changes in Price and Quantity The demand and supply model can be used to determine how changes in factors affect a good’s price and quantity.

A Change In Demand •

•

If the demand for a good or service increases, the demand curve shifts rightward. As a result, the equilibrium price rises and the equilibrium quantity increases. If the demand for a good or service decreases, the demand curve shifts leftward. As a result, the equilibrium price falls and the equilibrium quantity decreases. Supply does not change and the supply curve does not shift. Instead there is a change in the quantity supplied and a movement along the supply curve. The figure illustrates an increase in demand. In the figure the demand curve shifts from D0 to D1. As a result, the equilibrium price rises from $3 to $4 and the equilibrium quantity increases from 30 to 40. The supply curve does not shift; there is, however, a movement along the supply curve.

An Economic in the News feature discusses the factors that have led to higher price of chocolate. Because the quantity of chocolate has also increased, the analysis concludes that increases in demand are the factor that has created the higher price of chocolate. A Change In Supply •

•

If the supply of a good or service increases, the supply curve shifts rightward. As a result, the equilibrium price falls and the equilibrium quantity increases. If the supply of a good or service decreases, the supply curve shifts leftward. As a result, the equilibrium price rises and the equilibrium quantity decreases. Demand does not change and the demand curve does not shift. Instead there is a change in the quantity demanded and a movement along the .

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•

demand curve. The figure illustrates an increase in supply. In the figure the supply curve shifts from S0 to S1. As a result, the equilibrium price falls from $3 to $2 and the equilibrium quantity increases from 30 to 40. The demand curve does not shift; there is, however, a movement along the demand curve.

An Economic in the News explores the factors that led to a rise in the price of gasoline in Atlanta in September 2016. The analysis concludes that a decrease in supply from a broken pipeline lies behind the rise in price. The whole chapter builds up to this section, which now brings all the elements of demand, supply, and equilibrium together to make predictions. Students are remarkably ready to guess the consequences of some event that changes either demand or supply or both. They must be encouraged to work out the answer and draw the diagram. Explain that the way to answer any question that seeks a prediction about the effects of some event(s) on a market has five steps. Once you have already worked an example or two, walk them through the steps and have one or two students work some examples in front of the class. The five steps are: 1. Draw a demand-supply diagram and label the axes with the price and quantity of the good or service in question. 2. Think about the event(s) that you are told occur and decide whether they change demand, supply, or both demand and supply. 3. Determine if the events that change demand or supply bring an increase or a decrease. 4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curve(s) in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—this view works ok for demand but is exactly wrong for supply. So emphasize the left-right shift.) 5. Find the new equilibrium and compare it with the original one. It is critical at this stage to return to the distinction between a change in demand (supply) and a change in the quantity demanded (supplied). You can now use these distinctions to describe the effects of events that change market outcomes. At this point, the students know enough for it to be worthwhile emphasizing the magic of the market’s ability to coordinate plans and reallocate resources. Demand and Supply Change in the Same Direction •

•

If both the demand and the supply of a good or service increase, both the demand and supply curves shift rightward. The quantity unambiguously increases but the effect on the price is ambiguous. • If the increase in demand is greater than the increase in supply, the price rises. • If the increase in demand is the same size as the increase in supply, the price does not change. • If the increase in demand is less than the increase in supply, the price falls. If both the demand and the supply of a good or service decrease, both the demand and supply curves shift leftward. The quantity unambiguously decreases but the effect on the price is ambiguous. • If the decrease in demand is greater than the decrease in supply, the price falls. • If the decrease in demand is the same size as the decrease in supply, the price does not change. • If the decrease in demand is less than the decrease in supply, the price rises.

DEMAND AND SUPPLY

•

The figure illustrates an increase in both demand and supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium price does not change and the equilibrium quantity increases from 30 to 50.

Demand and Supply Change in the Opposite Directions •

If the demand increases and the supply decreases, the demand curve shifts rightward and the supply curve shifts leftward. The price unambiguously rises but the effect on the quantity is ambiguous. • If the increase in demand is greater than the decrease in supply, the quantity increases. • If the increase in demand is the same size as the decrease in supply, the quantity does not change. • If the increase in demand is less than the decrease in supply, the quantity decreases.

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•

If the demand decreases and the supply increases, the demand curve shifts leftward and the supply curves shifts rightward. The price unambiguously falls but the effect on the quantity is ambiguous. • If the decrease in demand is greater than the increase in supply, the quantity decreases. • If the decrease in demand is the same size as the increase in supply, the quantity does not change. • If the decrease in demand is less than the increase in supply, the quantity increases. The figure illustrates an increase in demand and a decrease in supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium quantity does not change and the equilibrium price rises from $3 to $5.

The Economic in the News explores the market for hand sanitizer during the pandemic. A massive increase in the demand lead to a massive increase in the price and the quantity.

DEMAND AND SUPPLY

Additional Problems 1.

What is the effect on the price of hotdogs and the quantity of hotdogs sold if The price of a hamburger rises? The price of a hotdog bun rises? The supply of hotdog sausages increases? Consumers’ incomes increase if hot dogs are a normal good? The wage rate of a hotdog seller increases? If the wage rate of the hotdog seller rises and at the same time prices of ketchup, mustard, and relish fall? 2. Suppose that one of the following events occurs: (i) The price of wool rises. (ii) The price of sweaters falls. (iii) A close substitute for wool is invented. (iv) A new high-speed loom is invented. Which of the above events increases or decreases (state which) a. The demand for wool? b. The supply of wool? c. The quantity of wool demanded? d. The quantity of wool supplied? 3. Figure 3.1 illustrates the market for bread. a. Label the curves in the figure. b. What are the equilibrium price of bread and the equilibrium quantity of bread? a. b. c. d. e. f.

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The demand and supply schedules for potato chips are in the table. Quantity Quantity Price demande supplied a. What are the equilibrium price and d equilibrium quantity of potato chips? (cents per bag) (millions of bags a week) b. If chips were 60 cents a bag, describe 40 170 90 the situation in the market for potato 50 160 100 chips and explain what would happen 60 150 110 to the price of a bag of chips. 70 140 120 5. In problem 4, suppose a new snack food 80 130 130 comes onto the market and as a result 90 120 140 the demand for potato chips decreases 100 110 150 by 40 million bags per week. 110 100 160 a. Has there been a shift in or a movement along the supply curve of chips? b. Has there been a shift in or a movement along the demand curve for chips? c. What is the new equilibrium price and quantity of chips? 6. In problem 5, suppose that a flood destroys several potato farms and as a result supply decreases by 20 million bags a week at the same time as the new snack food comes onto the market. What is the new equilibrium price and quantity of chips?

Solutions to Additional Problems 1. a. The price of a hot dog rises, and the quantity of hot dogs sold increases. Hot dogs and hamburgers are substitutes. If the price of a hamburger rises, people buy more hot dogs and fewer hamburgers. The demand for hot dogs increases. The price of a hot dog rises, and more hot dogs are sold. b. The price of a hot dog falls, and fewer hot dogs are sold. Hot dog buns and hot dogs are complements. If the price of a hot dog bun rises, fewer hot dog buns are bought. The demand for hot dogs decreases. The price of a hot dog falls, and people buy fewer hot dogs. c. The price of a hot dog falls and more hot dogs are sold. The increase in the supply of hot dog sausages lowers the price of hot dog sausages. Hot dog sausages are a factor used in the production of hot dogs. With the lower priced factor, the supply of hot dogs increases. The price of a hot dog falls and people buy more hot dogs. d. The price of a hot dog rises, and the quantity sold increases. An increase in consumers' income increases the demand for hot dogs. As a result, the price of a hot dog rises and the quantity bought increases. e. The price of a hot dog rises, and the quantity sold decreases. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs. f. The price of a hot dog rises, but the quantity might increase, decrease, or remain the same. Ketchup, mustard, and relish are complements of hot dogs. If the price of ketchup, mustard, and relish fall, more ketchup, mustard, and relish are bought and the demand for hot dogs increases. The price of a hot dog rises, and people buy more hot dogs. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of .

DEMAND AND SUPPLY

hot dogs decreases. The price rises, and people buy fewer hotdogs. Taking the two events together, the price of a hot dog rises, but the quantity might increase, decrease, or remain the same. 2. a. (ii) and (iii) Wool is used in the production of sweaters. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the demand for wool increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. If a close substitute for wool is invented, some sweater producers will switch from wool to the substitute. When they do, the demand for wool decreases. b. (iv) If a new high-speed loom is invented, the cost of making wool will fall and the supply of wool will increase. c. (i) and (iv) If the price of wool rises there is a movement up along the demand curve. The quantity demanded of wool decreases. If a new high-speed loom is invented, the cost of producing wool will fall. So the supply of wool increases. With no change in the demand for wool, the price of wool will fall and there is a movement down along the demand curve for wool. The quantity demanded of wool increases. d. (i), (ii), and (iii) If the price of wool rises there is a movement up along the supply curve. The quantity supplied of wool increases. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the demand for wool increases. With no change in the supply of wool, the price of wool rises and the quantity of wool supplied increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases. If some sweater producers switch to using the new close substitute for wool, the demand for wool will decrease. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases. 3. a. The demand curve is the curve that slopes down toward to the right. The supply curve is the curve that slopes up toward to the right. b. The equilibrium price is $3 a loaf, and the equilibrium quantity is 100 loaves a day. Market equilibrium is determined at the intersection of the demand curve and supply curve. 4. a. The equilibrium price is 80 cents a bag, and the equilibrium quantity is 130 million bags a week. The price of a bag adjusts until the quantity demanded equals the quantity supplied. At 80 cents a bag, the quantity demanded is 130 million bags a week and the quantity supplied is 130 million bags a week. b. At 60 cents a bag, there will be a shortage of potato chips and the price will rise. At 60 cents a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 110 million bags a week. There is a shortage of 40 million bags a week. The price will rise until market equilibrium is restored—80 cents a bag. 5. a. There has been a movement along the supply curve. The demand for potato chips decreases, and the demand curve shifts leftward. Supply does not change, so the price falls along the supply curve. .

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b. The demand curve has shifted leftward. As the new snack food comes onto the market, the demand for potato chips decreases. There is a new demand schedule, and the demand curve shifts leftward. c. The equilibrium price is 60 cents, and the equilibrium quantity is 110 million bags a week. Demand decreases by 40 million bags a week. That is, the quantity demanded at each price decreases by 40 million bags. The quantity demanded at 80 cents is now 90 million bags, and there is a surplus of potato chips. The price falls to 60 cents a bag, at which the quantity supplied equals the quantity demanded (110 million bags a week). 6.

The new price is 70 cents a bag, and the quantity is 100 million bags a week. The supply of potato chips decreases, and the supply curve shifts leftward. The quantity supplied at each price decreases by 20 million bags. The result of the new snack food entering the market is a price of 60 cents a bag. At this price, there is now a shortage of potato chips. The price of potato chips will rise until the shortage is eliminated.

Additional Discussion Questions

1. John Q: Could a legal market for human organ donations have saved his dying son? An opinion piece written by Richard Epstein in The Wall Street Journal (2/21/02) discusses the donation of human organs for transplant operations. He raises the issue that if a market for human donor organs were legal, the dilemma of a lack of organs, as raised by Denzel Washington’s character in the movie “John Q,” might be closer to fiction rather than fact. You can use this movie and the motive of the main character as an intriguing basis for getting students to construct and interpret the demand and supply model. Can we illustrate a market for something as vital as organ donations? Begin by asking the students to graph a demand and supply model for the market for human organ donations, making sure that their model reflects the real-life characteristics of this unique market: i) the federal government does not allow individuals or businesses to engage in the buying and selling of human organs, unless the organs are donated and received for free, ii) a small number of organs are donated by living volunteers (like kidney donations) or by the families of the recently deceased (especially after an otherwise healthy individual suffers an accidental death), meaning that the positively sloped supply curve for human organ donations intercepts the quantity axis at some positive value, iii) the demand curve for organs must intercept the supply curve at a positive price. Are there unintended consequences when market forces are ignored? The government wants to assure that poor people have the same access to available organ transplants as rich people, so it imposes a zero-price restriction on the market. However, this creates a shortage of organs available for transplant, where the quantity of organs demanded at a zero price far exceeds the quantity supplied. If the market for organ donations were unregulated, then the equilibrium price for an organ would surely increase, but so would the total number of people receiving an organ transplant, and presumably, the total number of people who would survive to live another day. Should society institute a policy that maximizes the numbers of lives saved or .

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manipulates the characteristics of those fewer lives that do get saved? Conclude this discussion with a great set-up for the efficiency versus equity issues developed later in chapter five. Our command of the demand and supply model for human organ donations allows us to discover an important insight into one aspect of health care policy: the government places a lower priority for maximizing the total number of people saved regardless of income, and a higher priority on achieving a “proper” income mix among the smaller number of people that are saved by being one of the few receiving organ transplants. 2. What are some goods that college students might buy today but will give up when they enter the workforce after graduation? College students usually recognize that they will change their consumption patterns when they are employed after college graduation. Use this to get the students to appreciate inferior goods. When you were an undergraduate, you probably complained about having to eat mostly canned soup or beans as a cheap staple to fill your hungry stomach on a small budget. You swore that when you finally entered the workforce you wouldn’t eat soup or beans again, unless under extreme duress. Today the single food item most frequently cited by students as an inferior good is the Raman style noodles—those dry, thin, near flavorless oriental style noodles that are reconstituted with boiling water. Get the students to create a list other such inferior goods they will avoid when their incomes increase. This gets them to carefully consider how income changes can cause demand curves to shift in an unintuitive manner for an inferior good. 3. Because tablets are cheaper and more abundantly available now than a decade ago, doesn’t this mean the supply curve for tablets is downward sloping? This is a real world example for illustrating the confusion between changes in supply and changes in the quantity supplied. (It is easier to analyze this example if the students assume that consumer demand for software applications has not changed over the last decade.) Has anything in the world of tablet manufacturing changed over the last decade? Point out that the observation about falling tablet prices with rising quantities sold assumes that nothing significant has changed in the tablet industry. Emphasize how such statements reflect how the ceteris paribus condition of careful economic analysis has been violated. Over the years, advances in technology have allowed tablet makers to: i) offer greater computer power and versatility for contemporary software applications at the same opportunity cost of resources (market price) as before, or ii) to provide the same level of computer power and versatility for contemporary software applications at lower opportunity costs (market prices) as before. Either way, this represents a rightward shift in the supply curve for tablets. The students should recognize that the two prices and two quantities that give the appearance of more tablets offered for less are actually from two separate supply curves. 4. Because the average price of a car has increased substantially over the last 30 years, and the number of cars owned has risen faster than the population, doesn’t this mean that the demand curve for cars is upward sloping? This is a real world example for illustrating the confusion between changes in demand and .

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changes in the quantity demanded. (It is easier to analyze this example if the students assume that automobile production technology has not changed over these last three decades.) Has anything in the world of consumers changed over the last decade? Point out that this real world observation of car prices and rising quantities sold over time assumes that nothing significant has changed in the consumers’ environment. Emphasize how statements such as these reflect how the ceteris paribus condition of careful economic analysis has been violated. Consumer incomes have increased significantly over the last three decades, allowing them to: i) consume greater personal transportation opportunities for more family members while giving up the same amount of other goods as before, or ii) consume the same level of personal transportation opportunities while giving up less of all other goods as before. Either way, this represents a rightward shift in the demand curve for automobiles. The students should recognize that the two prices and quantities that give the appearance of more automobiles demanded at higher prices are actually from two separate demand curves. If the status of the family automobile has increased in recent decades, what affect would this have on consumer demand? There is evidence that the proportion of income that typical families spend on automobiles (versus all other goods) has increased substantially over the last 30 years. This means that the percent increase in automobile purchases has been higher than the percent increase in family incomes. This makes for a great lead into the measures of the income elasticity of demand discussed in Chapter 4.

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C h a p t e r

MEASURING THE VALUE OF PRODUCTION: GDP**

The Big Picture Where we have been: Chapter 4 does not directly use the material developed in the previous chapters. Where we are going: Chapter 4 is the first of the macroeconomic chapters. It provides some basic definitions (GDP, real GDP, aggregate expenditure, potential GDP, and business cycles) that are used in virtually all the remaining chapters. The circular flow model and the national income accounting explained in this chapter serve as a general framework for macroeconomic analysis. The figures that show that aggregate expenditure equals aggregate income which all equals the value of production is the key to understanding why changes in aggregate expenditure feed back into aggregate income, which in-turn then feeds back into aggregate expenditure. The components of aggregate expenditure provide an underpinning for the theory of aggregate demand in Chapter 10 and the aggregate expenditure model and multiplier in Chapter 11. In these later chapters, the multiplier effect will be challenged by showing how inflation, imports and taxes dampen its size and potentially eliminate it all together.

New in the Fourteenth Edition

The content within the chapter is substantially the same as the 13th edition. All of the data within the chapter have been updated to use 2020 data. The chapter introduction discusses how economists are trying to get more timely measures of real GDP by “nowcasting.” The concluding ‘Economics in the News’ section discusses nowcasting and illustrates its use during the second and third quarters of 2020 during the Covid-19 pandemic.

* This is Chapter 21 in Economics. .

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Lecture Notes

Measuring GDP and Economic Growth • • •

GDP is a measure of total production and total income. Real GDP measures production of goods and services. GDP can be used to make comparisons over time and across countries.

I. Gross Domestic Product • GDP or gross domestic product is the market value of all the final goods and services produced within a country in a given time period. How do you add apples and oranges? You can pick any goods you like but I think it is helpful to show GDP as an equation early on. You can start with real goods and then generalize to “n goods”: GDP = PAQA + POQO + … GDP = P1Q1 + P2Q2 + P3Q3 + … + PNQN GDP = ∑ PiQi You may find it useful to add slang while you discuss GDP, “GDP is the dollar value of all ‘stuff’ made over one year.” Be sure to repeat the definition as you move through all the chapters rather than assuming your students always remember what is in GDP and how it is measured. A solid understanding of GDP is crucial for other material to make sense. •

• • • •

The items in GDP are valued at their market values, that is, at their prices. So if 100,000,000 slices of pizza are sold for $5 each, slices of pizza contribute $500,000,000 to GDP. Using market values means that the total value of output, that is, GDP will be in the dollars (or whatever the country’s currency unit might be). A final good is an item that is bought by its final user. It contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. To avoid double counting, GDP includes only final goods and services (no intermediate goods and services are directly counted). Only the goods and services produced within a country are counted. A Honda produced in North Carolina is counted in U.S. GDP. GDP is measured over a period of time, typically a quarter of a year or a year.

Gross Domestic Product. The main challenge in teaching this topic is generating interest in it. Many teachers are bored by it and not surprisingly, they bore their students. If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy. Working through issues with GDP is vital since it serves as the basis of measurement of the standard of living, economic welfare, and making international comparisons. Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software. The BEA began a major revision in 1998 and .

MEASURING THE VALUE OF PRODUCTION: GDP

published the first revisions to reclassify software from intermediate to final good status in 1999. When the 1996 GDP was recalculated to include software as a final good, GDP increased by $115 billion, or 1.5 percent. GDP and the Circular Flow of Expenditure and Income • The circular flow illustrates the equality of income, expenditure, and the value of production. The circular flow diagram shows the transactions among four economic agents—households, firms, governments, and the rest of the world—in two aggregate markets—goods markets and factor markets. • In the goods market, households, firms, governments, and foreigners buy goods and services. For analytical purposes, we can categorize spending by these four agents in the calculation of GDP: • The total payment for goods and services by households in the goods markets is consumption expenditure, C. • The purchases of new plants, equipment, and buildings and the additions to inventories are investment, I. • Governments buy goods and services, called government expenditure or G, from firms. • Firms sell goods and services to the rest of the world, exports or X, and buy goods and services from the rest of the world, imports or M. Exports minus imports are called net exports, X − M. Government transfer payments, such as Social Security payments, are not part of government expenditures because government expenditures include only funds used by the government to buy goods and services. Transfer payments are not buying a good or service for the government and so are not included in government expenditures. •

In factor markets households receive income from selling the services of resources to firms. The total income received is aggregate income. It includes wages paid to workers, interest for the use of capital, rent for the use of land and natural resources, and profits paid to entrepreneurs; retained profits can be viewed as part of household income, lent back to firms.

The Circular Flow Model. Start with a simpler picture than Figure 4.1—just households and firms, and just income and consumption. Explain that you are starting from the basics, in which all goods and services produced are sold to consumers. Explain that even beyond the assumption that all goods and services are consumption goods and services, we’re simplifying things in the picture but are not omitting anything that leads us into a misleading conclusion. For instance the picture envisages all the income being paid to households. Nothing is lost and clarity is gained by this device. Emphasize that the blue flows are incomes and the red flows are expenditures on final goods and services. Clearly in this simplest case aggregate income equals aggregate expenditure. Then add investment. It is still the case that aggregate expenditure (which is now C + I) equals aggregate income. Next add the government and the flow of government expenditure. Finally add the rest of the world and the flow of net exports. In both cases you can continue to make the crucial point at aggregate expenditure equals aggregate income. .

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GDP Equals Expenditure Equals Income • Aggregate expenditure equals C + I + G + (X − M). Aggregate expenditure equals GDP because all the goods and services that are produced are sold to households, firms, governments, or foreigners. (Goods and services not sold are included in investment as inventories and hence are “sold” to the producing firm.) • Because firms pay out as income everything they receive as revenue from selling goods and services, aggregate income equals aggregate expenditure equals GDP. Why “Domestic” and Why “Gross”? • Depreciation is the decrease in the stock of capital that results from wear and tear and obsolescence. The total amount spent on purchases of new capital and on replacing depreciated capital is called gross investment. The amount by which the stock of capital increases is net investment. Net investment = Gross investment − Depreciation. • The “Gross” in gross domestic product reflects the fact that the investment in GDP is gross investment and so part of it goes to replace depreciating capital. Net domestic product subtracts depreciation from GDP. II. Measuring U.S. GDP Most of the income data used by the BEA to measure GDP come from the IRS. Expenditure data come from a variety of sources. The Expenditure Approach • The expenditure approach measures GDP as the sum of consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports of goods and services, (X − M). So GDP = C + I + G + (X − M) or, in 2020 and in billions of dollars, $14,145 + $3,605 + $3,831 + −$645 = $20,936. The Income Approach • The income approach measures GDP as the sum of compensation of employees, net interest, rental income, corporate profits, and proprietors’ income. This sum equals net domestic income at factor costs. To obtain GDP, indirect taxes (which are taxes paid by consumers when they buy goods and services) minus subsidies plus depreciation are included. Finally any discrepancy between the expenditure approach and income approach is included in the income approach as “statistical discrepancy.” Measuring U.S. GDP, the low cost of economic data. You might like to tell your students that measuring real GDP is actually very cheap. The BEA (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of the nation’s production. For some further perspective, the National Oceanic and Atmospheric Administration (also in the Department of Commerce), whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion! Creative accounting and GDP measurement. In recent years, the first estimates of GDP, which are based on companies’ reported profits, have been revised downward when data on company .

MEASURING THE VALUE OF PRODUCTION: GDP

profits as reported to the IRS became available. You can make a nice point with one example of creative accounting. In the past some Internet companies recorded advertising expenditure as investment and amortized it over a number of years. First, you can explain that the correct treatment of this item is as an expenditure on intermediate goods and services and a charge against profit. Take, for example, Google. The expenditure on Google services is the value of Google’s production. And Google’s expenditure on advertising is part of the value of the production of the advertising agencies used by Google. You can go on to explain that Google’s accounting practice would misleadingly swell GDP by causing some double counting. On the expenditure approach, Google’s advertising expenditure shows up as investment in the national accounts. On the income approach, because the expenditure is not a cost, it swells profit, so Google’s corporate profit increases by the same amount as its “investment.” If Google filed its income tax return in this same way, the national income accounts wouldn’t get corrected. But if, when Google files its tax returns, it calls its advertising a cost and lowers its profits by that amount, the BEA picks up these numbers from the IRS and the national accounts are adjusted appropriately. Nominal GDP and Real GDP • The market value of production and hence GDP can increase either because the production of goods and services are higher or because the prices of goods and services are higher. • Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. • Nominal GDP is the value of the final goods and services produced in a given year valued at the prices that prevailed in that same year.

CHAPTER 4

Calculating Real GDP • Traditionally, real GDP is calculated using prices of the reference base year (the year in which real GDP=nominal GDP). • The tables to the right show this method of calculating real GDP for an economy that produces only books and coffee. If 2021 is the reference base year, nominal GDP in 2021 in the top table equals real GDP in 2021. Real GDP in 2021 is $3,000. • The second table shows the calculation for nominal GDP in 2022. • Real GDP in 2022 is in the bottom table. It values 2022 production using the prices from the reference base year, 2021. Real GDP in 2022 is $4,250.

Data for 2021 Item Books Coffee Nominal GDP Data for 2022 Item Books Coffee Nominal GDP

Quantity Price Market Value 40 $25 $1,000 1,000 $2 $2,000 $3,000

Quantity Price Market Value 50 $30 $1,500 1,500 $3 $4,500 $6,000

2022 Quantities and 2021 Prices Item Quantity Price Market Value Books 50 $25 $1,250 Coffee 1500 $2 $3,000 Real GDP $4,250 (2021 dollars)

You may want to mention the GDP deflator at this point even though coverage of it is in next chapter. Stress the separation of the “quantity effect,” measured by real GDP, and the “price effect,” measured by the price level. Real GDP will be used to compute the economic growth rate while the price level will be used to compute the inflation rate. REQUIRES MATHEMATICAL NOTE: Chained-Dollar Real GDP •

The top table to the right has data for 2021 for an economy that produces only books and coffee. In 2021, nominal GDP is $3,000. The second table to the right has the same data for 2022. (These tables are the same as used above to calculate real GDP using the standard method.) In 2022, nominal GDP

GDP Data for 2021 Item Quantity Price Market Value Books 40 $25 $1,000 Coffee 1,000 $2 $2,000 Nominal $3,000 GDP

MEASURING THE VALUE OF PRODUCTION: GDP

is $6,000. Nominal GDP has doubled but how much has real GDP changed between these years? To determine how real GDP changes, suppose that 2021 is the base year. Then we need to determine the growth rate between 2021 and 2022 by calculating the value of production in both years using 2026 prices and also calculating it in both years using 2022 prices. • Using 2021 prices, the value of 2022 Quantities and 2021 Prices production increases from Item Quantity Price Market $3,000 (the first table) to Value $4,250 (the third table). Using 2021 prices, the value of Books 50 $25 $1,250 production has grown by Coffee 1500 $2 $3,000 100  ($4,250 − $3,000)/$3,000 = 41.7 Value of $4,250 percent. production • Using 2022 prices, real GDP (2021 dollars) increases from $4,200 (the 2021 Quantities and 2022 Prices fourth table) to $6,000 (the second table). Using 2022 Item Quantity Price Market Value prices, the value of production Books 40 $30 $1,200 has grown by Coffee 1,000 $3 $3,000 100  ($6,000 − $4,200)/$4,200 = 42.9 percent. Value of $4,200 production • The average growth rate is equal to (41.7 percent + 42.9 percent)/2 = 42.3 percent. So real (2022 GDP between these years has grown by 42.3 dollars) percent. If 2021 is the base year, real GDP in 2022 is $3,000  1.423 = $4,269. • Similar calculations are made for each pair of adjacent years from the reference base year onwards. This procedure chains real GDP back to the reference base year. • •

III.

The Uses and Limitations of Real GDP

The Standard of Living Over Time • One measure of the standard of living over time is real GDP per person, or real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy. • The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed is called potential GDP. Potential GDP grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace. • The growth rate of real GDP slowed in the productivity growth slowdown after 1970. This slowdown created a Lucas wedge. A Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the growth rate had persisted and what real GDP per person actually turned out to be. The Importance of the Lucas Wedge. It is usually straightforward to interest students in the business cycle. But it is perhaps a bit more difficult to motivate interest in economic growth and the Lucas wedge. Yet economic growth and the Lucas wedge should be of immense importance to young students because they help determine the long-run living standard of their lives. One .

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way to make this point clear is to ask the students whether the difference between, say, 3 percent annual growth in income versus 4 percent annual growth is important. This difference probably does not sound important. But, suppose that the initial income was $35,000. After 10 years with 3 percent growth, the income would be $47,037 and with 4 percent growth the income would be $51,809. This difference of about $4,500 might not seem like much. But point out to the students that this difference is for only ten years and that the annual difference will continue to enlarge: After 30 years with 3 percent growth, the income would be $84,954 and with 4 percent growth the income would be $113,519, a one year difference of about $40,000. And, over a 30-year working career, the total differences in income, which is the analog to the Lucas wedge, is approximately $420,000. Over a 40-year working career, the Lucas wedge difference is over $1,000,000! Viewed from this perspective, the seemingly slight 1 percentage point difference in growth rates makes for an incredibly major difference in incomes, which should easily capture your students’ attention. • Fluctuations in the pace of expansion of real GDP is denoted the business cycle, periodic but irregular increases and decreases in the total production and other measures of economic activity. Each cycle is categorized by: trough, expansion, peak, recession. The Business Cycle. Students generally are interested in the topic of business cycles, particularly if the economy happens to be in a recession when this chapter is covered. Often it is very difficult to tell the future path of the economy. Stress to the students that it is not stupidity on the part of economists that prevents us from knowing where the economy is heading. Rather it is the fact that forecasting is difficult for at least two reasons. First, different sectors of the economy frequently send different signals. For instance, retail sales may be down, signaling a start to a recession, but housing starts may be up, indicating that an expansion will continue for a while. Second, the data that must be used always are at least a bit out-of-date. For example, the preliminary estimate of GDP is not made until approximately six weeks after the end of the quarter, and the final revision of GDP doesn’t appear until years later. Although economists’ forecasts are much better than those of others, forecasting GDP with complete accuracy is unlikely. Conclude by mentioning that this fact is important in later chapters when we discuss implementation of counter-cyclical policies. The Business Cycle, Part 2: The business cycle and its dating are interesting to students, especially when the economy is in or near a recession. If you have the capacity to show or assign Web pages, look at the NBER Business Cycle Dating Committee’s page at http://www.nber.org/cycles/recessions.html. You might like to look at the dating of the cycle in other countries. This dating is done by the Economic Cycle Research Institute (ECRI). You can find their Web site at http://www.businesscycle.com/. Another page on the ECRI Web site shows the cycle peak and trough dates for 18 countries from 1948 nicely aligned in a table. You can compare the timing of cycles internationally. You can also compare the severity of U.S. cycles over time. Note that the recession that the NBER dates as beginning in March 2001 and ending in November 2001 was incredibly mild on all criteria except the labor market. The “Great Recession” that started in 2007, however, is one of the worst since the great depression. And the Covid-19 recession is, by far, the shortest on record. The Standard of Living Across Countries • Real GDP can be used to compare living standards across countries. But two problems .

MEASURING THE VALUE OF PRODUCTION: GDP

•

arise in using real GDP to compare living standards: • First, the real GDP of one country must be converted into the same currency unit as the real GDP of the other country. Second, the goods and services in both countries must be valued at the same prices. Relative prices in countries will differ, so goods and services should be weighted accordingly. For example, if more prices are lower in China than in the United States, China’s prices put a lower value on China’s production than would U.S. prices. If all the goods and services produced in China are valued using U.S. prices, than a more valid comparison can be made of real GDP in the two countries. This comparison using the same prices is called purchasing power parity (PPP) prices.

Big Mac Index (http://www.economist.com/content/big-mac-index): This is an impressive and interactive site for measuring PPP of the Big Mac. Students will immediately relate to this example and you can ask them what country they want to check on. International comparisons and PPP prices. Students sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and students often ask how people can live on such low incomes. Point out that the estimate is biased downward in two ways. First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people ride a bus or subway and pay a fare, which is counted as part of GDP. Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs $20 in New York might cost $1 in Calcutta. (You might get a better haircut in New York, but probably not one that is 20 times better!) Converting Indian GDP into U.S. dollars at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into U.S. dollars avoids this bias.

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Limitations of Real GDP • Some of the factors that influence the standard of living are not part of real GDP. Omitted from GDP are: • Household Production: As more services, such as childcare, are provided in the marketplace, the measured growth rate overstates development of all economic activity. • Underground Economic Activity: If the underground economy is a reasonably stable proportion of all economic activity, though the level of GDP will be too low, the growth rate will be accurate. • Leisure Time: Increases in leisure time lower the economic growth rate, but we value our leisure time and we are better off with it. • Environmental Quality: Pollution does not directly lower the economic growth rate. The At Issue feature debates whether GNNP (Green net National Product) should replace GDP. Advocates say that a green measure is needed to take account of environmental damage that results from production; opponents say that other omissions from GDP are more important than environmental damage. An Economics in Action describes the United Nation’s broader measure of wellbeing, the Human development Index. YouTube Video: This is a wonderful video that should get anyone excited about data and its ability to help tell a story. Hans Rosling's 200 Countries, 200 Years, 4 Minutes - The Joy of Stats - BBC Four http://youtu.be/jbkSRLYSojo

Measuring Real GDP and Economic Growth. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if you mow your own lawn, the value of your production doesn’t show up in GDP. But if you hire a student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are the cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, .

MEASURING THE VALUE OF PRODUCTION: GDP

we hope, will be significantly different. Does such a good have any value? The concluding Economics in the News describes the NY Fed’s attempts to “nowcast” real GDP and focuses on the second and third quarter of 2020. In both quarters, the nowcast underestimated the change in real GDP: the actual decrease in real GDP in the second quarter about twice the nowcast and the increase in real GDP during the third quarter was about three times the nowcast..

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Additional Problems

Figure 4.1 shows the flows of expenditure and income for a small nation. During 2021, flow A was –$15 million, flow B was $40 million, flow C was $90 million, and flow D was $45 million. Calculate a. Aggregate expenditure. b. Aggregate income. c. GDP.

The transactions in Jupiter last year are in the table to the right. a. Calculate Jupiter’s aggregate expenditure. b. Calculate Jupiter’s net exports. c. Calculate Jupiter’s government expenditure.

Item GDP Consumption expenditure Taxes Transfer payments Profits Investment Exports Saving Imports

Dollars 1.400,000 700,000 350,000 150,000 300,000 350,000 400,000 400,000 350,000

MEASURING THE VALUE OF PRODUCTION: GDP

The table shows data from the United Kingdom in 2005. a. Calculate GDP in the United Kingdom. b. Explain the approach (expenditure or income) that you used to calculate GDP.

Item Wages paid to labor Consumption expenditure Taxes Transfer payments Profits Investment Government expenditure Exports Saving Imports 2016 2017 1,000 pounds 1,100 pounds 50 rides 60 rides

Desert Quantities Kingdom Dates dates and rides Rides base year is tables give the Prices produced and Dates $1 per pound 2021 and Rides $100 per ride Desert a. Nominal GDP and real GDP in 2021 and 2022. b. Real GDP in 2022 in terms of the base-year prices.

$2 per pound $120 per ride

Billions of pounds 685 791 394 267 273 209 267 322 38 366 produces only to sight see. The 2021, and the quantities the prices in 2022. Calculate Kingdom’s

Desert Kingdom (described in problem 3) decides to use the chain-weighted output index method of calculating real GDP. Using this method, calculate a. The growth rate of real GDP in 2022. b. Compare and comment on the differences in real GDP in terms of the base-year prices and real GDP calculated using the chain-weighted output index method.

Solutions to Additional Problems 1. a. Aggregate expenditure is $160 million. Aggregate expenditure is the sum of consumption expenditure, investment, government expenditure, and net exports. In the figure, flow C is consumption expenditure, flow D is investment, flow B is government expenditure, and flow A is net exports. So aggregate expenditure equals $90 million plus $45 million plus $40 million minus $15 million, which is $160 million. b. Aggregate income is $160 million. Aggregate income equals aggregate expenditure, which from part a is $160 million. c. GDP is $160 million. GDP equals aggregate expenditure, which from part a is $160 million. 2. a. Jupiter’s aggregate expenditure is $1,400,000. Aggregate expenditure equals GDP and Jupiter’s GDP is $1,400,000. b. Jupiter’s net exports equal $50,000. Net exports equal exports, $400,000, minus imports, $350,000. c. Jupiter’s government expenditure was $300,000. Aggregate expenditure equals the sum of consumption expenditure, investment, government expenditure, and exports minus .

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imports. That is, $1,400,000 equals $700,000 plus $350,000 plus government expenditure plus $400,000 minus $350,000. Solving this equation for government expenditure gives $300,000. 3. a. GDP in the United Kingdom was £1,223 billion. b. The expenditure approach was used; that is, GDP was calculated by adding consumption expenditure, investment, government expenditure, and exports, and subtracting imports. 4. a. In 2021, nominal GDP is $6,000. In 2022, nominal GDP is $9,400. Nominal GDP in 2021 is equal to total expenditure on the goods and services produced by Desert Kingdom in 2016. Expenditure on dates is 1,000 pounds at $1 a pound, which is $1,000. Expenditure on sight-seeing rides is 50 rides at $100 a ride, which is $5,000. Total expenditure is $6,000, so nominal GDP in 2021 is $6,000. Nominal GDP in 2022 is equal to total expenditure on the goods and services produced by Desert Kingdom in 2017. Expenditure on dates is 1,100 pounds at $2 a pound, which is $2,200. Expenditure on sight-seeing rides is 60 rides at $120 a ride, which is $7,200. Total expenditure is $9,400, so nominal GDP in 2022 is $9,400. b. Real GDP in 2022 in terms of base-year prices is $7,100. To calculate real GDP in 2022 in terms of base-year prices, we calculate market value of the 2022 quantities at the base-year prices of 2021. To value the 2022 output at 2021 prices, expenditure on dates is 1,100 pounds at $1 a pound (which is $1,100), and expenditure on sight-seeing rides is 60 rides at $100 a ride (which is $6,000). So real GDP in 2022 in terms of base-year prices is $7,100. 5. a. The growth rate of real GDP in 2022 is 17.9 percent. The chain-weighted output index method uses the prices of 2021 and 2022 to calculate the growth rate in 2022. The value of the 2021 quantities at 2021 prices is $6,000. The value of the 2022 quantities at 2021 prices is $7,100. We now compare these values. The increase in the value is $1,100. The percentage increase is ($1,100  $6,000)  100, which is 18.33 percent. The value of the 2021 quantities at 2022 prices is $8,000. The value of the 2022 quantities at 2022 prices is $9,400. We now compare these values. The increase in the value is $1,400. The percentage increase is ($1,400  8,000)  100, which is 17.5 percent. The chain-weighted output index calculates the growth rate as the average of these two percentage growth rates. That is, the growth rate in 2017 is 17.9 percent b. Real GDP in 2022 in terms of base-year prices is $7,100. Real GDP in 2022 using the chainweighted output index method is $7,074. Real GDP growth is fastest when real GDP is measured in terms of base-year prices.

Additional Discussion Questions 11. To estimate GDP you add the value of all the goods and services produced, both final and intermediate goods. Is this procedure correct? Why? Adding all the goods and services produced is incorrect because it will lead to significant double counting. Intermediate goods and services will be double counted. For instance, if a CPU produced by Intel and then used in a Dell computer is counted both as a CPU from Intel and as part of the computer from Dell, the CPU has been double counted. .

MEASURING THE VALUE OF PRODUCTION: GDP

12. What is the relationship between aggregate income and aggregate production? Why does this relationship exist? Aggregate income equals aggregate production. The circular flow shows this result: The flow of production out of business firms equals the flow of expenditure into business firms. The flow of expenditure into business firms equals the flow of costs out of business firms. And the flow of costs out of business firms is the same as the flow of aggregate income to households. 13. Does my purchase of a domestically produced Ford automobile that was manufactured in 2020 add to the current U.S. GDP? Why? How about my purchase of a domestically produced, newly produced Ford? Why? The purchase of the used Ford does not add to the current U.S. GDP though it did add to U.S. GDP in 2020 when the car was newly produced. GDP measures production within a given time period and the used Ford was not produced within the current year. A new Ford automobile, however, is counted in current U.S. GDP because it was produced in the current year. 4. Does my purchase of 100 shares of stock in Meta add to the nation’s GDP? Why? Purchasing shares of stock does not add to the nation’s GDP. GDP measures production. Shares of stock are not the production of a good or service and therefore are not included in GDP. 5. If a homeowner cuts his or her lawn, is the value of this work included in real GDP? Suppose that the homeowner hires a neighborhood kid to cut the lawn. Is this activity included in real GDP? Comment on your answers. The homeowner’s work around his or her home is not included in GDP because home production is excluded. Hiring a neighborhood kid to cut the lawn is, in theory, included in GDP because it is a service that has been sold in a market. This difference in the treatment of these two activities shows a flaw in how GDP is computed. In both cases the precise same lawn is mowed. But in one case GDP is unaffected and in the other GDP increases. It is paradoxical that the effect on GDP of producing the same service depends on who produces the service. 6. In 1900, the average work week was 65 hours; today it is approximately 35 hours. How did this change affect real GDP within the United States? How did it affect the standard of living within the United States? Comment on your answers. The decrease in the average work week decreases real GDP from what it would have been if the work week had remained at 65 hours because less time is spent at production of goods and services. Taken by itself, the decrease in real GDP means that the standard of living within the United States is lower. However the fall in the average work week also means a significant increase in people’s leisure time, which raises the standard of living. For many people it is likely the case that their standard of living is higher with the shorter work week—and hence lower level of real GDP—that it would be with the longer work week because they value their leisure more than the goods and services that would have been produced. But at the least, looking only at the change in real GDP as the sole measure of the standard of living is incorrect because that view ignores the gain in the standard of living from the increased leisure. 7. In the United States, many children receive day-care from commercial providers. In Africa, this is unknown; children are almost all cared for by .

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relatives. How would this difference affect comparisons of GDP per person? This difference means that U.S. GDP per person is biased higher than GDP per person in African countries. In both the United States and in Africa children are cared for so the same service is produced in both regions. But in the United States this service is included in GDP because it is purchased in a market; however, in Africa the service is not included in GDP because it is performed as household production.

C h a p t e r

MONITORING JOBS AND INFLATION**

The Big Picture Where we have been: Chapter 5 finishes introducing macroeconomic issues and describing how key macroeconomic variables are measured. The link developed in this chapter between employment and real GDP (from Chapter 4) is an important concept that helps serve as a foundation for the presentation of the aggregate production function in the next chapter. Where we have been: This chapter increases students’ understanding of the types and sources of unemployment. It also provides students with detail on the use of the CPI to measure inflation. Alternative price measures also are introduced. Perhaps more significantly, the explanation of the natural rate of unemployment and its relationship to potential GDP are important building blocks for the AS-AD model developed in Chapter 10 and the Phillips curve framework developed in Chapter 12. These topics also recur in Chapters 13 and 14 when fiscal and monetary policy is covered.

New in the Fourteenth Edition

The content in Chapter 5 is substantially the same as in the 13th edition with updates. The multiple graphs and data in this chapter have all been updated through 2020. The Personal Consumption Expenditure deflator is now referred to as the Personal Consumption Expenditure Price Index, or PCEPI. The very brief discussion of calculating real variables as well as the mention of sticky price inflation have been removed. The concluding Economics in the News discusses how the Covid-19 pandemic led to a miscalculation in the unemployment rate when workers on temporary layoff were incorrectly classified as “employed but absent from work” rather than correctly as “unemployed.” Correcting this error boosts the unemployment substantially, by 5 or 6 percentage points in April and May 2020.

* This is Chapter 22 in Economics. .

CHAPTER 5

MONITORING JOBS AND INFLATION

Lecture Notes

Monitoring Jobs and Inflation • • • • I.

The unemployment rate, the employment-to-population ratio, and the labor force participation rate are key labor market indicators. The natural unemployment rate is the unemployment rate at full employment; it is comprised of frictional and structural unemployment. The unemployment rate fluctuates over the business cycle. The price level and the inflation rate are measured using the CPI as well as other price indexes. Employment and Unemployment

Why Unemployment is a Problem • Unemployment means the unemployed person loses income and the nation loses production. Persistent unemployment damages a person’s future job prospects by destroying their human capital. Current Population Survey • The U.S. Census Bureau measures the population, labor force, and amount of employment. The working-age population is the total number of people aged 16 years and over who are not in jail, a hospital, or some other form of institutional care. The labor force is the sum of the employed and the unemployed. • Unemployment occurs when someone who wants a job cannot find one. To be counted as unemployed, a person must be available for work and must be in one of three categories: • Without work but has made specific efforts to find a job within the previous four weeks • Waiting to be called back to a job from which he or she has been laid off • Waiting to start a new job within 30 days Ask the students, “If I was to assign a homework assignment of estimating the unemployment rate in your city, how would you do it?” You will probably get an answer of “Google it,” but tell them that this is not an Internet mining project! Try to have some of your students suggest an in-person survey or a phone survey. Now you can walk through some of the issues economists face with data collection (questions to ask, sample size, bias, etc.). Discuss how a grocery store may be a decent place to get a random sample of people from all demographics and how a phone survey might miss some poor, unemployed person without a phone or students who do not have a land-based phone. Three Labor Market Indicators • The unemployment rate is the percentage of the people in the labor force who are unemployed. It equals

•

Number of peopleunemployed 100 and Labor force = Number of Labor force

people employed + Number of people unemployed. Between 1981 and 2021 the unemployment rate averaged 6.2 percent. The employment-to-population ratio is the percentage of people of working age who .

CHAPTER 5

have jobs. It equals

Number of peopleemployed 100. In recent years the employment-toWorking- age population

population ratio has been about 62 percent. It has fallen since 2000 and in May 2021 was 58 percent. •

The labor force participation rate is the percentage of working-age population who are members of the labor force. It equals

Labor force 100. The labor force Working - age population

participation rate has been declining since it reached about 67 percent in 2000 and in May 2021 was 61.6 percent. Jobs and home production. It is interesting to ask students to think about appropriate measures of labor force participation over long periods of time or in very different economic arrangements. The technical definition involves spending time working for gain, or seeking work for gain. In the United States, this usually equates to work outside the home. Ask students whether women who are unpaid family workers on farms are in or out of the labor force; and then ask whether they are if they don’t work outside the home, but cook, make and wash clothing, and otherwise maintain the household for a family. •

• •

Marginally attached workers are people who are available and willing to work but currently are neither working nor looking for work. These workers often temporarily leave the labor force during a recession and decrease the labor force participation rate. Because they are no longer counted as unemployed, marginally attached workers lower the unemployment rate. A discouraged worker is a marginally attached worker who has stopped looking for work because of repeated failures to find a job. Economic part-time workers are people who are working part-time but would like to find full time work. These workers are not unemployed by the U-3 standard but are considered “part-unemployed.” Marginally attached workers (and discouraged workers) as well as economic part-time workers who want a full-time job are not counted as unemployed in the official unemployment rate.

Real World Examples from the Class: Ask the class if anyone has an example of a ‘discouraged worker’ or someone who has taken a part-time job even though he or she wants a full-time job. It would be unusual if no one had a story to tell. Alternative Measures of Unemployment The BLS creates several alternative measures of unemployment to take account of the longterm unemployed (who lose the most from unemployment) and marginally attached workers: • U–1: includes only those unemployed for 15 weeks as unemployed. • U–2: includes only job losers as unemployed. • U–3: the official unemployment rate. • U–4: adds discouraged workers to the official unemployment rate. • U–5: adds all marginally attached workers to the official unemployment rate. • U–6: adds part-time workers who want full-time jobs to the U-5 unemployment rate. • Long-term unemployment (U–1) and unemployed job losers (U–2) are about 40 percent of the unemployed on average but 60 percent in a deep recession. • Adding discouraged workers (U–4) makes very little difference to the unemployment .

MONITORING JOBS AND INFLATION

•

rate, but adding all marginally attached workers (U–5) adds about one percentage point. A really big difference is made by adding the economic part-time workers (U–6). In May 2021, adding these workers to the U-5 unemployed increased the underemployed rate to 11 percent.

II. Unemployment and Full Employment Types of Unemployment • Frictional unemployment is the unemployment that arises from normal labor turnover. These workers are searching for jobs. The unemployment related to this search process is a permanent phenomenon in a dynamic, growing economy. Frictional unemployment increases when more people enter the labor market or when unemployment compensation payments increase. • Structural unemployment is the unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. Sometimes there is a mismatch between skills demanded by firms and skills provided by workers, especially when there are great technological changes in an industry. Structural unemployment generally lasts longer than frictional unemployment. Minimum wages and efficiency wages create structural unemployment. • Cyclical unemployment is the fluctuating unemployment over the business cycle. Cyclical unemployment increases during a recession and decreases during an expansion. Identifying frictional, structural, and cyclical unemployment. Ask your class if anyone they know has been laid off. Then discuss whether losing a job creates frictional, structural, or cyclical unemployment. Look at your local examples. If you live in a steel-producing or car manufacturing area, for example, you can talk about local structural unemployment arising from the closing of factories due to international competition. For cyclical unemployment, ask students how they think the business cycle and cyclical unemployment is related to full-time enrollments at higher education institutions. Students often don’t think there is any relationship. But nationally during a recession, the growth rate of full-time enrollments increases. Ask students if they can explain this relationship. The answer is that during a recession and due to the increase in cyclical unemployment, the opportunity cost of school decreases. This is a great way to keep students thinking about marginal benefits and costs. Work through each type of employment asking whether it is good or bad for society (call to their attention that it is usually bad for the individual, but may be good long term for society) • Frictional? Good because a healthy, dynamic, economy needs new entrants to the labor force , such ascollege graduates, and freedom for people to quit a job they don’t like. • Structural? Good because a healthy, growing economy has technological change that makes some jobs obsolete. • Cyclical? Bad because it is unfortunate to have unemployment strictly because of the cyclical nature of the economy. If it were possible to maintain the same level of economic growth with less fluctuation, we would have less cyclical unemployment with a higher level of welfare. Can and should the cycle be managed? This is a big question in Macroeconomics that we will continue to tackle! .

CHAPTER 5

“Natural” Unemployment • Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment—when all the unemployment is frictional and structural. Natural unemployment as a percentage of the labor force is called the natural unemployment rate. • Full employment is defined as a situation in which the unemployment rate equals the natural unemployment rate. What Determines the Natural Unemployment Rate? • The Age Distribution of the Population An economy with a young population has a large number of new job seekers every year and has a high level of frictional unemployment. • The Scale of Structural Change The scale of structural change is sometimes small but sometimes there is a technological upheaval. When the pace and volume of technological change and when the change driven by international competition increase, natural unemployment rises. • The Real Wage Rate The natural unemployment rate increases if minimum wage is raised to exceed the equilibrium wage rate or if more firms use an efficiency wage (a wage set above the equilibrium real wage to enable the firm to attract the most productive workers and motivate them to work hard and discourage them from quitting). • Unemployment Benefits Unemployment benefits increase the natural unemployment rate by lowering the opportunity cost of job search. There are two controversies that surround the natural unemployment rate. The first is the use of the term “natural,” which offends many who believe any unemployment is always a bad thing. From the perspective of an unemployed individual who has yet to find the job he or she wants, unemployment is bad. However, there is some level of unemployment that is good for society because it will help create more productive matches between firms and workers and allow for technological changes that lead to economic growth. The second controversy is what level of unemployment corresponds to the natural rate. Because this number is unobserved, it must be estimated. Some estimates imply the natural rate is stable and changes only slowly over time. Others imply that most of the fluctuations in unemployment are “natural”. These differences are important for macroeconomic policy because one of the typical goals of policy is to keep the unemployment rate from making wide swings around the natural rate. Real GDP and Unemployment Over the Cycle • When the economy is at full employment, the unemployment rate equals the natural unemployment rate and real GDP equals potential GDP. When the unemployment rate is greater than the natural unemployment rate, real GDP is less than potential GDP. And when the unemployment rate is less than the natural unemployment rate, real GDP is greater than potential GDP. The gap between real GDP and potential GDP is called the output gap. Students often have an innate sense of an asymmetry in business cycle fluctuations around potential GDP. In particular, students often think that the economy is almost always below potential GDP. It is important for students to understand that it is possible for the economy to temporarily rise above potential GDP so that the unemployment rate is less than natural unemployment rate. One (small) example of this state of affairs occurred in Silicon Valley in the late 1990s when workers who became dissatisfied with a job could quit and be assured of a new .

MONITORING JOBS AND INFLATION

job (often at higher pay!) within a few days. Indeed, firms paid for expensive radio advertisements “begging” for workers to apply for jobs. In 2021 similar advertisements were run but the economy clearly was not above potential GDP. III. The Price Level, Inflation, and Deflation The price level is the average level of prices. The average level of prices can be rising, falling, or stable. Inflation occurs when the price level persistently rises; deflation occurs when the price level persistently falls. The inflation rate is the percentage change in the price level. Why Inflation and Deflation are Problems • Unexpected inflation or deflation is a problem for society because they redistribute income and wealth. Unexpected inflation benefits workers and borrowers; unexpected deflation benefits employers and lenders. They motivate people to divert resources from producing goods and services to forecasting and protecting themselves from the inflation or deflation. • Unexpected deflation hurts businesses and households that are in debt (borrowers) who in turn cut their spending. A fall in total spending brings a recession and rising unemployment. • Hyperinflation is an inflation rate of 50 percent a month or higher The Consumer Price Index • The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumer for a fixed “basket” of consumer goods and services. The CPI is calculated monthly by the Bureau of Labor Statistics. • The CPI is defined to equal 100 for a period called the reference base period. The current reference base period is 1982-1984, so the average CPI during that period was 100. • In May 2021, the CPI was 269.2. Thus, since 1982-84, prices increased by 169.2 percent. Constructing the CPI • The BLS conducts an infrequent survey of consumers to determine the average “basket” of goods and services purchased by urban household. Then each month the BLS records the prices of goods and services in the basket, keeping the representative items as similar as possible in consecutive months. The BLS uses the fixed basket quantities and the recorded prices to determine the cost of the basket each month. The CPI for the month equals 100 multiplied by the ratio of the cost in the current month to the cost in the base period.

CHAPTER 5

•

For example, suppose the initial Cost survey shows that the CPI basket is 2 Item Quantity Price (dollars) books and 20 coffees. The initial base Books 2 $30 $60 period prices and quantities are in Coffee 20 $2 $40 the table to the right. In this base Basket $100 period, say 2005, the cost of the CPI basket is $100. Next suppose that the BLS survey taken one month this year reveals that the price of a book is $35 and the price of a coffee is Cost $3. These prices and the initial base Item Quantity Price (dollars) period quantities are in the table to the Books 2 $35 $70 right. In this period the cost of the CPI Coffee 20 $3 $60 basket is $130. Basket $130 Using these data, the CPI equals ($130  $100)  100, or 130. So between the base period and the current period, the CPI has risen by 30 percent.

Measuring the Inflation Rate • The inflation rate is the percentage change in the price level from one year to the next. In a  CPI this year - CPI last year    100. CPI last year  

formula, Inflation rate =  •

In May 2021, the CPI was 261.0. In May 2020, the CPI was 257.9. Using the formula, between 2021 and 2020, the inflation rate was 1.2%.

The Biased CPI • The CPI has four biases that lead it to overstate the inflation rate. The biases are: • Quality Change Bias: Sometimes price increases reflect quality improvements (safer cars, improved health care) and should not be counted as part of inflation. • Commodity Substitution Bias: Consumers substitute away from goods and services with large relative price increases. • Outlet Substitution Bias: When prices rise, people use discount stores more frequently and convenience stores less frequently. • New Goods Bias: New goods are often more expensive than the goods they replace. The Magnitude and Consequences of the Bias • The Boskin Commission in 1996 estimated the bias overstates the inflation rate by about 1.1 percentage points a year. The BLS has now corrected much of the bias with more frequent expenditure surveys to avoid substitution bias and by using statistical methods to lessen new goods and quality change bias. The bias in today’s CPI is almost certainly less than it was in 1996, but some remains. In terms of government outlays linked to the CPI, such as Social Security, a bias of 1 percent amounts to close to a trillion dollars in additional expenditures over a decade. Alternative Price Indexes • Three alternative to the CPI are: • Chained CPI: The chained CPI is calculated similarly to chained GDP (discussed in the .

MONITORING JOBS AND INFLATION

•

Mathematical Note to the previous chapter.) The chained CPI incorporates both new goods and the substitution of one good for another and so overcomes these sources of bias. But the difference between the chained CPI and regular CPI is small: on average, since 2000 the chained CPI is 0.7 percentage points lower per year. Personal Consumption Expenditure Price Index (PCEPI): The deflator from nominal and real consumption expenditure. The PCEPI equals

•

Nominal consumption expenditure 100. Realconsumption expenditure

The basket of goods in the PCEPI is broader than the basket in the CPI because it includes all consumption expenditure. GDP Deflator: Similar to the PCEPI, the GDP deflator is from nominal and real GDP. The GDP deflator equals

Nominal GDP 100. The difference between the GDP deflator RealGDP

and regular CPI is small: on average, since 2000 the GDP deflator is 0.2 percentage points lower per year. Core CPI • The inflation rate is often volatile. To strip out the volatile elements and focus on the underlying trend inflation, the core inflation rate is used. The core inflation rate is the PCEPI inflation rate excluding volatile elements. The core PCEPI inflation rate equals the percentage change in the PCEPI excluding food and fuel prices. The Economics in the News discusses “Jobs in the Covid-19 Pandemic.” It shows how the unemployment rate was miscalculated—workers on temporary layoff were incorrectly classified as “employed but absent from work” rather than correctly as “unemployed.” Correcting this error boosts the unemployment substantially, by 5 or 6 percentage points in April and May 2020.

CHAPTER 5

Additional Problems 1.

Michigan: Unemployment Record Holder Michigan now holds a dubious record: It leads the U.S. in joblessness. The state’s unemployment rate was 8.5% in May while the U.S. unemployment rate was only 5.5%. The reason is clear: Detroit’s emphasis on big trucks and sport-utility vehicles has turned sour. But even though the official unemployment numbers look awful, the reality is worse. The official number does not reflect those who have given up looking for a job. Business Week, June 24, 2008 In 2010, at 13.6 percent of the state’s labor force, Michigan had the nation’s highest official unemployment rate. But in 2012, Michigan’s unemployment rate fell to 9 percent, a larger fall than that in the United States as a whole. Around 11,000 businesses in Michigan produce high-tech scientific instruments and components for defense equipment, energy plants, and medical equipment. a. Why was the reality of the unemployment problem in Michigan actually worse than the 8.5 percent unemployment rate statistic in 2008? b. Was this higher unemployment rate in Michigan frictional, structural, or cyclical? Explain. c. What factor led to the favorable 2012 employment results in Michigan compared to the U.S. average? Was this a frictional, structural or cyclical factor? Explain.

The Great Inflation Bias In 1996 the Boskin Commission was established to determine the accuracy of the CPI. The commission concluded that the CPI overstated inflation by 1.1%. The commission described four biases in the way the CPI was determined. Fortune, April 3, 2008 a. What are the main sources of bias that are generally believed to make the CPI overstate the inflation rate? By how much did Boskin estimate the CPI overstates the inflation rate? b. Do the substitutions among different kinds of meat make the CPI biased up or down? c. Why does it matter if the CPI overstates or understates the rate of inflation? d. What steps has the BLS taken since 1996 to lower the bias?

Solutions to Additional Problems 1. a. The unemployment problem is worse than the 8.5 percent unemployment rate indicates for three reasons. First, the unemployment rate does not include marginally attached workers, such as discouraged workers. Second, the unemployment rate does not include part-time workers would want full-time jobs. Finally the unemployment rate counts only workers who are currently unemployed. If a company has announced that it will be laying off workers in the future, its workers are measured as employed even though they will shortly join the ranks of the unemployed. b. The higher unemployment rate in Michigan is structural. Consumers are decreasing the number of U.S.-made large cars in favor of foreign-made smaller cars. And to the extent that consumers are buying U.S.-made cars, they are generally smaller cars, many of which are not manufactured in Michigan. So the skills possessed by Michigan workers are not the skills needed for jobs and the location of workers in Michigan is not the location of available jobs. .

MONITORING JOBS AND INFLATION

c. The improved labor statistics for Michigan reflected a structural factor in that industries with goods in high demand were able to move to Michigan and use retrained skilled workers for their production. 2. a. The Boskin Commission presented four reasons why the CPI overstates the inflation rate. The four sources of bias are the new goods bias (new goods often cost more than the good they replace); quality change bias (price hikes might reflect quality changes); commodity change bias (changes in relative price lead consumers to switch away from goods and services whose price has risen more rapidly than other goods and services); and, outlet substitution bias (people buy from lower-priced sources when prices rise). The Boskin Commission estimated that the CPI overstates the inflation rate by 1.1 percentage points. b. Substitutions among different types of meat biases the CPI upward because the CPI ignores these substitutions. For instance, if the price of beef rises and the price of chicken does not change, then consumers respond by switching from beef to chicken. Consumers will eat (approximately) the same amount of protein as before but the substitution of chicken for beef means that their expenditure on protein will not change by the full amount of the price rise for beef. The CPI ignores this substitution and assumes that people buy the same amount of beef as before. Therefore the CPI erroneously reports that expenditure on protein has risen by the full amount of the price hike of beef. The article says that when consumers respond to a change in relative price by switching from one type of meat to another, the price of the new type can’t be compared to the price of the old type because consumers prefer the old type of meat to the new one. However the article’s statement can’t be literally true because consumers generally cannot think the second type of meat ranks at zero compared to the first type of meat. Hence allowing for no substitution biases the CPI upward because consumers will substitute from one meat to another when relative prices change. c. Many decisions depend on the CPI and any errors in the CPI will lead to errors in these decisions. For instance, some wage contracts are linked to the CPI. If the CPI overstates inflation, then the firms pay too much and some workers might lose their jobs if the firm decides to fire them. Conversely if the CPI understates inflation, then workers are paid too little. Additionally the government links about a third of its expenditures, including Social Security payments, to the CPI, If the CPI overstates inflation, then government outlays rise more rapidly than justified whereas if the CPI understates inflation, then outlays do not rise enough to offset the true inflation rate. d. The BLS has now corrected much of the bias with more frequent expenditure surveys to avoid substitution bias and by using statistical methods to lessen new goods and quality change bias. The bias in today’s CPI is almost certainly less than it was in 1996, but some remains.

Additional Discussion Questions 1. Should discouraged workers be counted as part of the unemployment rate? By definition, discouraged workers should not be counted as “officially” unemployed because they are not searching for employment. However, the real issue is whether the definition is appropriate. On the one hand, these people have given up looking for a job because they cannot find one. On the other hand, because these people .

CHAPTER 5

have given up looking for a job they are quite unlikely to find one. Discouraged workers are different from other unemployed workers because discouraged workers are unlikely to find work since they have stopped search. All in all, it is probably better that discouraged workers not be counted directly with other unemployed workers because their low likelihood of finding work makes them fundamentally different than other unemployed workers. What harm is there in calling a part-time worker that wants full-time work unemployed? Unlike discouraged workers or marginally attached workers, these people are employed. Interpretation of these statistics needs to be mindful that people may have a distorted view of what they want versus what they will do. The U-3 standard is based on their current situation and gives us actual knowledge of the current state of employment. The U-6 measure, which includes these part-time workers, might have more uncertainty in its level. Nonetheless, it is helpful to see how all of the various alternative measures compare and useful data can be obtained from all of them. “Unemployment is bad for the unemployed individual and bad for the nation. Hence the government should force the unemployment rate to 0 percent.” Comment on this assertion, discussing both its feasibility and its desirability. The assertion is highly unfeasible. The laws necessary to drive the unemployment rate to 0 percent would be draconian. For instance, no college student would be allowed to graduate until he or she had a job lined up. Once employed, workers would be forbidden to change jobs unless they had another job already arranged. Furthermore consumers would be forbidden to change their consumption baskets because if enough people changed, a firm might go bankrupt…allowing its workers to become unemployed. The assertion is similarly undesirable. Some unemployment is productive for the individual because it allows the worker to leave one job from which he or she is dissatisfied, to look for another job that will be a better match for the worker’s talents and skills. How can the unemployment rate be less than the natural rate? The unemployment rate can be less than the natural unemployment rate when the cyclical unemployment rate is negative. This outcome can occur when the economy is in a strong expansion. When the economy is growing rapidly, unemployed workers find jobs quickly. In many instances the match between worker and job will be poor: The firm is eager to find a worker and the worker accepts the offered job to end his or her spell of unemployment. But then as time passes the match is discovered to be poor—the worker does not perform well and/or dislikes the job. This situation is bad for the business and bad for the worker. Why is a change in the age structure of the population, increasing the proportions of young or old workers in the labor force, likely to change the natural unemployment rate? When the proportion of young workers increases, the natural unemployment rate rises because young workers change jobs more frequently than experienced workers. As these young workers change their jobs, frictional unemployment and, therefore, natural unemployment rise. Older workers are less prone to change jobs because they have had more time to find a good job match. The frictional unemployment rate is lower and so, too, is the natural .

MONITORING JOBS AND INFLATION

unemployment rate when the proportion of old workers in the labor force is higher. 6. What is the natural unemployment rate? What is the controversy concerning its measurement? The natural unemployment rate is the unemployment rate when the economy is at full employment. The natural rate is comprised of frictional and structural unemployment. One controversy arises because it is difficult to measure frictional and structural unemployment. Another controversy arises because the issue of whether discouraged workers and marginally attached workers should be included in the natural rate is unclear. While the number of these workers can be measured with reasonable accuracy, whether they should be included in the natural rate is controversial.

C h a p t e r

ECONOMIC GROWTH**

The Big Picture Where we have been: Chapter 6 focuses on economic growth. It uses the definitions and concepts of aggregate income and real GDP presented in Chapter 4 as well as tying economic growth in the macroeconomy to the PPF of Chapter 2. Where we are going: Chapter 6 is the first of four chapters that examine the economy in the long run when the economy is at full employment. The following chapters focus on finance and investment, money and the price level, and the exchange rate and balance of payments. After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model. The material presented in Chapter 6 provides the long run fundamental variables and results that need to be remembered as various other models are developed in future chapters. Chapter 6 (and Chapter 7) is particularly useful in Chapter 13 when the supply-side effects of fiscal policy are covered.

New in the Fourteenth Edition The chapter’s content and coverage are about the same as in the 13th edition. All time series data are updated through 2020. The concluding Economic in the News discusses China’s economic growth and notes that potential (and actual) GDP grew less rapidly during the last decade than during the previous two.

* This is Chapter 23 in Economics. .

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Lecture Notes

Economic Growth You can start your discussion of this chapter by listing on the board or on an overhead various countries ranked from highest per capita real GDP to lowest. It is a real eye opener for students to consider income per person because it really shows how fortunate we are in the United States. Tell your students that in the 1960s countries like Hong Kong, Singapore and Japan used to rank around where China ranks today. Explain that this extraordinary growth is part of what motivated economists over the last 20-30 years to try to deduce how this type of growth can occur. Is it possible the United States could do something differently to grow at those growth rates? Is the neoclassical model correct in its prediction that there will be a global equilibrium in which all nations have the same real GDP per person? Then leave your students with the fact that China is 200 times the population of Hong Kong and 4 times the population of the United States. This brings the obvious question: Should we be concerned? • • •

Economic growth leads to large changes in standards of living from one generation to the next. Economic growth rates vary across countries and across time. There are different economic theories to explain these variations in growth rates.

I. The Basics of Economic Growth • The economic growth rate is the annual percentage change of real GDP. This growth rate is equal to: Real GDP growth rate =

RealGDP in current year− Re al GDP in past year  100 Re al GDP in past year

•

The standard of living depends on real GDP per person, which is real GDP divided by the population. The growth rate of real GDP per person can be calculated using the formula above, though substituting real GDP per person. • The growth rate of real GDP per person also approximately equals the growth rate of real GDP minus the population growth rate. Real GDP can increase for two distinct reasons: The economy might be returning to full employment in an expansion phase of the business cycle or potential GDP might be increasing. •

The movement from point A to point B reflects an expansion phase of the business cycle. It occurs with no change in production possibilities. Such an expansion is not economic growth.

•

The increase in aggregate production reflected by the movement from point B on PPF0 to point C on PPF1 is economic growth—it reflects an expansion of production possibilities shown by an outward shift of the .

ECONOMIC GROWTH

PPF. The Rule of 70 is useful for determining how long it will take for a variable to double. The Rule of 70 states that the number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable. Run through an example of the rule of 70 that does not relate to economic growth. Examples: If tuition rates rise at 6 percent per year, how long will it take it to double? 70/6 = 11.67 years. If you invest $10,000 at 12 percent interest, how long will it take to double your money? 70/12 = 5.83 years. Compound Interest: You can reinforce the importance of economic growth by relating the fact that if real GDP per person had grown just 0.25 percentage points faster between 1960 and the present, every household today, on average, would have almost $12,000 more income (every person would have $4,500 more). If real GDP per person had grown 1 percentage point faster between 1960 and the present, every household today, on average, would have $50,000 more income (every person would have $21,200 more).To make concrete just how much better off we would have been, get the students to list what they would buy with an extra $21,200 a year. II. Long-Term Growth Trends Long-Term Growth in the U.S. Economy The growth of real GDP per person in the United States has fluctuated but has averaged 2 percent per year over the last century. The growth rate was 1.8 percent prior to the Great Depression and 2.1 percent after World War II. Real GDP Growth in the World Economy Economic growth varies across countries. Most countries are growing either slower or just slightly slower than the United States. The “Asian Miracle” is the fast rate of convergence for Hong Kong, Singapore, Taiwan, Korea, and China toward U.S. real GDP per person. Is there convergence or divergence in standards of living? What is the role of economic growth for economic inequality? These are highly controversial questions. Most anti-globalization activists treat it as incontrovertible that economic growth creates higher inequality. But this view is likely incorrect. First, there has been a general convergence of standards of living over the past 50 years. This fact is in part the result of economic growth in China with a population that accounts for close to one-fifth of humanity. Second, while some nations have fallen behind, those less developed countries that have grown fastest are those that have been most involved in “globalization” by becoming more integrated into global markets for goods and capital. The policy suggestions of the anti-globalization movement, such as reducing foreign trade and international capital mobility or even abandoning capitalism, property rights, and markets are the policies that are currently most practiced in countries that have grown the slowest. This result might not be a coincidence. III. How Potential GDP Grows Potential GDP is the amount of real GDP that is produced when the quantity of labor employed is the full-employment amount. To determine potential GDP we use the aggregate production function and the aggregate labor market. .

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The Aggregate Production Function • The aggregate production function is the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same. The figure shows an aggregate production function. • The additional real GDP produced by an additional hour of labor when all other influences on production remain the same is subject to the law of diminishing returns, which states that as the quantity of labor increases, other things remaining the same, the additional output produced by the labor decreases. The production function in the figure shows the law of diminishing returns because its shape demonstrates that as additional labor is employed, the additional GDP produced diminishes. The Labor Market The Demand for Labor

• •

•

The demand for labor is the relationship between the quantity of labor demanded and the real wage rate. The real wage rate equals the money wage rate divided by the price level. The real wage rate is the quantity of goods and services that an hour of labor earns and the money wage rate is the number of dollars that an hour of labor earns. Because of diminishing returns, firms hire more labor only if the real wage falls to reflect the fall in the additional output the labor produces. There is a negative relationship between the real wage rate and the quantity of labor demanded so, as illustrated in the figure, the demand for labor curve is downward sloping.

The Supply of Labor

• •

The supply of labor is the relationship between the quantity of labor supplied and the real wage rate. An increase in the real wage rate influences people to work more hours and also increases labor force participation. These factors mean there is a positive relationship between the real wage rate and the quantity of labor supplied so, as illustrated in the figure, the supply of labor curve is upward sloping.

Labor Market Equilibrium and Potential GDP

•

In the labor market, the real wage rate adjusts to equate the quantity of labor supplied to the quantity of labor demanded. In equilibrium, the labor market is at full .

ECONOMIC GROWTH

•

employment. In the figure, the equilibrium quantity of employment is 250 billions of hours per year. Potential GDP is the level of production produced by the full employment quantity of labor. In combination with the production function shown in the previous figure, the labor market equilibrium in the figure of 250 billion hours per year means that potential GDP is $20 trillion.

What Makes Potential GDP Grow? Potential GDP grows when the supply of labor grows and when labor productivity grows. Growth of the Supply of Labor

• • •

The supply of labor increases if average hours per worker increases, if the employmentto-population ratio increases, or if the working-age population increases. Of these factors, in the United States over the past years the first two have offset each other. Only increases in the working-age population can cause persisting economic growth. Persisting increases in the working-age population result from population growth. An increase in population increases the supply of labor, which shifts the labor supply curve rightward. The real wage rate falls and the quantity of employment increases. The increase in employment leads to a movement along the production function to a higher level of potential GDP.

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Growth of Labor Productivity

• • •

•

IV.

Labor productivity is the quantity of real GDP produced by an hour of labor and equals real GDP divided by aggregate hours. An increase in labor productivity increases the demand for labor and shifts the production function upward. As the top figure illustrates, the increase in the demand for labor from LD0 to LD1 raises the real wage rate, from $40 to $50 per hour in the figure, and increases the level of employment, from 250 billion hours per year to 300 billion hours per year. The bottom figure shows that the production function has shifted upward, from PF0 to PF1. Combined with the increase in employment to 300 billion hours per year, the increase in labor productivity increases potential GDP from $20.0 trillion to $22.5 trillion. An increase in labor productivity leads to an increase in real GDP per person and increases the standard of living. Why Labor Productivity Grows

Preconditions for Labor Productivity Growth • The institutions of markets, property rights, and monetary exchange create incentives for people to engage in activities that create economic growth and are preconditions for growth in labor productivity. Market prices send signals to buyers and sellers that create incentives to increase or decrease the quantities demanded and supplied. Property rights create incentives save and invest in new capital and develop new technologies. Monetary exchange creates incentives for people to specialize and trade. • Persistent growth requires that people face incentives to create: • Physical Capital Growth: Saving and investing in new capital expands production possibilities. • Human Capital Growth: Investing in human capital speeds growth because human capital is a fundamental source of increased productivity and technological advance. • Technological Advances: Technological change, the discovery and the application of new technologies and new goods, has made the largest contribution to economic growth. The Causes of Economic Growth: A First Look; The limits of economics. The major obstacles to growth are political, and economists don’t know much about how to remove those political obstacles. You can give your students a glimpse of these obstacles in their worst form by .

ECONOMIC GROWTH

reminding them of news video clips they’ve almost certainly seen of Kabul, Mogadishu, and other troubled cities in which the rule of law has completely broken down. Economists know a lot about how to make an economy grow if the preconditions are in place, but virtually nothing about how to bring those preconditions about. The preconditions. The three preconditions for growth—markets, property rights, and monetary exchange—are all essential to create acceptable levels of risk and low enough transaction costs to justify investment, specialization, and exchange. If you want to spend time on it, you can generate an interesting discussion on whether what matters is the particular system of property rights, or just that they be clear, certain, and enforceable with reasonable cost—the concept of the rule of law. Most students have never realized that property rights are highly varied, and many fast growing economies have nothing like U.S. absolute property rights in land, for example. Interactions of sources of growth. Most students can see immediately how investment in physical and human capital in the form of education and training contribute to growth. Some have more difficulty getting a clear view of the role of learning by doing and technical change, particularly the small continuous refinement and improvement to existing technology rather than the spectacular breakthroughs. Much growth probably comes from the interaction of the last two, and this source of growth can be illustrated with a discussion of why firms offer incentives to workers to suggest improvements to working methods and procedures. V. Is Economic Growth Sustainable? Theories, Evidence, and Policies. Classical Growth Theory Classical growth theory is the view that real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level. • A problem with the classical theory is that population growth is independent of economic growth rate. Classical growth theory is based on the work of Thomas Malthus, an economist from the early nineteenth century. Very few modern-day economists would refer to themselves as Malthusians. But, as the textbook says, there are many other people today who are Malthusians. The persistence of this viewpoint represents what one can only refer to as the triumph of despair over experience. At some point in history, Malthusian theory might have been applicable. But certainly since the industrial revolution, parents have chosen to concentrate on the quality of children not the quantity. And this shift in emphasis only gets stronger as economic growth advances. Thus, the assumption that the population growth rate is primarily determined by economic growth with a positive relationship has no basis in reality. Indeed, some of the richest countries in the world, such as Sweden and Japan, have some of the lowest birth rates. Neoclassical Growth Theory Neoclassical growth theory is the proposition that the real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow. • •

A technological advance increases productivity. Real GDP per person increases. The technological advances increase expected profit. Investment and saving increase so .

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• • •

that capital increases. The increase in capital raises real GDP per person. As more capital is accumulated, eventually projects with lower rates of return must be undertaken so that the incentive to invest and saving decrease. Eventually capital stops increasing so that economic growth stops. The improvement in technology permanently increases real GDP per person. A problem with the neoclassical theory is that it predicts that real GDP per person in different nations will converge to the same level. But in reality, convergence does not seem to be taking place for all nations.

An Economics in Action detail discusses the key role played by intellectual property rights. The section focuses on the start of the Industrial Revolution and looks at how England’s patent system helped sustain the revolution. New Growth Theory New growth theory holds that real GDP per person grows because of the choices people make in the pursuit of profit and that growth can persist indefinitely. • • • •

•

The theory emphasizes that discoveries result from choices, discoveries bring profit, and competition then destroys the profit. It also stresses that knowledge can be used by everyone at no cost and knowledge is not subject to diminishing returns. The ability to innovate means new technologies are developed and capital accumulated as in the neoclassical model. The production function shifts upward. Real GDP per person increases. The pursuit of profit means that more technological advances occur and the production function continues to shift upward. Nothing stops the upward shifts of the production function because the lure of profit is always present. The ability to innovate determines how capital accumulation feeds into technological change and the resulting growth path for the economy. Productivity and real GDP constantly grow.

The Classical Model. Explain that more capital and more productive capital that uses new technologies increases productivity, shifts the production function upward, and shifts the demand for labor curve rightward. Real GDP increases and on the average, the real wage rate rises. You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces. But it increases the demand for other types of labor—complementary labor. People must acquire more skill— some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on. All of these people are more productive that they were before. New technologies that create new products have even more obvious effects on productivity. The development of the CD in the early 1980s is a good example. Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs. The same type of thing is now happening with the conversion of media to digital formats for all of our digital devices and uploading to cloud services such as YouTube. .

ECONOMIC GROWTH

Historical development of theories and an aside. The three growth theories studied in this chapter—classical, neoclassical, and new—are presented in historical order. Point out this fact to the students to emphasize and illustrate how economic theory builds on itself. (An aside for you, not your students: Note that the chapter skips the Keynesian era Harrod-Domar model. The main reason for this omission is that these models were quickly shown to be in error and never formed the basis of a seriously proposed growth theory. Based on fixed coefficients and fixed saving rates, the Harrod-Domar model produces either secular stagnation or secular inflation. Neither phenomenon occurs in real economies. Solow’s neoclassical model was developed, historically, to show the error of the Harrod-Domar model, but the neoclassical model also builds naturally on its classical predecessor, and that is the sequence in the textbook.) Classical theory. Start with the classical theory. The classical theory of growth takes technological change as exogenous, essentially ignores the role of capital (as a result of the era in which it was developed), and assumes that population growth increases when income increases (also as a result of the era in which it was developed). As a result, the conclusions from the classical theory are “dismal” indeed! Some students find it interesting to know that Thomas Malthus, most closely associated with the population part of this theory, was a clergyman, but was also the first person in the Anglophone world to hold the title of Professor of Political Economy (at the East India College). Economists came to realize that capital accumulation and technological change were important parts of the growth process. They also came to understand that population growth does not necessarily increase with income. Hence the stage was set for the neoclassical theory. Neoclassical theory. Neoclassical theory follows the classical theory by taking technological growth as exogenous. It differs insofar as it assumes that population growth also is exogenous. The major difference is that neoclassical theory stresses the role played by technological change and how it influences saving and capital accumulation. So of the two differences between neoclassical and classical growth theory, the first—the different assumptions about how population growth is determined—reflects an advance in empirical knowledge of the relationship between population growth and income. The second difference—the importance given to technological change, saving, and capital—shows how the neoclassical theory built on the simpler classical model. New growth theory. Neoclassical theory also is incomplete because the primary engine of economic growth, technology, is exogenous. New growth theory attempts to overcome this weakness. It still uses many of the insights of the neoclassical theory by emphasizing the role of capital accumulation and assuming that population growth is exogenous. But the new growth theory builds on neoclassical theory by examining more closely the role of technology and the factors that influence technological advances. Giving the students this type of broad overview before presenting the details of the different models is important because it, along with the text’s outstanding overview, allows the students to see the forest as well as the trees. This knowledge not only helps them understand the particular models, but it also helps them gain an appreciation of how economics progresses. (Of course, progress is hardly as steady as the students might believe; for instance, Pigou and Ramsey presented important papers about growth in the early part of the twentieth century, but, nonetheless, progress has been made.) The Empirical Evidence on the Causes of Economic Growth • Economists have studied the growth rate data for more than 100 countries for the period since 1960 and explored the correlations between the growth rate and more than 60 .

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possible influences on it. The conclusion of this data crunching is that most of these possible influences have variable and unpredictable effects, but a few of them have strong and clear effects. Amongst the strongest are: • International Trade: Nations that are open to trade grow more rapidly • Investment: Nations that have more investment in human capital and physical capital grow more rapidly. • Market Distortions: Nations that have more exchange rate controls, price controls, and black markets grow more slowly. • Economic System: Capitalist nations grow more rapidly. • Politics: Nations that support the rule of law and protect civil liberties grow more rapidly. Nations that have revolutions, military coups, or fight wars grow more slowly. • Region: Nations located far from the equator grow more rapidly; nations in Sub-Sahara Africa grow more slowly. Policies for Achieving Faster Growth • Growth theory and the empirical evidence suggest some policies that might stimulate growth: • Stimulate saving, to increase capital accumulation • Stimulate research and development, to increase technology • Improve the quality of education, to increase human capital. • Provide international aid to developing nations. However, studies show that aid tends to get diverted to consumption. If the objective is to increase growth, then the aid must be carefully directed. • Encourage international trade, to increase international specialization Economic Freedom of the World Index: https://www.fraserinstitute.org/economicfreedom/economic-freedom-basics I like to bring in Economic Freedom to the discussion of this chapter. The website link above brings you to many classroom items you can use like a short video, interactive world map, and power point presentations that refer to the data collected on five categories that make up a single index number that allows the researchers to rank countries according to the amount of economic freedom. Students relate very easily to the correlations drawn between economic freedom and important variables like life satisfaction, income, life expectancy, political rights, civil rights, etc. The chapter concludes with an Economics in the News analysis of economic growth in China. Growth of potential GDP seems to have slowed during the past decade, possibly because more investment was less-productive government investment.

ECONOMIC GROWTH

Additional Problems 1.

If in 2008 China’s real GDP is growing at 9 percent a year, its population is growing at 1 percent a year, and these growth rates continue, in what year will China’s real GDP per person be twice what it is in 2008?

Underinvesting in the Future For the past half century, South Korea, Hong Kong, Taiwan and Singapore have averaged the highest consistent economic growth rates in the world. But in one vital respect these countries may have the worst record of investment in the future since homo sapiens evolved: They have the lowest fertility rates in the world. For economic growth, raising children is at least as raising new buildings. International Herald Tribune, July 7, 2008 a. Explain why the rapid growth rates of these Asian economies might be masking a misallocation of resources that will result in lower income per person in the future. b. Explain the difficulties in balancing goals for immediate economic growth and future economic growth.

Solutions to Additional Problems 1.

China’s real GDP is growing at 9 percent a year and its population is growing at 1 percent a year, so China’s real GDP per person is growing at 8 percent a year. The rule of 70 tells us that China’s real GDP per person will double in 70/8 = 8¾ years. So at this rate China’s real GDP per person will be twice what it is in 2008 in 2017.

2. a. The new growth theory concludes that population growth increases economic growth because population growth means more people to develop new knowledge and new technologies. The Asian economies are currently growing rapidly but their population growth is extremely slow. The new growth theory predicts that the slow population growth means that in the future their economic growth rates will slow. b. People have a limited amount of time, which they can spend at work, perhaps developing new knowledge or new technology, or at home, raising children. If they spend their time at work, immediate economic growth will be higher than if they spend the time at home. But if they spend their time at home raising children, the future economic growth will be higher as the population growth is higher.

Additional Discussion Questions 11. What has been the average annual growth in real GDP per person in the United States over the last 100 years? Over the past 50 years, during which periods has annual growth been more rapid than the average? When has it been slower? The average annual growth rate in real GDP per person in the United States has been 2 percent over the past 100 years. Growth was most rapid in the 1960s. It was also rapid in the 1990s. Growth slowed in the 1970s. This slowdown is the “productivity growth slowdown.” 12. What is an aggregate production function? A change in what factor or factors .

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cause a movement along the aggregate production function? A change in what factor or factors shifts the aggregate production function? The aggregate production function shows the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same. Changes in employment create movements along the aggregate production function. Changes in other factors of production, such as capital, as well as changes in technology, shift the aggregate production function. 13. Define labor productivity. Why is labor productivity important? Labor productivity is equal to real GDP divided by aggregate labor hours, so it tells the quantity of real GDP produced by an hour of labor. Labor productivity is important because it is directly related to the standard of living. The standard of living is real GDP per person so labor productivity is essentially the “standard of living per worker.” Therefore an increase in labor productivity means there is an increase in the standard of living. 14. Explain why reducing uncertainty with respect to property rights is regarded as likely to stimulate economic growth. Necessary preconditions for economic growth are physical capital growth, human capital growth, and technological advances. However people are willing to invest in physical capital and human capital only if they believe they will be able to reap the rewards from their investment. If property rights are unsecure, so that investors are unsure if they will gain from the investment, then people are much less likely to invest in either physical capital or human capital. Uncertainty about property rights therefore will dramatically slow economic growth because it will slow growth in physical and human capital. The story about technology is similar: People are willing to invest in new technology only if they believe they personally will reap the rewards. Once again, reducing uncertainty about property rights will increase people’s incentives to develop new technology, which will lead to more rapid economic growth. 15. What role do technological advances play in the classical theory of growth? The neoclassical theory? The new theory? In all the growth models a technological advance raises economic growth and real GDP per person. But whether the increase is temporary or permanent differ among the models. In the classical growth model a technological advance temporarily raises economic growth and real GDP per person. After the advance economic growth ceases. And the ensuing increase in population drives real GDP per person back to the subsistence level. In the neoclassical growth model a technological advance temporarily raises economic growth and permanently raises real GDP per person. After the advance economic growth ceases. But the increase in the capital stock brought about by the advance allows real GDP per person to remain permanently higher. In the new growth theory a technological advance permanently increases economic growth and real GDP per person. In the new growth theory a technological advance creates new profit opportunities so that pursuit of profit leads to still more technological advances and investment in capital. As a result economic growth persists. And with the persistence of economic growth, the increase in real GDP per person is permanent and increasing over time. .

C h a p t e r

FINANCE, SAVING, AND INVESTMENT**

The Big Picture Where we have been: This chapter builds on the definition of real GDP from Chapter 4 to explain how investment is financed. It also uses the demand and supply model explained in Chapter 3. The chapter explains how equilibrium in the loanable funds market determines the real interest rate and quantity of investment. It also discusses how government actions affect this market. Where we are going: Chapter 7 is the second of four chapters that examine the economy in the long run when the economy is at full employment. The following chapters focus on money and the price level, and the exchange rate and balance of payments. After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model. The material presented in Chapter 7 is used in many of the following chapters. For instance the result that the real interest rate is determined in the loanable funds market is important in the next chapter to help determine the longrun effects from changes in the quantity of money. The loanable funds model also is used in Chapter 13 when examining the supply-side effects of fiscal policy.

New in the Fourteenth Edition

A new Economics in Action box presents two figures (the interest rate yield curve and risk premiums) that highlight interest rate patterns. The Economics in Action feature that used the loanable funds market to examine the home price bubble that helped lead to the financial crisis has been replaced with an Economic in Action box that shows data for the global financial crisis and explains how it affected financial institutions. Data throughout the chapter are updated through 2020 and 2021. The concluding Economics In The News has a new article and an analysis of how new fintech firms are increasing their market share at the expense of older traditional financial firms in the market for personal loans.

* This is Chapter 24 in Economics. .

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Lecture Notes

Finance, Saving, and Investment • • I.

The supply and demand for loanable funds determine the real interest rate and the quantity of loanable fund and investment. Government budget deficits might also affect the real interest rate and quantity of investment.

Financial Markets and Financial Institutions

Finance and Money; Capital and Financial Capital • Finance and money differ: • Finance refers to providing the funds used for investment. • Money refers to what is used to pay for goods and services. • Capital and financial capital differ: • Capital consists of physical capital, the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to today to produce goods and services. • Financial capital is the funds that firms use to buy physical capital. Definitions and the meaning of investment in economics. The student has met the key definitions of investment in this chapter, but to be absolutely sure that they are remembered it is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion, so it is worth getting these matters clear right from the start. Capital and Investment;Wealth and Saving • The quantity of capital changes because of investment and depreciation. Gross investment is the total amount spent on new capital; net investment is the change in the capital stock. Net investment equals gross investment minus depreciation. A concrete understanding of stock and flow variables is an important building block to understanding economic principles. You can use “buckets” to convey the relationship between stock and flow variables. Buckets are easy to draw along with a simple faucet and hole in the bucket. You can use this illustration to show how the stock changes over time due to the inflow and outflow of material into the bucket. You can extend the use of buckets to any stock/flow concept, such as wealth and saving. For use with the capital stock, draw a bucket with a “K” on it. At a point in time there is fixed amount of capital in the bucket. Over some time period, investment flows in the top and depreciation flows out. The net effect of these two flows leaves the bucket higher or lower at the end of that time period. •

Wealth is the value of all the things people own; saving is the amount of income not paid in taxes or spent on consumption. Saving adds to wealth. Wealth also changes when the market value of wealth changes. Financial Capital Markets Financial markets transform saving and wealth into investment and capital. • Loan markets: Both businesses and households obtain loans from banks. Financing for .

FINANCE, SAVING, AND INVESTMENT

•

inventories, purchasing houses, and so forth can be obtained in this market. Bond markets: Businesses and governments can raise funds by issuing bonds. A bond is a promise to make specified payments on specified dates. One type of bond is a mortgagebacked security, which entitles its owner to the income from a package of mortgages. The failure of many mortgage-backed securities to make their specified payments was a factor leading to the financial crisis in 2007 and 2008. Stock markets: Businesses can raise funds by issuing stock. A stock is a certificate of ownership and a claim to the firm’s profit.

A new Economics in Action has two figures showing interest rate patterns. One figure shows the yield curve—longer maturity bonds have higher interest rates—and another shows risk premiums—risky assets have higher interest rates. Financial Institutions • A financial institution is a firm that operates on both sides of the markets for financial capital by being a borrower in one market and a lender in another market. Financial institutions include, commercial banks, government-sponsored mortgage lenders (Fannie Mae and Freddie Mac), pension funds, and insurance companies. An Economics in Action box presents data and an explanation of the global financial crisis in 2007. Essentially securities, largely mortgage-backed securities, lost value and many financial institutions became insolvent. These institutions, such as Fannie Mae, Freddie Mac, Bear Sterns, AIG, and others were considered “too large” to fail. While you cannot fully explain the reasons why failure of a large financial institution might have external costs, your students can readily appreciate the point that if these institutions failed many borrowers would find it significantly more costly to arrange loans. The government acted in most all of these cases by arranging a bailout in form or another. Some companies were given government loans (AIG received an $85 billion loan from the Fed); others were taken into government oversight (Fannie Mae and Freddie Mac); others were merged into healthier companies, albeit with government assistance (Bear Sterns); a few were allowed to fail (Lehman Brothers). Even beyond these events, most financial institutions were given government assistance in the form of government loans and/or government purchase of stock. Funds that Finance Investment • The funds that finance investment are from household saving, the government budget surplus, and international borrowing. • Households’ income is consumed, saved, or paid in net taxes (taxes paid to the government minus transfer payments received from the government): Y = C + S + T. GDP equals income and also equals aggregate expenditure, so Y = C + I + G + (X − M). Combining shows that C + S + T = C + I + G + (X − M), which can be rearranged to show how investment is financed:

I = S + (T − G) + (X − M).

This formula shows that investment is financed using private saving, the government budget surplus, (T − G), and borrowing from the rest of the world, (X − M). • The sum of private saving, S, plus government saving, (T − G), is national saving. • If we export less than we import, (X − M) is negative and we borrow (M − X) from the rest of the world. • If we export more than we import, (X − M) is positive and we loan (X − M) to the rest .

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of the world. II. Financial Decisions and Risks Financial markets allow us to decide when to use scarce resources and how to manage the risks from these decisions. Because time is involved in these decisions, the value of money at different points in time must be compared. The Time Value of Money • To compare current and future dollars, we convert future dollars, called “future value,” to current dollars, called “present value.” • The present value of a future dollar is the amount that will grow to be as large as that future value when the interest that it will earn is considered. In terms of a formula,

where r is the interest rate and n is the number of years the future value is from the present time. Net Present Value The decision of “invest” versus “don’t invest” or “buy an asset” versus “don’t buy the asset” comes down to whether or not the present value of the future income stream is greater than or less than the initial cost to acquire the asset. • The net present value formula is: NPV = (Present Value of Income Stream) – Initial Cost • If NPV > 0, make the investment or buy the asset. buy it. If NPV < 0, don’t make the investment or buy the asset Financial Risk: Insolvency and Illiquidity • A financial institution’s net worth is the total market value of what it has lent minus the market value of what it has borrowed. If the net worth is positive, the institution is solvent and can remain in business. If the net worth is negative, the institution is insolvent and might go out of business. • A firm is illiquid if it can not meet a sudden demand to repay what it has borrowed because it does not have enough available cash. A firm can be illiquid but solvent. Market Risk: Interest Rates and Asset Prices • Stocks, bonds, short-term securities, and loans are financial assets. • The interest rate on a financial asset is equal to the interest paid on the asset expressed as a percentage of the asset’s price. • If the price of the asset rises, the interest rate falls. Conversely if the interest rate falls, the price of the asset rises. The Real Interest Rate • The nominal interest rate is the number of dollars that a borrower pays and a lender receives expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds. .

FINANCE, SAVING, AND INVESTMENT

Giving a numeric example of why the real interest rate and nominal interest rate differ can be enlightening for your students. Suppose you have $100 this year and you can invest it at a (nominal) interest rate of 10 percent. One year later you will have $110, that is, 10 percent more dollars. If the price of a cheeseburger is $1 this year you can buy 100 cheeseburgers. But if one year later the price level rose from 100 to 108 and the price of cheeseburgers rose at this average rate, then the cheeseburgers will cost you $1.08. Next year your $110 will only buy about 102 cheeseburgers ($110/$1.08). The purchasing power of your 10 nominal interest rate is only about 2 more cheeseburgers, a 2 percent real interest rate! Real versus nominal interest rate. To drive home the distinction between the nominal interest rate and real interest rate, ask your class if an interest rate of 10 percent is high. Almost assuredly they will respond with a resounding “Yes.” Point out to them that around 1980 a 10 percent interest rate was exceedingly low. At the time a typical interest rate was between 12 percent and 17 percent, depending on the riskiness of the asset and the length of the loan. What accounts for the difference between then and now? The answer is simple: inflation. In 1980 the inflation rate was running at more than 10 percent per year. Given the high inflation rate, the nominal interest rate adjusted so that it, too, was high. Most of the dollars lenders received as (nominal) interest went to keeping their purchasing power intact. But the real interest rate at that time was not much different than the real interest rate nowadays. In other words, the increase in purchasing power received by lenders (the real interest rate) in the 1980s was about the same as the increase in purchasing power received by lenders today. III. The Loanable Funds Market The loanable funds market is the aggregate of all the individual financial markets. In this market households, firms, governments, banks, and other financial institutions lend and borrow. The Demand for Loanable Funds • The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given time period. Business investment makes up the majority of the demand for loanable funds and so the initial focus is on investment. • Investment depends on the real interest rate and expected profit. Firms will make the investment only if they expect to earn a profit. • The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same. • The real interest rate is the opportunity cost of loanable funds, so there is a negative relationship between the quantity of loanable funds demanded and the real interest rate. • Investment is influenced by expected profit. The higher the expected profit, the more investment firms make. Expected profit rises during a business cycle expansion and falls during a business cycle recession; rises when technology advances; rises as the population grows; and fluctuates with swings in business optimism and pessimism. • The demand curve for loanable funds is downward sloping as shown in the figure. The demand for loanable funds increases when investment increases, so when expected profit increases, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward. .

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The Supply of Loanable Funds • The quantity of loanable funds supplied is the total quantity of funds available from private saving, the government budget surplus, and international borrowing during a given time period. Saving makes up the majority of the loanable funds available, so the initial focus is on saving. • The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same. • When the real interest rate rises, saving increases so the supply of loanable funds increases. As illustrated in the figure, the supply of loanable funds curve is upward sloping. • Saving and hence the supply of loanable funds increases when disposable income increases, when wealth decreases, when expected future income decreases, and when default risk decreases. When the supply of loanable funds increases the supply curve of loanable funds curve shifts rightward. Equilibrium in the Loanable Funds Market • As the figure shows, the equilibrium real interest rate sets the quantity of loanable funds demanded equal to the quantity of loanable funds supplied. In the figure, the equilibrium real interest rate is 3 percent and the equilibrium quantity of loanable funds is $2.0 trillion. In reality, the equilibrium quantity of loanable funds is about $260 trillion. Changes in Demand and Supply • Changes in either demand or supply change the real interest rate and the price of financial assets. • If expected profit increases the demand for loanable funds increases. The equilibrium real interest rate rises and the equilibrium quantity of loanable funds and investment increase. • If the supply of loanable funds increases, the equilibrium real interest rate falls and the equilibrium quantity of loanable funds and investment increase. • Short-run changes in the demand and supply can be sharp so that changes in the real interest rate also can be sharp. But in the long run the demand and supply grow at the same pace so there is no upward or downward trend in the real interest rate. •

An Economics in Action feature shows that households supply 41 percent of the $260 trillion of loanable funds while firms demand 40 percent of the loanable funds

•

The Economics in Action feature uses the loanable funds market to examine the home price bubble that helped lead to the financial crisis. Between 2001 and 2005, a massive increase in the supply of loanable funds lowered the real interest rate and led to many .

FINANCE, SAVING, AND INVESTMENT

people purchasing homes. As the price of homes rose, the demand for loanable funds increased to try to take advantage of the price rise. The increase in the demand increased the real interest rate, which put many homeowners in financial difficulty and ultimately lead to defaults and foreclosures. IV. Government in the Loanable Funds Market A Government Budget Surplus • Changes in the government surplus can shift the supply of loanable funds curve. In the figure, PSLF is the private supply of loanable funds curve. The government has a budget surplus equal to the length of the arrow ($0.4 trillion). The surplus adds to private saving and so the supply of loanable funds curve becomes SLF. Without the budget surplus, the real interest rate is 4 percent and the quantity of loanable funds and investment is $2.0 trillion; with a budget surplus, the real interest rate is 3 percent and the quantity of loanable funds and investment is $2.2 trillion.

A Government Budget Deficit • Changes in the government deficit can shift the demand for loanable funds curve. In the figure, PDLF is the private demand for loanable funds curve. The government has a budget deficit equal to the length of the arrow ($0.4 trillion). The deficit adds to private demand and so the demand for loanable funds curve becomes DLF. Without the budget deficit, the real interest rate is 5 percent and the quantity of loanable funds and investment is $2.0 trillion; with the budget deficit, the real interest rate is 6 percent, the quantity of loanable funds is $2.2 trillion, and investment is $1.8 trillion. • The tendency for a government budget deficit to decrease investment is called a crowding-out effect. • The possibility that a budget deficit increases private saving supply in order to offset the increase in the demand for loanable funds is called the Ricardo-Barro effect. The reasoning behind this effect is that taxpayers will save to pay higher future taxes that result from the deficit. To the extent that the Ricardo-Barro effect occurs, it reduces the crowding-out effect because the SLF curve shifts rightward to offset the deficit. .

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The Economics in the News section examines how fintech firms are taking market share in personal loans away from traditional financial firms.

FINANCE, SAVING, AND INVESTMENT

Additional

Problems

Government expenditure decreases by $100 billion. a. If there is no Ricardo-Barro effect, explain how loanable funds, saving, investment, and the real interest rate respond to this fiscal policy. b. How does your answer in part a depend on the strength of the Ricardo-Barro effect?

Figure 7.1 shows the market for loanable funds. The government is running a budget surplus of $900 billion. a. Show the effect of a $400 billion decrease in the government budget surplus if there is no RicardoBarro effect. How much investment is crowded out by the fall in the surplus? b. How does the Ricardo-Barro effect change the results?

IMF Warning Over Slowing Growth Turmoil in the world’s financial markets may well slow global economic growth. BBC News, October 10, 2007 Explain how turmoil in global financial markets might affect the demand for loanable funds, investment, and global economic growth in the future.

Solutions

Additional

Problems

1. a. The decrease in government expenditure by $100 billion increases the supply of loanable funds, which increases the equilibrium quantity of loanable funds. Compared to what otherwise would have been the case, the decrease in government expenditure lowers the real interest rate and increases investment. b. The stronger the Ricardo-Barro effect, the less the increase in the supply of loanable funds as taxpayers expect future taxes to be lower due to the decrease in government expenditures. The smaller the increase in the supply of loanable funds, the smaller the changes in loanable funds, the real interest rate, and investment.

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2. a. Figure 7.2 shows the effect of the $400 billion decrease in the government surplus. The government deficit decreases saving by $400 billion and so shifts the supply of loanable funds curve leftward by $400 billion. As the figure shows, the equilibrium real interest rate rises from 3 percent to 4 percent and the equilibrium quantity of loanable funds decreases from $2.0 trillion to $1.8 trillion. So the $400 billion decrease in surplus crowds out (decreases) $200 billion of investment. b. The Ricardo-Barro effect says that people change their saving to offset the effect of changes in the government budget balance. In the extreme, people increase their saving by the full amount of the decrease in surplus, in which case the supply of loanable funds curve does not shift and so investment and the real interest rate do not change. In a less extreme case, the saving increase offsets only some of the decrease in surplus, so the supply of loanable funds curve still shifts leftward, but by a smaller amount. As a result, the real interest rises less and investment decreases less that they would in the absence of the Ricardo-Barro effect. 3. The turmoil in financial markets leads some people to decrease their saving because of fear that they might lose these funds due to the turmoil; in other words, default risk increases. As a result, the supply of loanable funds decreases, which pushes up the real interest rate. The primary source demanding loanable funds is business firms who want these funds to make investment. If the real interest rate rises, the quantity of loanable funds demanded decreases as businesses cancel no-longer profitable investments. With less investment there will be less capital and so the growth in potential GDP slows.

Additional Discussion Questions

11. What is the difference between “insolvency” and “illiquidity”? Insolvency occurs when a firm has negative net worth; that is, the firm’s liabilities—what it owes— exceed the firm’s assets—what it owns. Illiquidity occurs when a firm does not have enough cash to meet a sudden demand for repayment of what it has borrowed. The situations are different: A firm can be insolvent and liquid. A firm can also be solvent and illiquid. 12. Explain why and how investment depends on the real interest rate. The real interest rate is the opportunity cost of investment. A firm that borrows funds to make an investment faces the real interest as the opportunity cost of its investment because the real interest rate determines the purchasing power—the amount of goods and services—that a firm must repay on its loan. A firm that uses its own funds to make an investment also faces the real interest rate as the opportunity cost of its investment because the firm could loan the funds to others and collect as its return the real interest rate. Because the real interest rate is the opportunity cost of investment, an increase in the real interest rate decreases the quantity of investment firms demand. .

FINANCE, SAVING, AND INVESTMENT

13. If the actual real interest rate differs from the equilibrium real interest rate, what forces drive the real interest rate to the equilibrium real interest rate? If the real interest rate is higher than the equilibrium real interest rate, there is a surplus of loanable funds. In this case lenders cannot loan all the funds they want. In order to loan their funds, loaners reduce the real interest rate they charge and the real interest falls to the equilibrium real interest rate. If the real interest rate is lower than the equilibrium real interest rate, there is a shortage of loanable funds. In this case borrowers cannot borrow all the funds they want. In order to borrow their funds, borrowers raise the real interest rate they will pay and the real interest rises to the equilibrium real interest rate.

C h a p t e r

MONEY, THE PRICE LEVEL, AND INFLATION**

The Big Picture Where we have been: Chapters 6 and 7 focused on the markets for labor and capital, both real resources used in the production of real GDP. This chapter now shifts gears to study money and how money impacts markets. Because Chapter 8 is the first chapter on money, it introduces a lot of new material. The discussion of the market for money relates back to the supply and demand model in Chapter 3. Where we are going: Chapter 8 is the first of two chapters that examine money and the economy. This chapter defines money, introduces the Federal Reserve, explains the money creation process, and then concentrates on the long run effects (the quantity theory) of changes in the quantity of money. Chapter 14 returns to these topics to study monetary policy. Chapter 8 also is the 3rd of 4 chapters that cover the economy in the long run. The next chapter looks at the exchange rate and balance of payments.

New in the Fourteenth Edition An important change concerns the Fed’s policy instruments. They are now given as “open market operations,” the “discount window and discount rate,” and the “interest on reserves rate.” This new emphasis on the discount rate and interest on reserves rate plays a key role in Chapter 14. Another important change for you to take note of for your lecture notes is that the supply of money curve now depends on what the Fed targets, the monetary base, the nominal interest rate, or the quantity of money. Additionally, the text uses the demand and supply of nominal money rather than real money. All the data and the key institutional material (such as the definition of M1 currency plus demand deposits plus other liquid deposits and M2 as M1 plus smalldenomination time deposits plus retail money market mutual funds) have been updated. “Checking accounts” are now called “demand deposits.” *

* This is Chapter 25 in Economics. .

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The concluding Economics In The News feature examines the massive injections of money (quantitative easing) the Fed made in response to the Covid-19 pandemic in 2020.

MONEY, THE PRICE LEVEL, AND INFLATION

Lecture Notes

Money, the Price Level, and Inflation • • • •

Money is anything that is used as a means of payment. Banks play a major role in creating money but this process is ultimately controlled by the Federal Reserve. In the short run, equilibrium in the money market determines the nominal interest rate. In the long run, an increase in the growth rate of the quantity of money leads to a higher inflation rate.

I. What Is Money? The contrast between money in economics and money in everyday language. It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in everyday language. For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why. •

Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three functions: • Medium of exchange • Unit of account • Store of value

Medium of Exchange A medium of exchange is any object that is generally accepted in exchange for goods and services. Money acts as a medium of exchange. As a result, money eliminates the need for barter, which is the exchange of goods and services directly for other goods and services. The defining characteristic of money. Adam Smith wrote, “Money is a commodity or token that everyone will accept in exchange for the things they have to sell.” Most people have interpreted this statement as defining money as the medium of exchange. That interpretation is wrong. Smith is defining money as the means of payment. Money is a commodity or token that everyone will accept as payment for the things they have to sell. When Michael Parkin was a young economist, he had the enormous good fortune to meet Anna Schwartz, Milton Friedman, and a group of other leading monetary economists. It was during the late 1960s when the monetarist debate was alive and well and people were still arguing about whether the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic (as the Keynesians claimed). Anna made a remark that for Michael was one of those defining moments. She said money is the means of payment. Nothing else performs this function. It is unique to money. Many things serve as a medium of exchange, unit of account, or store of value, but money alone serves as the means of payment—the means of settling a debt so that there is no remaining obligation between the parties to a transaction. Get the class involved in figuring out what money is. To involve the students in the process of .

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determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards. The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you might point out that students rarely pay for books by giving the bookstore shares of IBM stock and asking for change in AT&T stock. By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is. Unit of Account Money serves as a unit of account, which is an agreed measure for stating the prices of goods and services. Store of Value Money serves as a store of value because it can be held and exchange later for goods and services. During the Great Depression there was deflation so the real return on money was positive. Thus, many people held money as an asset and did not immediately use it to spend on goods and services. This is the idea behind Keynes’ concern that people were stuffing money in their mattresses instead of spending it. Concerns about deflation have been revived in recent years. Japan has had deflation on and off for the past decade and many other countries have very low rates of inflation. One of the more interesting suggestions by Fed economists in thinking how to avoid the problem of money serving so well as a store of value is to have money which expires like a coupon. It is not clear whether such a form of money is feasible from a political or psychological point of view, but the suggestion is interesting. Money in the United States Today • Money consists of currency (the notes and coins held by individuals and businesses) and deposits at banks and other depository institutions. Deposits are also money because they can be converted into currency and because they are used to settle debts. • M1 consists of currency plus demand deposits plus other liquid deposits. • M2 consists of M1 plus small-denomination time deposits plus retail money market mutual funds. M2 is larger than M1, $20,278 billion versus $19,154 billion in May, 2021. Liquidity is the property of being instantly convertible into a means of payment with little loss in value. The assets in M2 are generally quite liquid. • Checks are not money—they are instructions to transfer money from one person’s deposits to another person’s deposits. Credit cards are not money—they are IDs that allow an instant loan. Fiat money. Pull out a dollar bill, wave it at the class and ask, “What backs our currency?” You should get someone to state gold. Tell them, “Yes, I have heard about all the gold stored in Fort Knox, but none of it is there for a trade-in value. We went off the gold standard with Nixon. If you look closely at the bill you’ll find your backing, “In God we trust,” That’s it! The dollar has value because of your faith that someone else will accept it for something else you want. .

MONEY, THE PRICE LEVEL, AND INFLATION

Alternatively (or additionally) take a green piece of paper and cut it to the same size as a dollar bill. Then take the paper into class along with a dollar bill. Ask the students why one piece of paper has value and the other does not. Is there anything intrinsically more valuable about the dollar bill? If not, why won’t someone in class exchange his or her old wrinkled piece of green paper with writing on it for the nice new piece you offer? II. Depository Institutions • A firm that takes deposits from households and firms and makes loans to other households and firms is called a depository institution. There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds. Commercial Banks • A commercial bank is a firm that is licensed to receive deposits and make loans. In 2017 there are about 4,983 commercial banks but that number has been trending downward. The deposits of commercial banks account for more than 67 percent of M1 and M2. • Banks accept deposits and then divide these funds into reserves (cash in the vault plus its deposits at the Federal Reserve), liquid assets (such as Treasury bills and commercial bills), securities (such as U.S. government bonds and mortgage-backed securities), and loans (made primarily to corporations for purchases of capital equipment and to households to finance homes, consumer durable goods, and credit cards). Loans are the riskiest of a bank’s assets. As a percentage of deposits, in June, 2021 cash assets were 21.1 percent, securities were 31.0 percent, loans were 60.9 percent, and other assets were 12.7 percent. (The percentages sum to more than 100 percent because deposits are just one source of funds; borrowing and the banks’ own capital are other sources of funds and are equal to about 25 percent of deposits.) Thrift Institutions The thrift institutions are savings and loan associations, savings banks, and credit unions. Money Market Mutual Funds A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills and short-term commercial bills. The Economic Functions of Depository Institutions • Depository institutions make a profit from the spread on the interest rate at which they lend over the interest rate they pay on deposits. The spread reflects four services provided by depository institutions: • Create Liquidity: Most assets are less liquid than liabilities, so depository institutions turn less-liquid funds into more liquid funds. A bank run is a liquidity crisis in the sense that banks can have the deposits backed by assets such as mortgage loans, but the assets are less liquid than the deposits. This scenario should be familiar to anyone who has seen It’s a Wonderful Life with Jimmy Stewart. As suggested by the movie, bank runs were a big problem in the 1930s and many economists believe they made the Great Depression much worse than other recessions. Indeed, banks runs were feared by the Federal Reserve during the financial crisis of 2008 and this fear likely accounted one reason why the Fed responded so strongly to the crisis. .

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• • •

Lower the Cost of Borrowing: Depository institutions lower transaction costs of matching borrowers and lenders. Lower the Cost of Monitoring Borrowers: Depository institutions lower transaction costs by specializing in monitoring risky loans. Pool Risk: The costs of defaults on loans are spread across all depositors, instead of being borne by individual lenders.

What do banks do? Students usually have bank accounts, but often they have never fully thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice commercial banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students. How Depository Institutions Are Regulated • To make the risk of failure small, depository institutions are required to hold levels of reserves and owners’ capital that equal or surpass ratios laid down by regulation. Financial Technology • The development of new financial products is called financial innovation. Some innovation has been a response to economic circumstances such as high inflation and high interest rates in the 1970s. Others, such communications networks which have spread the use of credit cards, are the result of advances in technology. Still others, such as sub-prime mortgages, were developed during the 2000s. III. The Federal Reserve System The central bank of the United States is the Federal Reserve System. A central bank is a bank’s bank and a public authority that regulates a nation’s depository institutions and controls the quantity of money. The Fed conducts the nation’s monetary policy, which means that it adjusts the quantity of money in circulation. By adjusting the quantity of money, the Fed can change interest rates. Conspiracy theory of the Fed. Some students will have heard about a “conspiracy theory of the Fed.” This theory, advanced by the ignorant, the misinformed, or the deceitful, is that the commercial banks own the Fed, which is run solely to benefit the banks to ensure that they earn large profits. Point out that commercial banks do indeed own the Fed—they own all the stock issued by the Fed. But Fed stock is not like shares in General Electric or Microsoft. The dividend on the Fed’s stock is fixed at 6 percent of the purchase price, and the stock cannot be sold in a marketplace. So this stock is a lousy investment. What privileges come with the stock? Commercial banks elect six of the nine directors of their Federal Reserve Regional bank; each commercial bank has the same number of votes regardless of the amount of stock it owns. But the directors of the regional banks are hardly key players in the Federal Reserve System. Essentially, the most important task they perform is nominating a president for the regional bank. The regional banks’ presidents are important. The directors, however, do not get much freedom in this choice because their nominee must be approved by .

MONEY, THE PRICE LEVEL, AND INFLATION

the Board of Governors, which does not hesitate to veto anyone considered unacceptable. Regional bank presidents gain their power from sitting on the FOMC. But there they are a minority because the voting members of the FOMC consist of five regional bank presidents and seven members of the Board of Governors. Because the board members are appointed by the president and approved by the Senate, the government thus wields the ultimate power in the Federal Reserve. The regional bank presidents must be approved by the publicly appointed board members and the board members constitute a majority on the FOMC. The Structure of the Fed • The Board of Governors has seven members, including the chairman (currently Ben Bernanke). • There are 12 regional Federal Reserve banks. • The Federal Open Market Committee (FOMC) is the main policy-making group of the Fed. It is comprised of the members of the Board of Governors and the Presidents of the regional Federal Reserve Banks. The Board of Governors, the President of the Federal Reserve Bank of New York, and, on a rotating basis, the presidents of four other regional Federal Reserve Banks, vote on monetary policy. In practice, the chairman has the largest influence on policy. The Fed’s Balance Sheet • The Fed’s two main assets are U.S. government securities and mortgage-backed securities. • The Fed’s three main liabilities are Federal Reserve notes (currency),reserves of depository institutions, and other deposits at the Fed. The Economics in Action detail discusses how the Fed’s balance sheet changed dramatically as a result of the financial crisis in 2008 and Covid pandemic in 2020. U.S. government securities and mortgage-backed securities soared from less than $1,000 billion to approximately $8,0500 billion and currency from less than $1,000 billion to approximately $2,000 billion. Banks now hold almost $4,000 billion reserves. The monetary base rose about 800 percent in size! •

The monetary base is the sum of currency and reserves of depository institutions. The parts of the monetary base, currency and depository institution reserves, are liabilities of the Federal Reserve. Changes in the monetary base lead to changes in the quantity of money.

The Fed’s Policy Tools • Open Market Operation: An open market operation is the purchase or sale of securities by the Federal Reserve System in the open market. When the Fed buys a security, it pays for the purchase with newly created reserves and when it sells a security, the Fed is paid with reserves held by banks. Accordingly, open market operations change the monetary base, which influences the quantity of money. For example, an open market purchase increases the monetary base which leads to an increase in the money supply. • Discount Window and Discount Rate: The Fed is the lender of last resort, which means that if depository institutions are short of reserves, they can borrow from the Fed. The interest rate charged on these loans is the discount rate. The Board of Governors sets this rate. • Interest on Reserves Rate: The interest on reserves rate is the interest rate that the Fed pays banks on their reserves kept at the Fed. The Board of Governors sets this rate. .

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IV. How Banks Create Money Creating Deposits by Making Loans When a bank makes a loan, it makes a deposit to finance the loan. Because deposits are money, the bank has created money. For example, if you use a credit card to buy $50 at Walgreens, loans to you increase and Walgreens deposits increase. The increase in deposits increases the quantity of money. Three factors limit the amount of deposits that the banking system can create: • The monetary base: Banks have a desired amount of reserves they want to hold and people have a desired amount of currency. The monetary base sets a limit on the sum of these two. Both of these desired holdings depend on the quantity of money, and so the monetary base limits the amount of money that can be created. Alternatively, the monetary base limits the amount of the banking systems’ reserves. • Desired reserves: A bank’s actual reserves are the coin and currency in its vault and its deposits at the Federal Reserve. The fraction of a bank’s total deposits that are held in reserves is called the reserve ratio. The desired reserve ratio is the ratio of reserves to deposits that banks want to hold. Actual reserves minus desired reserves are unplanned reserves. Unplanned reserves can be loaned and can thereby create money. • Desired currency holding: The other use of the monetary base involves the public’s holding it as currency. When banks create new money by creating new deposits, the public wants to hold some of this money as currency. As a result, currency leaves the banking system when banks increase their loans, which limits the overall increase in loans. The currency drain ratio is the ratio of currency to deposits. • Banks use unplanned reserves to make loans. In the process, banks create money. • For each dollar deposited, a bank keeps a fraction as reserves and lends out the rest. When a bank makes a loan, it creates a new deposit (new money) equal to the value of the loan. After the loan is spent by the borrower, the new money eventually ends up back as a new deposit in a bank. As new deposits are made, the process of money creation begins again, albeit with a smaller amounts each time because banks keep a fraction of each deposit in the form of reserves. • The total of amount of new money created by the entire banking system depends on the fraction of the deposits that banks loan at each step in the process. The Money Creation Process • The monetary base increases and banks have unplanned reserves. Banks lend the unplanned reserves and thereby create new deposits, that is, create new money. • The new money is used to make payments. Some of the new money remains in the banking system as deposits and some of it is drained out of the banking system via the currency drain. • The funds that stay within the banking system are reserves for the banks. Because deposits have increased, banks’ desired reserves have increased. But the actual reserves have increased by more than desired reserves, so banks still have unplanned reserves to loan. Banks lend these unplanned reserves and the process continues. • Eventually the money creation process comes to a stop when the sum of additional currency holdings plus additional desired reserves equals the initial increase in the monetary base and banks’ reserves. • The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base. It determines the change in the quantity of money that results from a given change in the monetary base. A change in the monetary base has a multiplied effect .

MONEY, THE PRICE LEVEL, AND INFLATION

on the quantity of money because banks’ loans are deposited in other banks where they are loaned once again. The formula for the money multiplier is derived in the Mathematical Note to the chapter (see the end of these lecture notes). A money creation experiment. The process through which banks “create money” can be a dark and mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused. The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance. Mark Rush (our supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money.”) Label this piece of paper a “$100 bill.” In class use one of the students by handing him the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the desired reserve ratio is 10 percent, so this bank currently has no unplanned reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has unplanned reserves of $90. Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound—coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row. Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has unplanned reserves but the second bank now has $81 of unplanned reserves ($90 of additional deposits minus $9 of desired reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.” An Economics in Action discusses how the M1 and M2 money multipliers have changed since .

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the global financial crisis. The M1 multiplier has increased from 1.7 to 2.8 while the M2 multiplier has decreased from 8.8 to 3.8. An Economics in News detail defines, describes, and analyzes QE2, that is, the second round of quantitative easing the occurred in 2011. V. The Money Market The Demand for Money The demand for money is the relationship between the quantity of money demanded and the nominal interest rate, holding all else equal. Factors that affect the demand for money are: • The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of money demanded. • Real GDP: An increase in real GDP increases the quantity of money people plan to hold. • Financial Technology: Some financial innovation decreases the quantity of money people plan to hold (ATM machines) and other financial innovation increases it (interest paid on checking accounts). As the figure shows, the negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping. Shifts in the Demand for Money Curve • A change in real GDP, the price level, or financial technology changes the demand for money and shifts the demand for money curve. An increase in real GDP or the price level increase the demand for money and shift the demand for money curve rightward. The Demand for Money Students are often confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public want to hold in the particular form of “money.” Students often find it straightforward to think about their behavior and the quantity of cash they hold in their wallet when dealing with the factors that change the demand for money and shift the demand for money curve. But they frequently get confused about the effect the interest rate has on the quantity of money demanded, probably because their holdings of money are not large. So tell your students to imagine themselves in the job of treasurer of a corporation with large liquid resources and to think how their behavior with respect to those funds might differ according to the short-term interest rates available on non-money alternatives, such as bonds. It is easier for them to see that a treasurer will surely shift $5 million dollars into non-money assets in order to reap the higher interest-rate reward when the interest rate rises. The Supply of Money The supply of money curve is the relationship between the quantity of money supplied and the nominal interest rate when all other influences on the amount of money .

MONEY, THE PRICE LEVEL, AND INFLATION

that the Fed and banks wish to create remain the same. The supply curve depends on the Fed’s monetary policy strategy and what the Fed targets. Potential Fed targets are: • • •

Monetary Base: If the Fed targets the monetary base, a rise in the nominal interest rate increases the quantity of money supplied because banks make more loans. This supply of money curve is illustrated in the figure as MSB. Nominal Interest Rate: If the Fed targets the nominal interest rate, the Fed pegs the nominal interest rate so a change in demand is fully accommodated by changing the quantity of money. This supply of money curve is illustrated in the figure as MSR. Quantity of Money: If the Fed targets the quantity of money, the Fed pegs the quantity of money, so a change in demand is completely offset by changing the quantity of money to keep it fixed. This supply of money curve is illustrated in the figure as MSM.

Money Market Equilibrium Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied. • Short Run: In the figure the Fed targets the monetary base. The nominal interest rate adjusts to establish equilibrium in the money market. The equilibrium nominal interest rate equates the quantity of money demanded with the quantity of money supplied. In the figure, the equilibrium interest rate is 3 percent. • The Short-Run Effect of a Change in the Supply of Money: Starting from a short-run equilibrium, if the Fed increases the quantity of money, people hold more money than the quantity demanded. With a surplus of money holding, people enter the loanable funds market and buy bonds. The increase in demand for bonds raises the price of a bond and lowers the interest rate. • Long Run: In the long run, supply and demand in the loanable funds market determines the equilibrium real interest rate. That, plus the expected inflation rate determines the nominal interest rate, so the nominal interest rate cannot adjust to restore equilibrium in the money market. The factor that adjusts in the long run is the price level: The price level adjusts to make the quantity of money equal to the quantity of money demanded. In the long run, an increase in the quantity of money raises the price level by the same proportion. No real variables change in the long run. VI. •

The Quantity Theory of Money The quantity theory of money is the proposition that in the long run, an increase in .

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•

the quantity of money brings an equal percentage increase in the price level. The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. Nominal GDP equals real GDP, Y, multiplied by the price level, P, or GDP=PY. So the velocity of circulation, V, is given by V = PY/M. The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals GDP: MV = PY. The equation of exchange is a definition and so is always true. It becomes the quantity theory of money by adding two assumptions: • The velocity of circulation is not influenced by the quantity of money. • Potential GDP is not influenced by the quantity of money. The equation of exchange can be rearranged as P = M(V/Y). This equation, together with the assumptions about velocity and potential GDP, implies that in the long run, the price level is determined by the quantity of money. • In growth rates, the equation of exchange is: (Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate). Rearranging this equation gives (Inflation rate) = (Money growth rate) + (Growth rate of velocity) − (Real GDP growth rate). If velocity does not grow, then in the long run the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP.

Historical Insight. When Milton Friedman’s quantity theory of money was brought to the attention of policymakers during the 1960s, he was labeled an ivory tower academic with his head in the clouds. When his predictions of inflation came true in the 1970s, he was crowned king of monetary theory. Evidence on the Quantity Theory of Money The predictions of the quantity theory can be tested using evidence on money growth and inflation across time. On the average, the money growth rate and the inflation rate are correlated, supporting the quantity theory. The predictions of the quantity theory also can be tested using the evidence on money growth and inflation across countries. As predicted, rapid money growth is correlated with high inflation. The idea that growth in the quantity of money causes inflation sounds obvious enough to students that they might miss just how controversial the idea is, at least outside of the economics profession. In an economy suffering from inflation, many observers blame “special circumstances,” such as hikes in the price of oil, bad crop harvests, import prices, or whatever. Economists from the central bank often lend their support to these assertions. The fact that central bank employees wish to divert attention away from their role in creating inflation is understandable if not commendable. But why do other observers go astray? Most often it is because they look at only their economy and do not consider what data from other economies indicates or data from their own economy over a long period of time shows. When looking at only one economy and one time period, it is always possible to find some price-increasing factor other than growth in the quantity of money and blame inflation on it. But when looking across economies or across time, the paramount role growth in the quantity of money plays in creating inflation is immediately apparent. So, contrary to the assertions emanating from the central banks and other analysts in nations with high inflation, almost surely their inflation is the result of high monetary growth and not some other “special, unique to them, unique to this time .

MONEY, THE PRICE LEVEL, AND INFLATION

period circumstance!” The concluding Economics in the News section deals with the Fed’s reactions in 2020 to the start of the Covid-19 pandemic. It discusses the Fed’s massive quantitative easing program as well as the Fed slashing the federal funds rate to virtually zero.

MATHEMATICAL NOTE The mathematical note derives the formula for the money multiplier. • Money is M, deposits is D, and currency is C. M=D+C • The monetary base is MB and banks’ reserves is R. MB = C + R •

The money multiplier, mm, is equal to mm = M/MB = (D + C)/(R + C)

•

Divide all the variables on the right side of the money multiplier equation by D: mm = (1 + C/D)/(R/D + C/D) C/D is the currency drain ratio and R/D is the banks’ reserve ratio. The formula shows that the size of the money multiplier depends on the reserve ratio and the currency drain. In June 2021, when banks are holding substantially more reserves than in past decades, for M1 the currency drain ratio, C/D, was equal to 0.13 and the reserve ratio, R/D, was

• • •

equal to 0.22, so the money multiplier for M1 was

= 3.21.

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Additional Problems 1.

In Zimbabwe the growth rate of the quantity of money increased from 52 percent a year to 66,700 percent a year in 2007. Accordingly the inflation rate in Zimbabwe skyrocketed, from 56 percent a year in 2000 to 24,000 percent a year in 2007. The growth rate of real GDP between these years is harder to measure but was probably −30 percent per year. a. How do we know that Zimbabwe’s reported inflation between 2003 and 2007 is almost certainly below the true inflation rate? b. What must be done to stop Zimbabwe’s inflation? c. Zimbabwe’s government frequently responded to its inflation by changing its currency to “knock off” zeros on the currency. At one point it was proposed to knock off ten zeros from the currency (so that an old 10,000,000,000 denomination bill would become a new 1 domination bill). Why will knocking ten zeroes off all prices not stop Zimbabwe’s inflation?

Solutions to Additional Problems 1. a. We know that the reported inflation rate is too low because the velocity of circulation calculated with it fell. The (true) velocity of circulation rises during hyperinflations as people strive to spend money as rapidly as possible. If the true velocity of circulation rose, then the true inflation rate is higher (probably much higher) than the reported inflation rate. b. To stop Zimbabwe’s inflation, the central bank must stop or drastically lower the growth rate of the quantity of money. c. Knocking ten zeros off of all prices will not stop Zimbabwe's inflation because it just changes the units in which prices are measured. Prices will continue to grow as long as the quantity of money grows.

Additional Discussion Questions

11. Why is the use of money in the exchange of goods and services less costly than using barter? Barter requires a “double coincidence of wants.” For instance, suppose the first person has good A and wants good B. The person must find a second person with good B and who wants good A. Barter requires that the first person must undertake costly search for his or her trade partner. Use of money, on the other hand, breaks the necessity for the double coincidence of wants. The first person who has good A and wants good B can trade with anyone who wants good A and has money. After exchanging good A for money, the first person can now search for anyone who has good B and wants something else. That person will be willing to accept money in exchange for his or her good B because that person knows that the money can then be exchanged for whatever he or she wants. Therefore money has eliminated the need for the time-consuming and costly search needed with barter. 12. “Everyone knows that true money is issued by the government; that is, the only real form of money is the nation’s currency.” Comment on this assertion. This assertion is false. Money is anything that can be used as a medium of exchange. .

MONEY, THE PRICE LEVEL, AND INFLATION

Funds in checking accounts clearly qualify because they can be used as a medium of exchange. Therefore funds in checking accounts are definitely money. Other sources of funds, such as funds in savings accounts, also come close to be money because they can be used with only slight difficulty as a medium of exchange. Therefore money includes many assets beyond government-issued currency. 13. Define the monetary base. The monetary base is equal to the currency and reserves of depository institutions’. The monetary base is made up of liabilities of the Federal Reserve. 14. “Ask anyone if he or she has enough money. No one ever has enough money, that is, everyone demands more money. Thus theorizing about the demand for money makes no sense because this demand obviously is infinite.” Correct and comment on the error in this assertion. This assertion makes a fundamental error by confusing money with income. Money is M1. The demand for money is the amount of M1 people want to hold. People have a finite amount of M1 that they want to hold; that is, no one wants to hold an infinite amount of M1. Income, however, is a different story: people would like to receive infinite income because that means that they could have infinite consumption. But infinite income is not the same as holding an infinite quantity of M1! 15. If the price level was already doubling every month and inflation accelerating, what would you expect to happen to the velocity of circulation and why? How close would you expect the relation between the quantity of money and the price level to be? The velocity of circulation would increase. People would try to spend the money they receive as rapidly as possible in order to avoid suffering the loss that comes from higher prices. In this case, which occurs in hyperinflations, the inflation rate exceeds the growth rate of the quantity of money. In a hyperinflation with accelerating inflation, the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity. 16. How does a currency drain affect the money multiplier? [Requires Mathematical Note] A currency drain decreases the magnitude of the money multiplier. The money multiplier exists because some of the proceeds of the loans that one bank makes are deposited in other banks where it can be loaned once again. The more of the proceeds that are deposited in banks, the larger will be the next round of loans and hence the larger will be the money multiplier. A currency drain decreases the amount of the loans that is deposited back in banks. Because the faction of the loans that is deposited is less, the ultimate increase in the quantity of money—and hence the money multiplier—is smaller.

C h a p t e r

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS**

The Big Picture Where we have been: Chapter 9 is the last of four that examine the long-run trends of the economy. It uses the quantity theory result from Chapter 8 that in the long run, the price level is determined by the quantity of money. This result is used to show that in the long run, the nominal exchange rate is determined by the quantities of money in the two countries. Chapter 9 also uses the national income accounting identities introduced in Chapter 4 when explaining the balance of payments and, quite importantly, the demand and supply model of Chapter 3 when explaining short-run fluctuations in the exchange rate. Where we are going: Chapter 9 is the last of the “long-run chapters.” The next section looks at short-run fluctuations. Chapter 10, with its introduction of the aggregate supply/aggregate demand model, is key to understanding short run business cycle fluctuations. The material in this chapter is not prominently featured in future chapters, though it makes a slight recurrence in Chapter 14 when monetary policy is covered. Chapter 15, on International Trade, does not use the material in this chapter directly. However, the global loanable funds market can be used to motivate the models for the global market in goods and services.

New in the Fourteenth Edition

The content in this chapter is substantially the same as in the previous edition. Data in tables and graphs have been updated to 2020. The concluding Economics in the News feature has a 2021 article covering currency manipulation and, following the story, the feature analyzes the topic using tools developed in the chapter.

* This is Chapter 26 in Economics. .

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Lecture Notes

The Exchange Rate and the Balance of Payments • • •

International trade, borrowing, and lending, make it necessary to exchange currencies and the foreign exchange value of the dollar is determined in the foreign exchange market. The exchange rates for currencies are determined by supply and demand in the foreign exchange market. When a nation trades with other nations, the country’s balance of payments records the transactions.

I. The Foreign Exchange Market Trading Currencies • International trade, borrowing, and lending, make it necessary to exchange currencies. Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The price at which one currency exchanges for another is called the exchange rate. Exchange rates: Exchange rates are always somewhat confusing. The problem is that there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S. dollars (109 yen per U.S. dollar) or as U.S. dollars per unit of foreign currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the textbook is consistent in using the exchange rate as the units of foreign currency per U.S. dollars, stick to the “109 yen per dollar” format in your lectures. This also makes it easier for graphing and for the discussion about appreciation or depreciation. A change from 109 to 110 yen per dollar is dollar appreciation and shown by an increase along the vertical axis. •

Over time, the U.S. dollar appreciates and depreciates against other currencies such as the Japanese yen or European euro. Currency depreciation is the fall in the value of one currency in terms of another currency. Currency appreciation is the rise in the value of one currency in terms of another currency. • A rise in the U.S. exchange rate is called an appreciation of the dollar; a fall in the U.S. exchange rate is called a depreciation of the dollar.

The Demand for One Money is the Supply of Another Money The exchange rate is determined by demand and supply in the (competitive) foreign exchange market. When people holding the money of some other country want to exchange it for U.S. dollars, they supply the other currency and demand dollars. When people holding U.S. dollars want to buy the currency of some other country, they supply U.S. dollars and demand the other currency. Demand in the Foreign Exchange Market The main factors that influence the dollars that people plan to buy in the foreign exchange market are the exchange rate, world demand for U.S. exports, interest rates in the United States and other countries, and the expected future exchange rate. • The law of demand in the foreign exchange market is: Other things remaining the same, the .

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

•

higher the exchange rate, the smaller is the quantity of dollars demanded in the foreign exchange market. There are two reasons for the law of demand: • Exports Effect: Dollars are used to buy U.S. exports. The lower the exchange rate, with everything else the same, the cheaper are U.S. exports so the greater the quantity of dollars demanded on the foreign exchange market to pay for the exports. • Expected Profit Effect: The lower the exchange rate, with everything else the same (including the expected future exchange rate), the larger the expected profit from buying dollars so the greater the quantity of dollars demanded on the foreign exchange market. The law of demand means that the demand curve for U.S. dollars is downward sloping, as illustrated in the figure below.

Supply in the Foreign Exchange Market The main factors that influence the dollars that people plan to sell in the foreign exchange market are the exchange rate, U.S. demand for imports, interest rates in the United States and other countries, and the expected future exchange rate. • The law of supply in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market. There are two reasons for the law of supply: • Imports Effect: Dollars are used to buy U.S. imports. The higher the exchange rate, with everything else the same, the cheaper are foreign produced imports so the greater the quantity of dollars supplied on the foreign exchange market to buy these imports. • Expected Profit Effect: The higher the exchange rate, with everything else the same (including the expected future exchange rate), the smaller the expected profit from holding dollars so the larger the quantity of dollars supplied on the foreign exchange market. • The law of supply means that the supply curve for U.S. dollars is upward sloping, as shown in the figure. Market Equilibrium • Demand and supply in the foreign exchange market determine the exchange rate. In the figure, the equilibrium exchange rate is 100 yen per dollar, where the demand and supply curves intersect. • If the exchange rate is higher than the equilibrium exchange rate, a surplus of dollars drives the exchange rate down. • If the exchange rate is lower than the equilibrium exchange rate, a shortage of dollars drives the exchange rate up. • The market is pulled to the equilibrium exchange rate at which there is neither a shortage nor a surplus. Changes in the Demand for U.S. Dollars • A change in any relevant factor other than the exchange rate changes the demand for .

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dollars and shifts the demand curve for dollars. • World Demand for U.S. Exports: An increase in the world demand for U.S. exports increases the demand for U.S. dollars because U.S. producers must be paid in U.S. dollars. The demand curve for U.S. dollars shifts rightward. • U.S. Interest Rate Differential: The U.S. interest rate differential is the U.S. interest rate minus the foreign interest rate. The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the demand curve for U.S. dollars rightward. • Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the demand for U.S. dollars increases and the demand curve shifts rightward. Changes in the Supply of U.S. Dollars • A change in any relevant factor other than the exchange rate changes the supply of dollars and shifts the supply curve of dollars. • U.S. Demand for Imports: An increase in the U.S. demand for imports increases the supply of U.S. dollars because U.S. importers offer U.S. dollars in order to buy the foreign currency necessary to pay foreign producers. The supply curve of U.S. dollars shifts rightward. • U.S. Interest Rate Differential: The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the smaller is the supply of U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the supply curve for U.S. dollars leftward. • Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the supply of U.S. dollars decreases and the supply curve shifts leftward. Emphasize that the quantity of dollars measured on the horizontal axis are only dollars that are being offered for foreign exchange, not the entire quantity of money as we learned in Chapter 8. Changes in the Exchange Rate The exchange rate changes when the demand for and/or the supply of foreign exchange change. • When the expected future U.S. exchange rate increases, the demand for U.S. dollars increases and the supply decreases. As the figure shows, the demand curve shifts rightward, from D0 to D1, and the supply curve shifts leftward, from S0 to S1. The exchange rate rises, in the figure from 77 yen per dollar to 102 yen per dollar, and quantity traded does not change by much, indeed in the figure it does not change at all. Such changes took place between 2012 and 2014 when traders started to expect that the .

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

Federal Reserve would raise the interest rate in the United States while the Japanese interest rate would not change. II. Arbitrage, Speculation, and Market Fundamentals Exchange rate expectations depend on deeper economic forces that influence the value of money. •

Arbitrage is the practice of seeking to profit by buying in one market and selling for a higher price in another related market. Arbitrage in the foreign exchange market and international loans markets and goods markets achieves four outcomes: • The law of one price: If an item is traded in more than one place, the price will be the same in all locations. An example of this law is that the exchange rate between the U.S. dollar and the U.K. pound is the same in New York as it is in London. • No round-trip profit: A round trip is using currency A to buy currency B, and then using B to buy A. A round trip might involve more stages, using B to buy C and then using C to buy A. Regardless, arbitrage removes the profit made from a round trip. • Interest rate parity: Borrowers and lenders must choose the currency in which to denominate their assets and debts. Interest rate parity, which means equal rates of return across currencies, means that for risk-free transactions, there is no gain from choosing one currency over another. • Purchasing power parity: Purchasing power parity, which means equal value of money, is the idea that, at a given exchange rate, goods and services should cost the same amount in different countries. Purchasing power parity is an important force affecting prices and exchange rates in the long run and influences exchange rate expectations.

Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity. One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans. Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person (or organization) that acts as if it can beat the market. If one U.S. dollar exchanges for 1.33 Canadian dollars, then purchasing power parity is attained when one U.S. dollar buys the same quantity goods and services in the United States as 1.33 Canadian dollars buys in Canada. • If one U.S. dollar buys more goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually appreciate. • Similarly, if one U.S. dollar buys less goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually depreciate. The Economics in Action detail discusses the “Big Mac Index.” If you go to the website there is an interactive map and other tools that are fun to go through with students to investigate Big Mac prices throughout the world. .

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The Economist reports a Big Mac Index that uses the prices of McDonald’s Big Macs and purchasing power parity to make predictions about exchange rate movements. The index is somewhat tongue-in-cheek as it would be hard to arbitrage differences in Big Mac prices by taking a Big Mac on a plane from, say, Japan to the United States. However, it is easier to arbitrage the inputs into Big Macs such as beef. Thus, one might still expect some convergence of Big Mac prices over time. The Economist claims some success in its exchange rate predictions. Speculation Speculation is trading on the expectation of making a profit. Speculation contrasts with arbitrage, which is trading on the certainty of making a profit. Most foreign exchange transactions are based on speculation, which explains why the expected future exchange rate plays such a central role in the foreign exchange market. Changes in the expected future exchange rate instantly change the current exchange rate. Market Fundamentals The fundamentals underlying the exchange rate are the demand for U.S. dollars, which depends on world demand for U.S. exports, and the supply of U.S. dollars, which depends on U.S. demand for imports. Both demand and supply depend on the U.S. interest rate differential. The Real Exchange Rate • The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It tells how many units of a foreign currency one U.S. dollar buys. The real exchange rate is the relative price of U.S-produced goods and services to foreign-produced goods and services. It tells how many units of foreign GDP one unit of U.S. GDP buys. The real exchange rate, RER, is equal to RER = (E  P)/P* where E is the nominal exchange rate, P is the U.S. price level, and P* is the foreign price level. • Price Levels and Money: Nominal and real exchange rates are linked by the equation RER = E  (P/P*). This relationship can be used in the short run and long run: • Short Run: In the short run, this equation determines the real exchange rate. The nominal exchange rate is determined in the foreign exchange market by the supply and demand for dollars. Price levels do not change rapidly and so any change in the nominal exchange rate translates into a change in the real exchange rate. • Long Run: In the long run, rewrite the equation as E = RER  (P*/P). In the long run, the real exchange rate is determined by the supply and demand for imports and exports and the price level in each nation is determined by the quantity of money in that nation. So in the long run, a change in the quantity of money changes the price level and thereby changes the nominal exchange rate. This result means that in the long run, the nominal exchange rate is a monetary phenomenon. Chapter 8 showed that in the long run, the quantity of money determines a nation’s price level, so the nominal exchange rate is determined by the quantities of money in the two countries.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

III. Exchange Rate Policy Because the exchange rate is the price of a country’s money, governments and central banks must have a policy toward the exchange rate. Three possible exchange rates policies are. Flexible Exchange Rate • A flexible exchange rate policy permits the exchange rate to be determined by demand and supply with no direct intervention by the central bank. Even so, the exchange rate is influenced by the central bank’s actions. For instance, if the Fed raises the U.S. interest rate, the U.S. interest rate differential increases, which appreciates the U.S. exchange rate. Most countries, including the United States, have flexible exchange rates. Fixed Exchange Rate • A fixed exchange rate policy pegs the exchange rate at a value determined by the government or the central bank and blocks the unregulated forces of supply and demand by direct intervention in the foreign exchange market. A fixed exchange rate requires direct and frequent intervention by the central bank. • If the demand for dollars decreases or the supply of dollars increases, to fix the exchange rate the Fed buys U.S. dollars. By so doing the Fed increases the demand for dollars and raises the exchange rate. But the Fed cannot pursue this policy forever because it eventually will run out of the foreign reserves it is using to purchase the dollars. • In the figure the demand for dollars has decreased from D0 to D1. To keep the exchange rate fixed at 100 yen per dollar, the Fed needs to buy 2 billion dollars per day, the difference between the quantity of dollars supplied at the fixed exchange rate (7 billion dollars per day) and the [new] quantity of dollars demanded (5 billion dollars per day). To purchase these dollars the Fed must use its foreign reserves. Ultimately the Fed will run out of foreign reserves and when that takes place the Fed can no longer peg the exchange rate at 100 yen per dollar. • If the demand for dollars increases or the supply of dollars decreases, with no intervention the exchange rate will rise. To fix the exchange rate the Fed sells U.S. dollars so that it increases the supply of dollars and lowers the exchange rate. But the Fed will accumulate large stocks of the foreign reserves it is accepting in payment for the dollars. The People’s Bank of China pursued such a policy to hold down the value of the yuan and while so doing accumulated billions of dollars of U.S. dollars. Crawling Peg • A crawling peg policy selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate only the target value changes. The target changes whenever the central bank changes. .

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China is now currently using a crawling peg exchange rate policy for the yuan. The People’s Bank of China in the Foreign Exchange Market (Economics In Action Detail) • From 1997 until 2005, the People’s Bank of China fixed the Chinese exchange rate by selling yuan and buying dollars to offset the effects of increases in the demand for yuan. Between 2000 and 2014, China’s reserves increased by $3.7 trillion. • Since 2005, the People’s Bank has allowed the yuan to crawl. Initially the Yuan crawled slowly upward until 2014, after which it moved slowly downward for a few years. Since then it has fluctuated with no clear direction. IV.

Financing International Trade

Balance of Payments Accounts • A country’s balance of payments accounts records its international trading, borrowing, and lending. There are three balance of payments accounts: • The current account records payments for imports of goods and services from abroad, receipts for exports of goods and services sold abroad, net interest income paid abroad, and net transfers (such as foreign aid payment). The current account balance equals exports plus net interest income plus net transfers minus imports. • The capital account records foreign investment in the United States minus U.S. investment abroad. Any statistical discrepancy is included in this account. • The official settlements account records the change in U.S. official reserves, which are the government’s holdings of foreign currency. An increase in foreign reserves corresponds to a negative official settlements account balance. This occurs because holding foreign currency is like (but not the same as) investing abroad, which is a negative entry in the capital account. • The sum of the balances always equals zero: current account + capital account + official settlements account = 0. • In 2020, the U.S. current account balance was negative and almost entirely offset by a positive capital account balance. Over time, the current account balance tends to mirror the capital account balance because the official settlements account balance is small. Borrowers and Lenders Because of current account deficits and surpluses, countries, like individuals, can be borrowers or lenders. • A country that is borrowing more from the rest of the world than it is lending to it is a net borrower. A net lender is a country that is lending more to the rest of the world than it is borrowing from the rest of the world. The United States currently is net borrower. Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

The Global Loanable Funds Market Demand and Supply in Global and National Markets • Demand and supply in the world global loanable funds market determines the world equilibrium real interest rate. • A country is a net foreign borrower if the world equilibrium real interest rate is less than what would be the no-trade interest rate in the country. The figure shows this situation. • In the figure, when the country is isolated from international trade the equilibrium real interest rate would be 6 percent and the equilibrium quantity of loanable funds would be $1.6 trillion. • With international trade, the real interest rate in the country becomes the world real interest rate, 5 percent. At this lower real interest rate, the quantity of loanable funds supplied decreases to $1.4 trillion and the quantity of loanable funds demanded increases to $1.8 trillion. The difference, $0.4 trillion, is borrowed from abroad. The country has negative net exports, with X < M.

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•

A country is a net foreign lender if the world equilibrium real interest rate exceeds what would be the no-trade interest rate in the country. The figure shows this situation. • In the figure, when the country is isolated from international trade the equilibrium real interest rate would be 4 percent and the equilibrium quantity of loanable funds would be $1.6 trillion. • With international trade, the real interest rate in the country becomes the world real interest rate, 5 percent. At this higher real interest rate, the quantity of loanable funds supplied increases to $1.8 trillion and the quantity of loanable funds demanded decreases to $1.4 trillion. The difference, $0.4 trillion, is loaned abroad. The country has positive net exports, with X > M. In a small country, changes in the national demand and supply of loanable funds change the country’s international loaning or borrowing and will change the country’s net exports.

Debtors and Creditors • A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. A creditor nation is a country that during its entire history has invested more in the rest of the world than other countries have invested in it. The United States currently is debtor nation. • The net borrower/net lender difference refers to the current flow of borrowing or lending over a period of time. The debtor nation/creditor nation refers to the stock of debt or foreign assets that exists at a moment in time. The analogy of a country being like an individual in terms of being a borrower or lender is revealing. However, you may want to point out a big difference in lifespan. Long periods of deficit seem bad for an individual, but are short when you are expected to live forever. Much economic activity and development would be impossible without borrowing and lending. This is true at the individual level and for countries. The key is what the debt is being spent on. The United States financed its industrialization and railroads in the nineteenth century by being a debtor nation. Current Account Balance and Net Exports • The current account balance (CAB) is: CAB = X − M + Net interest income + Net transfers • The main item in the current account balance is net exports (X − M). The other two items are much smaller and don’t fluctuate much. • The national accounts show that Y = C + I + G + X − M and also that Y = C + S + T. These two relationships can be equated and rearranged to give (X − M) = (S − I) + (T − G). In this formula, • (X − M) is net exports, exports of goods and services minus imports of goods and .

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

services. (S − I) is the private sector balance, saving minus investment. (T − G) is the government sector balance, net taxes minus government expenditures on goods and services. The formula shows that net exports equal the sum of the private sector balance and the government sector balance. There is a strong tendency for the private sector balance and the government sector balance to move in opposite directions, which means that the relationship between net exports and the other two sectors taken individually is not a strong one. • •

•

Where Is the Exchange Rate? In the short run, a change in the nominal exchange rate changes the real exchange rate and affects the U.S. current account balance. In the long run, a change in the nominal exchange rate leaves the real exchange rate unaffected and so in the long the nominal exchange rate plays no role in determining the current account balance. The concluding Economics in the News discusses currency manipulation. Students often find this topic interesting, and the fact that Switzerland may be manipulating its currency is likely to take them by surprise. Regardless, the article describes the issues and then this is analyzed using the material from the chapter.

100

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Additional Problems 1.

The Dollar’s Short-Lived Comeback The dollar fell to record lows against the euro in April. Over the next month the exchange rate rose because traders began to expect that the Federal Reserve was not going to cut U.S. interest rates any further. CNN, May 16, 2008 Explain how expectations that the Federal Reserve will not cut the interest rate can make the dollar appreciate.

Suppose that traders in the foreign exchange market come to believe that the U.S. exchange rate will rise over the next few months. How does this belief affect the demand for U.S. dollars and the supply of U.S. dollars? What is the impact of this belief on the current exchange rate? Draw a graph of the foreign exchange market to illustrate your answer.

A country has a lower inflation rate than all other countries. It has more rapid economic growth. The central bank does not intervene in the foreign exchange market. What can you say (and why) about: a. The exchange rate? b. The current account balance? c. The expected exchange rate? d. The interest rate differential? e. Interest rate parity? f. Purchasing power parity?

Solutions to Additional Problems 1.

If traders come to believe that the Federal Reserve will not cut interest rates, the interest rate in the future will be higher than previously expected. With the higher future U.S. interest rate, the future U.S. interest rate differential will also be higher. In turn, the higher future U.S. interest rate differential will raise the future U.S. exchange rate. Finally, the expected higher future U.S. exchange rate increases the current demand for U.S. dollars and decreases the current supply, thereby raising the current exchange rate and appreciating the dollar.

The rise in the expected future exchange rate increases the expected profit from holding dollars. The increase in expected profit increases the current demand for U.S. dollars and decreases the current supply of U.S. dollars. The current exchange rate rises. Figure 9.1 shows the effect on the foreign exchange market of the change in traders’ beliefs. The demand increases so the demand curve for dollars shifts rightward from D0 to D1. The supply curve of dollars shifts leftward from S0 to S1. The dollar immediately appreciates, rising in the figure .

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from 110 yen per dollar to 120 yen per dollar.

3. a. The exchange rate most likely rises—the currency appreciates. The reason is that to preserve purchasing power parity, the lower inflation rate means that the currency must appreciate. b. The current account balance depends on domestic investment relative to national saving. The balance could be positive or negative. Possibly with more rapid growth, investment in the country is high and so the current account might be in deficit. c. The exchange rate will be expected to appreciate so the expected future exchange rate is higher than the current exchange rate. d. The interest rate differential is negative. The interest rates in other countries exceed the domestic interest rate by an amount equal to the expected exchange rate appreciation. e. Interest rate parity holds every day. If it did not, large above-average profits would be available. Such profit opportunities do not go unexploited. f. Purchasing power parity probably doesn’t hold every day, but does hold on the average in the long run.

Additional Discussion Questions

1. In 2007−2008, the nominal exchange rate of U.S. dollars declined relative to both the Japanese yen and the European euro. What would you need to know about the U.S. economy to determine whether this would be a benefit or a problem for the U.S. economy? Point out that the United States was just starting to enter a recession in 2008, as potentially was Japan and most of Europe. The Federal Reserve was ahead of other central banks in responding to the recession by lowering the interest rate before the other central banks took action. By lowering the U.S. interest rate, the U.S. interest rate differential decreased, which decreased the demand for U.S. dollars, increased the supply of U.S. dollars, and forced the exchange rate lower. By lowering the U.S. exchange rate, U.S. exports increased, which helped keep the U.S. economy stronger than otherwise would have been the case. 2. When the Federal Reserve Chairman Ben Bernanke repeatedly decreased the interest rate during late 2008, he was attempting to stimulate the U.S. economy by lowering the interest rates in the U.S. financial markets and lowering the cost of employing productive capital. What impact did this policy have on the exchange rates in the foreign exchange markets, all else equal? The fall in U.S. interest rates means that the U.S. interest rate differential falls. The fall in the interest rate differential increases the supply of dollars to the foreign currency exchange market, shifting the supply curve of dollars rightward. It also decreases .

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the demand for dollars, shifting the demand curve for dollars leftward. With no other changes, the equilibrium exchange rate for dollars falls. As it happened, however, other factors were not equal. In late 2008 other central banks also lowered their interest rates. And apparently investors believed that the United States had less default risk than other countries. So on net the demand for dollars actually increased and the supply decreased so that the U.S. exchange rate rose. But the increase would have been significantly greater had it not been for the actions of the Federal Reserve. 3. Due to the Covid recession of 2020, the U.S. government budget changed from smaller deficits to very large deficits. What impact would this have on the net exports and private sector balances, all else equal? The three balances are related: Net exports equal the sum of government and private sector balances. If the private sector balance does not change, the net export deficit will increase. However if the private sector surplus were to increase substantially, the net export deficit might decrease.

C h a p t e r

AGGREGATE SUPPLY AND AGGREGATE DEMAND**

The Big Picture Where we have been: This chapter provides the work horse model, the aggregate supply-aggregate demand model, used to explore answers to the questions about short-run macroeconomic issues. The chapter uses the fact established in Chapter 4, that expenditure equals C + I + G + (X – M), to explain the forces that determine aggregate demand. It also draws on Chapter 3, demand and supply, for the crucial concepts of equilibrium and the distinction between shifts and movements along demand and supply curves. Where we are going: This chapter provides a description of the AS-AD model. The treatment parallels that of the demand and supply model in Chapter 3. That is, the curves are defined and the reasons for their slopes and the factors that shift them are explained. But the curves are not formally derived. The next chapter more formally derives the aggregate demand curve from the aggregate expenditure curve. It lays out the aggregate expenditure model, explains the multiplier effect of changes in investment, describes the adjustment process that moves the economy toward the AD curve, and derives the AD curve from the AE equilibrium. Then Chapters 12, 13, and 14 make use of the aggregate supply-aggregate supply framework to explore business cycles and inflation, fiscal policy, and monetary policy.

New in the Fourteenth Edition

All the data are updated through 2021 and the long-run equilibrium value in the figures is now $20 trillion to stay closer to the current U.S. economy. The concluding Economics In The News feature has a discussion and analysis of the two-month recession caused by Covid-19.

* This is Chapter 27 in Economics. .

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Lecture Notes

Aggregate Supply and Aggregate Demand • •

The aggregate supply-aggregate demand (AS-AD) model explains how real GDP and the price level are determined. The model also helps explains the factors that determine inflation and the business cycle.

Tell students that there is heated debate among economists on the most important influences in the macro economy and how to model those influences. Economists as a group are ambivalent about the aggregate supply-aggregate demand (AS-AD) model. Real business cycle theorists, who like to build their models from the base of production functions and preferences, don’t use the model because the AS and AD curves are not independent. Technological change shifts both the AS and AD curves simultaneously and in complicated ways. New Keynesian economists have dropped the model in favor of a dynamic variant that places the inflation rate on the y-axis and the output gap (real GDP minus potential GDP as a percentage of potential GDP) on the x-axis. Despite the controversy, the AS-AD model is the key macroeconomic model for most economists. The model plays a similar role in the organization of the macroeconomics to that played by the demand and supply model in microeconomics. The author does a good job of using the AS-AD model to explain various schools of thought. The AS-AD model is the best model currently available for introducing students to macroeconomics. It enables them to gain insights into the way the economy works, to organize their study of the subject, and to understand the debates surrounding the effects of policies designed to improve macroeconomic performance. Devoting at least a week of lecture time to the AS-AD model is worthwhile. Your goal at this point in the course is to help them understand the components of the model intuitively and to put the model to work using some of its more simple and obvious features. I.

Aggregate Supply The quantity of real GDP supplied is the total quantity of goods and services, valued in constant dollar prices, that firms plan to produce in a given time period. This amount depends on the quantity of labor employed, the capital stock, and the state of technology. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP.

Long-Run Aggregate Supply • The long-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP. As illustrated in the figure, the LAS curve is vertical at the level of potential GDP ($20 trillion in the figure), showing that potential GDP does not depend on the specific price level. • In the long run, the wage rate and other resource prices change in proportion to the price .

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level. So moving along the LAS curve both the price level and the money wage rate change by the same percentage. Short-Run Aggregate Supply • The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the short run when the money wage rate, the prices of other resources, and potential GDP remain constant. • As illustrated in the figure, the SAS curve is upward sloping. This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, thereby increasing the quantity of labor firms employ and hence increasing the real GDP firms produce. Difference between LAS and SAS: The distinction between the LAS and the SAS comes about by assuming that resource and output prices adjust at different rates. Ask the class, “When there is an increase in demand, what do you think adjusts first, prices of goods on the shelves at Walmart or wages of employees at Walmart?” By discussing out the potential lag times in resource price adjustment, you have opened up a hotly contested item among economists. How long is that lag time? Tell the students that there are different schools of thought about this issue and during the term we will see how different assumptions yield different answers. Movements Along the LAS and SAS Curves and Changes in Aggregate Supply Movements Along the Curves

• •

When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along the LAS curve. When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the SAS curve.

Shifts in the Curves

• •

When potential GDP increases, both long-run and short-run aggregate supply increase and the LAS and SAS curves shift rightward. Potential GDP increases when the full employment quantity of labor increases, the quantity of capital increases, or technology advances. Short-run aggregate supply changes and the SAS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the SAS curve leftward.

The flavor of the Classical-Keynesian controversy. If you want to convey the flavor of one of the biggest controversies in macroeconomics, you can do so at this early stage of the course by using only the aggregate supply curves. The difference between the upward-sloping SAS and the vertical LAS lies at the core of the disagreement between Classical economists who believe that wages and prices are highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in particular adjusts very slowly. Along the SAS curve: You cannot repeat yourself too many times about this topic: Moving along the SAS curve, resource prices are fixed. Point out that this is the same assumption for the “micro” supply curve. In particular, if there is an increase in the money wage rate at the Pepsi .

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plant, the supply curve for Pepsi shifts leftward. That same principle gets applied to all goods and services in the AS-AD model so an increase in the money wage rate shifts the SAS curve leftward. Along the LAS curve: Students seem comfortable with the idea that the SAS curve has a positive slope, but they seem less at ease with the vertical LAS curve. Emphasize (as the textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices of output and the prices of resources, especially the money wage rate. Once they get this point, students quickly catch on to the result that firms won’t be motivated to change their production levels along the LAS curve. The vertical LAS curve is both vital and difficult and class time spent on this concept is well justified. Though you do not “need” to emphasize this point, what the LAS curve illustrates is that the real economy is independent of money prices! II. Aggregate Demand • The quantity of real GDP demanded is the sum of consumption expenditure (C), investment (I), government expenditure (G), and net exports (X − M), or Y = C + I + G + (X − M). • Buying plans depend on many factors including: • The price level • Expectations • Fiscal policy and monetary policy • The world economy The Aggregate Demand Curve • Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. The relationship between the quantity of real GDP demanded and the price level is called aggregate demand. As the figure shows, the AD curve is downward sloping. • The negative relationship between the price level and the quantity of real GDP demanded reflects the wealth effect (when the price level rises, real wealth decreases and so people decrease consumption) and substitution effects (first, the intertemporal substitution effect: when the price level rises, real money decreases and the interest rates rises so that consumption expenditure and investment decrease; and, second, the international price substitution effect: when the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded). Keep it simple. You know that the AD curve is a subtle object—an equilibrium relationship derived from simultaneous equilibrium in the goods market and the money market. This description of the AD curve is not helpful to students in the principles course and is a topic for the intermediate macro course. At the same time that we want to simplify the aggregate demand .

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story, we also want to avoid being misleading. The textbook walks that fine line, and we suggest that you stick closely to the textbook treatment and don’t try to convey the more subtle aspects of aggregate demand. A major problem with the AD curve is that a change in the price level that brings a movement along the curve is not a strict ceteris paribus event. A change in the price level changes the quantity of real money, which changes the interest rate. Indeed, this chain of events is one of the reasons for the negative slope of the AD curve. In telling this story, we must be sensitive to the fact that the students don’t totally appreciate the ceteris paribus condition. We must provide intuition with stories such as the Maria stories in the textbook. Income equals expenditure on the AD curve. Some instructors want to emphasize a second and more subtle violation of ceteris paribus, that along the AD curve, aggregate planned expenditure equals real GDP. That is, the AD curve is not drawn for a given level of income but for the varying level of income that equals the level of planned expenditure. If you want to make this point when you first introduce the AD curve, you must cover the AE model in the next chapter before you cover this chapter. (The material is written in a way that permits this change of order.) If you do not want to derive the AD curve from the equilibrium of the AE model, don’t even mention what’s going on with income along the AD curve. Silence is vastly better than confusion. You can pull this rabbit out of the hat when you get to the next chapter if you’re covering the material in the order presented in the textbook. Changes in Aggregate Demand • Any factor that influences buying plans other than the price level brings a change in aggregate demand and a shift in the aggregate demand curve. Factors that change aggregate demand are: • Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward. • Fiscal policy and monetary policy: The government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy. Tax cuts or increased transfer payments increase disposable income (aggregate income minus tax payments plus transfers) and thereby increase consumption expenditure and aggregate demand. Increased government expenditures increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand. • The world economy: Exchange rates and foreign income affect net exports (X − M) and, therefore, aggregate demand. A decrease in the exchange rate or an increase in foreign income increases aggregate demand. An Economics in Action feature discusses the “World Economy Tailwinds”—more rapid real GDP growth in other countries and a depreciating dollar in 2021—that increased U.S. exports and thereby increased U.S. aggregate demand.

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III. Explaining Macroeconomic Trends and Fluctuations Short-Run and Long-Run Macroeconomic Equilibrium • Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. This equilibrium is determined where the AD and SAS curves intersect. • If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices. • If the quantity of real demanded exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices. Short-run macroeconomic equilibrium. Emphasize that in short-run macroeconomic equilibrium, firms are producing the quantities that maximize profit and everyone is spending the amount that they want to spend. Describe the convergence process using the mechanism laid out in the textbook. In that process, firms always produce the profit-maximizing quantities—the economy is on the SAS curve. If they can’t sell everything they produce, firms lower prices and cut production. Similarly, they can’t keep up with sales and inventories are falling, firms raise prices and increase production. These adjustment processes continues until firms are selling their profit-maximizing output. •

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP— equivalently, as the figure shows, when the economy is on its long-run aggregate supply curve. The figure shows the long-run macroeconomic equilibrium at a real GDP of $20 trillion and a price level of 110.

From the short run to the long run. Explain that market forces move the money wage rate to the longrun equilibrium level. At money wage rates below the long-run equilibrium level, there is a shortage of labor, so the money wage rate rises and employment decreases. At money wage rates above the long-run equilibrium level, there is a surplus of labor, so the money wage rate falls and employment increases. At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labor and the money wage rate remains constant and employment is constant at its full employment level. Economic Growth and Inflation • Economic growth occurs when potential GDP increases so that the LAS curve shifts rightward. .

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Inflation occurs when the AD curve continually shifts rightward at a faster rate than the LAS curve. In the long run, only growth in the quantity of money makes the AD curve continually shift rightward.

The Business Cycle The business cycle occurs because aggregate demand and aggregate supply fluctuate and the money wage rate does not adjust quickly enough to keep the economy at potential GDP. • A below full-employment equilibrium is a macroeconomic equilibrium in which potential GDP exceeds real GDP. The gap between real GDP and potential GDP is the output gap. With a below-full employment equilibrium, the gap is called a recessionary gap. A recessionary gap occurs when the SAS curve and the AD curve intersect to the left of the LAS curve. • An above full-employment equilibrium is a macroeconomic equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP, the output gap, is called an inflationary gap. An inflationary gap occurs when the SAS curve and the AD curve intersect to the right of the LAS curve. • A full-employment equilibrium is a macroeconomic equilibrium in which real GDP equals potential GDP. • The figure below to the left shows a below-full employment equilibrium with a recessionary gap of $1 trillion. The figure on the right shows an above full-employment equilibrium with an inflationary gap of $1 trillion.

Point out to the students that to simplify analysis of the business cycle, economists typically abstract from the long-term persisting increases in the LAS curve and AD curve that generate economic growth and inflation, respectively. So, by fixing the LAS curve when considering business cycle fluctuations, economists are looking at short-term movements around a slower moving long-run equilibrium level of output. Explain to the students that one reason to abstract from these long-term movements is simply that the figures get very complicated if all the curves shift rather than just the immediately relevant ones. A second reason is the standard view that short-term movements around the LAS are driven by different economic forces than the .

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persisting long-run shifts in the LAS curve. So abstracting from long-term growth in order to focus on business cycle fluctuations simplifies matters without any loss of relevant details.

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Fluctuations in Aggregate Demand An increase in aggregate demand shifts the AD curve rightward, as in the figure where the aggregate demand curve shifts from AD0 to AD1. In the short run, a rightward shift of the AD curve leads to movement along the SAS curve so that both the price level and real GDP increase. In the figure the economy moves from an initial equilibrium at point a with real GDP equal to potential GDP of $20 trillion and a price level of 100 to point b with real GDP of $21 trillion and a price level of 105. But in the long run, the higher price level and tight labor market lead to an increase in the money wage rate. Short-run aggregate supply decreases and the SAS curve shifts leftward, in the figure from SAS0 to SAS1. The long-run equilibrium is reached when the short-run aggregate supply has decreased enough so that the economy is back producing at potential GDP, which in the figure occurs when the economy moves from b to point c. In the long run, the increase in aggregate demand has no effect on real GDP—it has returned to potential GDP, $20 trillion in the figure--and only results in a higher price level— which has risen from 100 to 110 in the figure. Shifting the SAS curve. Reinforce the movement toward long-run equilibrium with a curveshifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium occurs where the new AD curve intersects the SAS curve is not difficult. But the notion that the SAS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the SAS so that the students realize that wages and other input prices remain constant along an SAS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of (output) prices, the SAS curve shifts leftward. Avoid confusing students by using “up” to correspond to a decrease in SAS. But do point out that that when the SAS curve shifts leftward it is moving vertically upward, as input prices rise to become consistent with potential GDP and the new long-run equilibrium price level. Most students find it easier to see why the SAS curve shifts leftward once they see that rising input prices shift the curve vertically upward. In the figure above, instead of using identifying the short-run aggregate supply curve with SAS0 you might use SASW = $20 with the explanation that along this SAS curve the money wage rate, W, is fixed at $20/hour. Then, rather than label the new short-run aggregate supply curve SAS1, can identify it as SASW = $22. You can now show your students the qualitative point that the money wage rate has increased and you can show them the quantitative point that the 10 percent increase in the price level (from 100 to 110) lead to a 10 percent increase in the money wage rate. Fluctuations in Aggregate Supply Some business cycle fluctuations are driven by shifts in short-run aggregate supply. An increase in .

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energy prices decreases the short-run aggregate supply and shifts the SAS curve leftward. The price level increases and real GDP decreases. The combination of recession and higher inflation is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks. IV. Macroeconomic Schools of Thought There is a fair degree of consensus among mainstream economists about economic growth and inflation, although there is still immense debate about the business cycle. The importance of macroeconomic issues and the complexities of economic systems mean that there are strong incentives to speak knowledgeably about macroeconomics, but it is difficult for most people to evaluate whether the speaker is truly knowledgeable or a charlatan. Mainstream economic theories are completely thought out and fully articulated. Thus, one should be wary of anyone who confidently rejects that one of these mainstream theories as “just plain wrong.” The Classical View • A classical macroeconomist believes that the economy is self-regulating and that it is always at full employment. A new classical view is that business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change. • The uneven pace of technological advancement are the main source of business cycle fluctuations. There is no distinct short-run aggregate supply curve because the economy is always producing at potential GDP. • Classical economists emphasize that taxes blunt people’s incentives to work, so the most the government should do to affect the business cycle is to keep taxes low. The Keynesian View • A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required. • Aggregate demand fluctuations driven by changes in expectations (“animal spirits”) about business conditions and profits are the main source of business cycle fluctuations. Because money wages are sticky (slow to adjust), especially in the downward direction, the economy can remain mired in a recession. • A modern version of the Keynesian view known as the new Keynesian view holds that not only is the money wage rate sticky but that the prices of some goods and services are also sticky. • Keynesians believe that fiscal policy and monetary policy should be used actively to stimulate demand to end recessions and restore full employment. Although Keynes agreed that the economy would return to its potential in the long run, he stated, “In the long run, we are all dead”. Keynes believed that because of the interaction between financial markets, the price level, and the labor market, there was no inherent tendency of the market system to return quick enough to potential GDP following an aggregate demand shock. The role of the government, in Keynes’ view, was not to replace markets with central planning, but to use stabilization policies to help the macroeconomy find equilibrium at potential GDP. Keynes’ analogy was that market capitalism in the Great Depression was like a .

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car with a broken alternator. Fiscal policy would give the economy a jump-start when aggregate demand was inadequate. Keynes worried that without active aggregate demand management, high unemployment would lead to a breakdown of capitalism, with revolution leading to totalitarianism in the form of communism or fascism. The Monetarist View • A monetarist macroeconomist believes that the economy is self-regulating and that it will normally operate at full employment provided that monetary policy is not erratic and that the pace of money growth is kept steady. • Aggregate demand fluctuations driven by monetary policy mistakes are the main source of business cycle fluctuations. • There is a short-run aggregate supply curve because money wages are sticky. • The monetarist view of policy is that tax rates should be kept low and the quantity of money should be kept growing on a steady path. Beyond these policies, however, the government should not undertake active stabilization policy. The concluding Economics in the News discusses and uses the AS-AD model to analyze the twomonth recession caused by the Covid-19 pandemic.

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Additional

Problems

Explain and draw a graph to illustrate how a depreciation of the dollar changes the shortrun equilibrium real GDP and price level.

Suppose the government creates a fiscal stimulus by sending people checks representing temporary tax cuts. a. Explain and draw a graph to illustrate the effect of this fiscal stimulus payments on real GDP and the price level in the short run. b. At which type of short-run equilibrium would the government want to use this policy? c. Which macroeconomic school of thought would justify this policy? d. If the government used this policy when the economy was at full employment, explain what would happen in the long run. e. Draw a graph to illustrate your answer to d.

What is stagflation? Explain how the increase in the price of oil can cause stagflation and draw a graph to illustrate this outcome.

Solutions 1.

Additional

The depreciation of the dollar increases U.S. net exports, which increases U.S. aggregate demand. The increase in aggregate demand increases real GDP and raises the price level. These changes are illustrated in Figure 10.1. In this figure the aggregate demand curve shifts rightward from AD0 to AD1. As a result, zreal GDP increases, from $20.0 trillion to $20.2 trillion, and the price level rises, from 119 to 121.

Problems

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2. a. The fiscal stimulus check increased households’ consumer expenditure. The increase in consumption expenditure boosted aggregate demand so the aggregate demand curve shifted rightward. Figure 10.2 shows the effect of this change. The aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, in the figure from $20.0 trillion to $20.1 trillion, and the price level rises, in the figure from 119 to 121. b. The government wants to use this type of policy when the economy is in a below fullemployment equilibrium with a recessionary gap. c. Keynesian economists would support this policy. d. If this stimulus policy was used when the economy was at full employment, in the short run the price rises and real GDP increases. But in the long run the money wage rate rises to reflect the higher price level. The rise in the money wage rate decreases short-run aggregate supply. Ultimately in the long run real GDP returns to potential GDP so there is no long-run change in real GDP. The price level, however, rises as short-run aggregate supply decreases. So the price level in the long-run is higher than in the short run. e. Figure 10.3 shows the long-run changes described in the previous answer. After the initial shift in the aggregate demand curve from AD0 to AD1, the price level has risen. As a result, the money wage rate rises so that the short-run aggregate supply curve shifts leftward, in the figure from SAS0 to SAS1. In turn the price level rises still more, in the figure ultimately to 122. Real GDP, however, decreases and eventually returns to its initial level, which is potential GDP and in the figure is $20.0 trillion.

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Stagflation is the combination of recession and inflation. Increases in the price of oil can decrease aggregate supply. The decrease in aggregate supply raises the price level—so there is inflation—and decreases real GDP—so there is a recession. Figure 10.4 illustrates these results. In this figure the aggregate supply curve shifts leftward from AS0 to AS1. As a result real GDP decreases from $20.0 trillion to $19.8 trillion and the price level rises, from 118 to 120.

Additional Discussion Questions 11. “The demand curves for all products have negative slopes. For instance, the demand curves for milk, automobiles, personal computers, and shirts all have negative slopes. Therefore, because the aggregate demand curve shows the demand for all products, it too must have a negative slope.” Comment on this assertion. The assertion is incorrect. Demand curves for goods and services such as milk and so forth have negative slopes because the price measured along the vertical axis is a relative price; that is, it is the price of the good or service relative to the price of another good or service. As a result, the demand curve for these goods or services captures the possibility of substitution: A higher price for a gallon of milk causes consumers to substitute away from milk and toward other beverages, such as water or soda, whose price has not risen. The price level, which is the variable along the vertical axis for the aggregate demand curve, is not a relative price. It is the average of all prices. When the price level rises, all domestic prices have risen so the only substitution possibility is toward imported goods and over time (the intertemporal substitution effect). These substitutions offer reasons why the aggregate demand curve has a negative slope. Another, possibly more important reason for the negative slope is the wealth effect: When the price level rises and nothing else changes, people’s real wealth decreases. When real wealth decreases, people’s consumption expenditure decreases so that the aggregate quantity of goods and services demanded decreases. 12. Explain why the SAS curve slopes upward and the LAS curve is vertical. The SAS curve applies in the short run; the LAS curve applies in the long run. When the price level rises, firms find that the prices of the goods and services they produce have .

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risen. In the short run the money wage rate (and other costs) do not change. With higher prices and unchanged costs, firms find it profitable to increase their production. Hence in the short run the quantity of real GDP produced increases, which means that along the SAS curve a higher price level leads to an increase in the quantity of real GDP supplied. However in the long run money wage rates adjust to reflect the higher price level. In the long run the money wage rate and price level rise in the same proportion. In the long run, with both higher prices and higher costs, firms return to their initial level of production. Hence in the long run the quantity of real GDP produced does not change, which means that along the LAS curve a higher price level leads to no change in (potential) GDP. 13. When the equilibrium real GDP is below potential GDP, how does the unemployment rate compare with the natural rate? What is the result of this state of affairs that restores the long-run equilibrium? When real GDP is less than potential GDP, the unemployment rate exceeds the natural rate. In the labor market, the high unemployment rate forces the money wage rate lower. As the money wage rate falls, firms hire more workers and short-run aggregate supply increases. The increase in short-run aggregate supply increases real GDP. Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP. At this point, long-run equilibrium is reached and the money wage rate no longer falls so that all adjustments cease. 14. Explain how an increase in money wages affects the SAS curve. Why does a change in money wages affect only the SAS curve and not the LAS curve? An increase in the money wage rate means that firms’ costs have risen. At a given price level, the increase in their costs causes firms to decrease the quantity of goods and services they produce. The quantity of real GDP produced decreases and the SAS curve shifts leftward. The change in the money wage rate does not affect the quantity of production along the LAS curve because along that curve both the money wage rate and price level change in the same proportion. In other words, it is not possible to assume a given price level to investigate the effect of an increase in the money wage rate along the LAS curve because along that curve both variables change. And when both the price level and money wage rate change by the same proportion, firms will not change the quantity of real GDP they produce. 15. If the government spends more money by buying more goods and services, is this change an example of fiscal policy or monetary policy? When the government increases its expenditure by purchasing more goods and services, the government is engaging in fiscal policy. 16. What is a recessionary gap? How does the economy adjust to eliminate a recessionary gap? A recessionary gap occurs when actual real GDP is less than potential GDP. With a recessionary gap the unemployment rate exceeds the natural rate. In the labor market, the high unemployment rate forces the money wage rate lower. As the money wage rate falls, firms hire more workers and short-run aggregate supply increases. The increase in short-run aggregate supply increases real GDP. Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP. At this point, long-run equilibrium is reached and the money wage .

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rate stops falling so that short-run aggregate supply stops increasing.

C h a p t e r

EXPENDITURE MULTIPLIERS**

The Big Picture Where we have been: Chapter 11 uses the background provided in Chapters 4 and 10 to focus on aggregate expenditure and aggregate demand. It builds on the division of GDP into C + I + G + (X – M) explained in Chapter 4 and then derives the aggregate demand curve previously used in Chapter 10. Where we are going: Chapter 11 examines the details of the AS-AD model by focusing on the factors that determine the AD curve. The AD curve is important in all the core short-run macroeconomic chapters. The material in this chapter is used in Chapters 12-14 on the business cycle, fiscal policy, and monetary policy.

New in the Fourteenth Edition

The data in this chapter have been updated to reflect 2020 information. The content of this chapter is substantially the same as the 13th edition. As was assumed in the previous chapter, the long run equilibrium level of real GDP is $20 trillion. The Economics In The News feature reports the BEA statistics for 2017 with economic analysis using the Aggregate Expenditure model. Inventories along with other key macroeconomic variables are discussed. The end-of-chapter Economics in the News explores the effect of the Covid-19 pandemic on aggregate expenditure and GDP.

* This is Chapter 28 in Economics. .

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Lecture Notes

Expenditure Multipliers • • •

The Keynesian model focuses on the short run. In the Keynesian model, business cycle fluctuations are driven by changes in the components of aggregate expenditure, especially investment. The multiplier effect describes the amplified effect on real GDP from changes in expenditure.

Historical background. If you want to talk about Keynes and his contribution to economics, this is probably the best place to do it. The model, now generally called the aggregate expenditure model, presented in this section is the essence of Keynes General Theory. According to Don Patinkin, a leading historian of economic thought and Keynes scholar, the innovation of the General Theory was to replace price with income (GDP) as the equilibrating variable. This version of the model cannot be found in the General Theory, mainly because Keynes was writing before the national income accounting system had been developed. So he made up his own aggregates, based on employment and a money wage measure of the price level. But the words and equations of the General Theory can be translated readily into the textbook version of the model. This version of the model first appeared in The Elements of Economics, a textbook authored by Lorie Tarshis published in 1947. It was popularized by Paul Samuelson in the first edition of his celebrated text published in 1948. The main difference between the Keynesian cross model of the 1940s and the aggregate expenditure model of today is that from the 1940s through the mid-1960s, economists believed that the fixed price level assumption was an acceptable (if not exactly accurate) description of reality, so the model was seen as actually determining real GDP, and the multiplier was seen as an empirically relevant phenomenon. In contrast, today, we see the model as part of the aggregate demand story. The value of the model today—and it is valuable today and not, as some people claim, eclipsed by the AS-AD model and irrelevant—is that it explains the multiplier that translates a change in autonomous expenditure into a shift of the AD curve and it explains the multiplier convergence process that pulls the economy toward the AD curve. (When an unintended change in inventories occurs, the economy is off the AD curve but moving toward it.) I. Fixed Prices and Expenditure Plans The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and services. As a result, the price level is fixed and so aggregate demand determines real GDP. Expenditure Plans • Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports. • In the very short term, planned investment, planned government expenditure, and planned exports are fixed. Planned consumption expenditure and planned imports are not fixed, but depend on aggregate income. An increase in real GDP increases aggregate .

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expenditure and an increase in aggregate expenditure increases real GDP. Consumption Function and Saving Function • Consumption expenditure and saving depend on the real interest rate, disposable income, wealth, and expected future income. Disposable income is aggregate income minus taxes plus transfer payments. The relationship between consumption expenditure and disposable income, other things remaining the same, is called the consumption function. The relationship between saving and disposable income, other things remaining the same, is called the saving function.

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•

The figure shows a consumption function. Along the 45 degree line, consumption equals disposable income. When the consumption function is above the 45 degree line, there is dissaving. When the consumption function is below the 45 degree line, there is saving. The consumption expenditure when disposable income is zero, $4 trillion in the figure, is autonomous consumption. Consumption expenditure in excess of this amount is induced consumption.

The 45° line. Don’t assume that your students immediately understand the 45° line! Spend a bit of time explaining how to “read” it. Fundamentally, it shows all points where x = y. This line happens to be a 45° line when the scales along the x-axis and the y- axis are the same. Then point out that the horizontal distance to a point along the x-axis equals the vertical distance from that point to the 45° line. So at all points along the 45° line, x = y. If you wish, you can go on to show the students how the x = y line changes its appearance if we stretch or squeeze the scale on the y-axis holding the scale on the x-axis constant. Emphasize that x and y can be anything. In the figure above, x is disposable income and y is consumption expenditure; in the figure below, x is real GDP and y is aggregate planned expenditure. Marginal Propensities to Consume and Save • The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed, C/YD. The MPC is the slope of the consumption function, which is 0.67 in the figure. • The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved, S/YD. The MPS is the slope of the saving function. • The sum of the MPC plus the MPS equals 1.0. Marginal propensities. The text defines the MPC and MPS, and shows that they sum to one because disposable income can only be consumed or saved. Students generally relate to percentages better, so you can explain it as percent but stress that we use the decimal number for analytical purposes. Other Influences on Consumption Expenditure and Saving A change in any other factor influencing consumption and saving besides disposable income (such as the real interest rate, wealth, and expected future income) shifts the consumption function and the saving function. An increase in wealth or expected future income and a decrease in the real interest rate increases consumption—and shifts the consumption function upward—and decreases saving—and shifts the saving function downward. .

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The U.S. MPC is about 0.9. Since the 1960s, increases in expected future income and wealth have shifted the consumption function upward.

Consumption as a Function of Real GDP and the Import Function • For a given level of taxes and transfers, disposable income changes when real GDP changes, so consumption also is a function of real GDP. We use this observation when we derive the aggregate expenditure function. • Just as consumption of domestically produced goods and services depends on real GDP, so do imports. The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports. II. Real GDP with a Fixed Price Level

Real GDP (Y) 18.0 19.0 20.0 21.0

Consumption Government expenditure Investment expenditure Exports Imports (C) (I) (G) (X) (M)

14.2 15.1 16.0 16.9

(trillions of 2012 dollars) 2.0 2.0 1.0 2.0 2.0 1.0 2.0 2.0 1.0 2.0 2.0 1.0

0.8 0.9 1.0 1.1

Aggregate planned expenditure (AE=C+I+G+X−M) 18.4 19.2 20.0 21.8

Aggregate Planned Expenditure and Real GDP • Aggregate planned expenditure, AE, is the sum of planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports. The above table shows the calculation of an aggregate planned expenditure schedule. The figure shows the resulting AE curve. • Consumption expenditure minus imports vary with real GDP and are induced expenditure. The sum of investment, government expenditures, and exports do not vary with real GDP and are autonomous expenditure. Consumption expenditure and imports also have an autonomous component. • Actual expenditure can differ from planned expenditure because firms do not always sell .

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what they plan to, in which case they have unplanned inventory investment. For instance, a car that is manufactured but not immediately sold is part of that firm’s actual inventory investment regardless of whether the firm planned to add it to inventory or not. Equilibrium Expenditure and Convergence to the Equilibrium • Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. In the figure, equilibrium expenditure is $20 trillion. • If aggregate expenditure does not equal its equilibrium, forces lead to convergence. For example, if real GDP exceeds aggregate planned expenditure, firms find their inventories are increasing more than planned. The unplanned inventory accumulation leads firms to cut production so that real GDP decreases, which decreases aggregate planned expenditures. Real GDP still exceeds aggregate planned expenditure, but by less than before. The process continues until real GDP equals aggregate planned expenditure so that there is no unplanned inventory accumulation. III. The Multiplier • The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP. • When there is an autonomous change in a component of expenditure such as investment, additional changes in aggregate expenditure are set in motion. Because of the feedback between real GDP and consumption expenditure, the total change in real GDP is larger than the initial change in autonomous expenditure. • The multiplier effect operates for a decrease as well as an increase in autonomous expenditure. Work through an example of a change in government spending. Suppose there are no taxes, no imports, no exports and the MPC is 0.9. If the government purchases $5 billion of weapons from Nuc’s-R-US, what happens to that spending? Nuc’s has to pay all of its employees, subcontractors and material suppliers among other costs. These costs to Nuc’s turn into income (Y) for others (remind your students of the circular flow). These other people are going to consume 90 percent of that income, $45 billion, at stores such as JCPenney. Now JCPenney must pay its costs, which again turns into other people’s income, of which 90 percent again gets spent again ($40.5 billion) and so on and so on and so on… Explain to the students that we have a short-cut to explain this iterative process and capture the total change in income (Y) from the change in government spending (G). That short-cut is the multiplier, which shows that the change in GDP is given by GDP = 1/(1 − MPC) × G Why is the Multiplier Greater Than 1? An increase in autonomous expenditure increases real GDP and the increase in real GDP induces an additional increase in aggregate expenditure (primarily an increase in consumption expenditure). Each additional increase in aggregate expenditure increases real GDP further, leading to yet further increases in aggregate expenditure. The process converges because the increase in aggregate expenditure is smaller at each step of the process. The Multiplier and the Marginal Propensities to Consume and Save • The change in real GDP can be divided into the change in induced expenditure plus the .

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change in autonomous expenditure, Y = N + A, where Y is real GDP, N is induced expenditures, and A is autonomous expenditure. The slope of the AE curve = N÷Y, so N = (slope of AE curve) Y. Using this equality in the previous formula shows Y = (slope of AE curve) Y + A. Solving for the change in GDP, Y, gives Y =  A. This last result shows that the multiplier equals. • •

. In the previous

figure, the slope of the AE curve is 0.8, so the multiplier is 5.0. If there are no imports or income taxes, the slope of AE curve equals the MPC so the multiplier equals or, equivalently, . The size of the multiplier depends on the MPC and the MPS. The smaller the MPC or, equivalently, the larger the MPS, the smaller the increase in expenditure at each step of the multiplier process and so the smaller the multiplier.

The basic idea and practice. Students need quite a lot of practice using multipliers. One good problem involves working out the effects on consumption as well as on GDP of a change in investment (when the price level is fixed). The best way to present this problem to the students seems to be sequentially. Begin by giving them the data necessary to deduce how real GDP changes from an increase in investment. Tell them there is no foreign trade, so that there are no exports or imports, and no income taxes. Tell them that the marginal propensity to consume is b (pick any valid number you like), and that investment has changed by I (pick any valid number you like). Then, after the students have computed the change in GDP, ask them what the change in consumption expenditure is. Review their attempts to answer this question as follows: The change in GDP, Y, is given by the equation: Y = C + I. Given I from the initial statement of the problem and Y from the first set of calculations, the students can readily calculate C. Focusing the students’ attention on the change in consumption is important because it reinforces the point that a change in autonomous expenditure (investment in this example) leads to an induced change in consumption expenditure and that this increase in consumption expenditure is the source of the multiplier. An Economics in Action detail analyzes the multiplier in the Great Depression. The analysis concludes that the multiplier during that episode in history equaled 1.6. The Effect of Imports and Income Taxes on the Multiplier; Business Cycle Turning Points • Imports and income taxes both mean that the increase in expenditure on domestic production will be smaller at each step of the multiplier process and so the multiplier is smaller. • An unexpected decrease in autonomous expenditure is signaled by a buildup of unplanned inventories. The buildup in inventories sets the multiplier process in motion that decreases aggregate expenditure and real GDP so that a recession follows. • An unexpected increase in autonomous expenditure is signaled by an unwanted depletion of inventories. The depletion in inventories sets the multiplier process in motion and an expansion follows. .

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The idea that prices are fixed, even in the very short run, is controversial in economics. However, the fact that changes in inventories have long been a good leading indicator of business cycles is less controversial. IV. The Multiplier and the Price Level In the short run, when firms find their inventories changing in an unexpected fashion, they change their production not their prices. But eventually they also change prices. To study the determination of the price level and real GDP the AS-AD model must be used. The AD curve is related to the AE curve. The Aggregate Expenditure Curve and the Aggregate Demand Curve • The AE curve is the relationship between aggregate planned expenditures and real GDP, all other influences (such as the price level) remaining the same. The AD curve is the relationship between the aggregate quantity of goods and services demanded and the price level. When the price level changes, the AE curve shifts and there is a movement along the AD curve. • A change in the price level has two effects on consumption expenditure: • Wealth Effect: A rise in the price level decreases the purchasing power of consumers’ real wealth, which decreases their consumption expenditures. • Substitution Effects: A rise in the price level makes purchasing today more expensive relative to the future (an intertemporal substitution effect). It also makes U.S. goods and services more expensive relative to imports (an international substitution effect). The multiplier and the price level: Emphasize the key point of this section: That the AE model and the multiplier tell us how far the AD curve shifts when autonomous expenditure changes. It is through the multiplier process that expenditure and GDP respond to unplanned changes in inventories. I like to draw out the model with AE curve on top and the AD and AS curves on the bottom. Then: 1. Shift AE curve upward by change in G. 2. Show the larger change in Y due to multiplier. 3. Shift the AD curve rightward by an amount equal to the change in Y holding the price level constant. Ask the students, “Will the economy get the full change in Y?” They will see that in that the upward sloping SAS curve means that there is an increase in the price level, lowering the multiplier effect. 4. Next, show them the price level effect in the AE graph (a smaller downward shift in the AE curve). Now ask them, “How big is the multiplier in the long run?” You should be able to get a few to mumble “Zero”. So, tell them the conclusion: There is no multiplier in the long run! If the long run is not so long, then it is questionable to increase G in order to increase Y. Students appreciate learning about the tension in economics surrounding this issue since it relates well with politics too.

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The mechanics of the relationship between the AE and AD curves. Students need a lot of help and clear explanation of the mechanics of the link between these two curves. Here’s what to stress: 1. The AE curve shows how aggregate planned expenditure depends on real GDP (through the effects of disposable income), other things remaining the same. 2. The AD curve shows how equilibrium aggregate expenditure depends on the price level, other things remaining the same. The next two points are really hard for students: 3. A change in the price level changes autonomous expenditure, which shifts the AE curve, generates a new level of equilibrium expenditure, and creates a new point on the AD curve. 4. A change in autonomous expenditure at a given price level shifts the AE curve, generates a new level of equilibrium expenditure, and shifts the AD curve by an amount equal to the change in autonomous expenditure multiplied by the multiplier. •

•

The wealth effect and the substitution effects show that a rise in the price level decreases c o n s u m p ti o n e x p e n diture. So, as shown in the figure below to the left, a rise in the price level from 120 to 140 decreases aggregate planned expenditure and shifts the AE curve downward from AE0 to AE1. In the figure, equilibrium expenditure decreases to $18 trillion. The diagram to the right, below, shows that when the price level rises from 120 to 140, there is a movement along the AD curve from point a to point b. The aggregate quantity of real GDP demanded decreases from $20 trillion (which is the initial equilibrium expenditure in the AE diagram to the left) to $18 trillion (which is the new equilibrium expenditure along AE1 in the AE diagram to the left).

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•

If the AE curve shifts for any reason other than a change in the price level, then the AD curve also shifts. For instance, an increase in autonomous expenditures shifts the AE curve upward and increases equilibrium expenditure by a multiplied amount. In this case, the AD curve shifts rightward and the amount of the rightward shift is equal to the increase in equilibrium expenditure.

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In the figure to the right, autonomous expenditure increases so that the AD curve shifts rightward. The multiplied increase in autonomous expenditure has created a $2 trillion increase in equilibrium expenditure, so the AD curve shifts rightward by $2 trillion (which equals the length of the double headed arrow) from AD0 to AD1.

Equilibrium Real GDP and the Price Level • Aggregate demand and short-run aggregate supply determine the equilibrium price level and real GDP. • In the short run: • An increase in aggregate demand raises the price level and increases real GDP. In the figure to the right, the increase in aggregate demand and rightward shift of the aggregate demand curve from AD0 to AD1 creates a movement from point a to point b so that the price level rises from 120 to 130 and real GDP increases from $20 trillion to $21 trillion. • The increase in real GDP ($1 trillion) is less than the initial increase in equilibrium expenditure ($2 trillion) because the rise in the price level decreases aggregate planned expenditure. In terms of the AE curve, the increase in the price level shifts the AE curve downward. • Because the actual increase in real GDP is less than the initial increase in equilibrium expenditure, the multiplier is smaller once price level effects are taken into account. The more that the price level changes (that is, the steeper the SAS curve), the smaller the multiplier in the short run. • In the long run: • Real GDP exceeds potential GDP and employment exceeds full employment. So the money wage rate rises, which decreases the short-run aggregate supply and shifts the SAS curve leftward. The economy moves along the AD curve so that the price level rises and real GDP decreases. • In the figure above, the economy moves along AD1 from point b to point c. (The shift in the SAS curve is not illustrated in order to simplify the figure.) The price level rises from 130 to 140 and real GDP decreases from $21 trillion back to potential GDP of $20 trillion. • The further increase in the price level further decreases aggregate planned expenditure. In terms of the AE curve, the AE curve shifts downward and eventually returns to its initial level. As a result, the long-run multiplier is equal to zero. It is important to emphasize that the aggregate expenditure model is not without connection to the AS-AD model. Point out to the students that the AE model provides the underpinnings for the AD curve in the AS-AD model used throughout macroeconomics. That is, the students can now understand why the AD curve shifts, why it is downward sloping, and why changes in the price level lead to movements along the AD curve. It may be a good time to remind students that, just as the Keynesian AE model provides .

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underpinnings for the AD curve, the labor market/aggregate production function model discussed in Chapter 6 provides underpinnings for the long-run aggregate supply curve. Thus, the mechanics of the model have not changed, but the students now have a deeper understanding of the forces behind those mechanics. The concluding Economics in the News section studies expenditure changes in the 2020 Covid pandemic. It analyzes the massive fall in GDP decrease during the second quarter in terms of the aggregate expenditure model. It focuses on the changes in autonomous expenditure that were responsible for decreasing aggregate expenditure and the response of unplanned inventory change.

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Problems

1. a. How is it possible for households to have a negative savings rate? What has caused this negative household savings rate? b. Is this negative household savings rate sustainable in the long-run? 2.

Why is the multiplier only a short-run influence on GDP?

When the economy is in a recession and the government enacts a stimulus package, why might a low MPS be good in the short-run in this situation, but not in the long-run?

Solutions

Additional

Problems

1. a. Households can have a negative saving rate by borrowing. Households increase their borrowing if their wealth rises, if the real interest rate falls, or if their expected future income rises. Any or all of these factors could lead to a negative saving rate. b. A negative saving rate is not sustainable in the long run. In the long run the saving rate must be positive, if for no other reason than to repay the borrowing. 2.

The multiplier has only a short-run influence on real GDP because in the long run the money wage rate changes. The change in the money wage rate affects short-run aggregate supply and lowers the price level. The fall in the price level restores aggregate planned expenditure back to its initial level and moves the economy back to its long-run equilibrium. The longrun change in aggregate expenditure offsets the initial multiplier effect on real GDP.

In the short run, the fear is that a stimulus package while not have enough force to move the economy back to potential GDP. In this situation a small MPS is desirable because it means more spending from any increase in disposable income. However in the long run the economy needs saving to help it grow. Saving in the United States is quite low so in the long run a small value for the MPS is not helpful.

Additional Discussion Questions

11. Why is there a “two-way” link between consumption and GDP? Consumption is part of aggregate expenditure so an increase in consumption increases aggregate expenditure and hence increases GDP. Simultaneously GDP is equal to aggregate income so an increase in GDP increases disposable income and hence increases consumption. 12. How does an increase in disposable income affect the consumption function? An increase in expected future income? An increase in disposable income leads to a movement upward along the consumption function. An increase in expected future income shifts the consumption function upward. 13. If the consumption function shifts upward, what happens to the saving function? Why? If the consumption function shifts upward, the saving function shifts downward. The upward shift in the consumption function means that for each level of disposable income consumption increases. If consumption increases at each level of disposable income, saving necessarily must decrease. The decrease in saving at each level of disposable income means that the saving function shifts .

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downward. 14. When is actual aggregate expenditure different from planned aggregate expenditure? What happens to bring the two back to equality? Actual aggregate expenditure differs from planned aggregate expenditure whenever the economy is not at its equilibrium. These amounts differ as a result of unplanned inventory changes. Take, for instance, the situation when actual aggregate expenditure exceeds equilibrium expenditure. In this case the 45° line, which shows actual aggregate expenditure, lies above the aggregate planned expenditure curve, which shows planned aggregate expenditure. Hence actual aggregate expenditure exceeds planned aggregate expenditure. In this situation actual inventory change—which is the measure of inventory change that is included in actual aggregate expenditure— exceeds planned inventory change—which is the measure of inventory change that is included in planned aggregate expenditure. Because actual inventory change exceeds the planned inventory change, firms are finding that their inventories are accumulating in an undesired fashion. They respond to this state of affairs by decreasing their production. As production decreases, real GDP and hence aggregate expenditure decrease until aggregate expenditure eventually equals equilibrium expenditure. 15. Explain why income taxes reduce the size of the expenditure multiplier. The expenditure multiplier results because an increase in autonomous expenditure increases disposable income and induces additional consumption expenditure. In turn the additional consumption expenditure increases disposable income once again, which then induces still additional consumption expenditure. The result that expenditure increases because of the initial increase in autonomous expenditure and then also because of the induced increase in consumption expenditure is why the expenditure multiplier exists. Income taxes decrease the size of the increase in disposable income that results from an increase in expenditure. Therefore the resulting (induced) increase in consumption expenditure is smaller so that the overall expenditure multiplier is smaller. 16. Explain the difference between the aggregate expenditure curve and the aggregate demand curve. The aggregate expenditure curve shows how aggregate expenditure changes when GDP changes. The aggregate demand curve shows how (equilibrium) expenditure and GDP change when the price level changes. 17. Suppose that exports (autonomously) increase. What happens to the aggregate expenditure curve? The equilibrium level of aggregate expenditure? The aggregate demand curve? The aggregate expenditure curve shifts upward. Through the multiplier process the equilibrium level of aggregate expenditure increases. The aggregate demand curve shifts rightward by an amount equal to the increase in equilibrium expenditure.

C h a p t e r

THE BUSINESS CYCLE, INFLATION AND DEFLATION**

The Big Picture Where we have been: Chapter 12 uses the AS-AD model developed in Chapter 10 to explore business cycles, inflation, and deflation. The distinction between the short-run and long-run aggregate supply curves is useful for appreciating the difference between the shortrun and long-run Phillips curves. Chapter 12 also draws on the definition of inflation in Chapter 5. Where we are going: Chapter 12 is the last of three chapters dealing with macroeconomic fluctuations. The explanation of the business cycle through the lens of the aggregate supplyaggregate demand model lays the foundation for the next two chapters, on fiscal policy and monetary policy respectively.

New in the Fourteenth Edition

The content of the chapter is substantially the same as the previous edition except that the data have all been updated through 2020. As in the prior chapters, the equilibrium level of real GDP is now $20 trillion to reflect better the level in the U.S. economy. The concluding Economics In The News has an article that discusses the rise in prices that occurred in early 2021 and the concern that this rise signals higher inflation and inflation expectations.

* This is Chapter 29 in Economics. .

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The Business Cycle, Inflation and Deflation • • • •

Explain how aggregate demand shocks and aggregate supply shocks create the business cycle Explain how demand-pull and cost-push forces bring cycles in inflation and output Explain the causes and consequences of deflation Explain the short-run and long-run tradeoff between inflation and unemployment

I. The Business Cycle Business Cycles. Most principles of economics textbooks have a chapter that is similar to this one. However, many of them contain an extended discussion to the effect that, “This school of thought thinks this, but this other school of thought disagrees, and, by the way, here’s a third school of thought that thinks the first school is partially correct but partially wrong ...” This material is (appropriately enough!) found to be exceptionally tedious by the students. Fortunately, Parkin’s chapter is not at all like these other weak attempts. Parkin shows the students how the schools relate to each other and presents an incredibly exciting chapter. You can take advantage of this fact in your lecture by discussing with your students which school of thought best describes your views and what evidence convinced you. Just as students are always fascinated by why their instructor chose his or her field, so, too, are students fascinated about where their instructor fits into the scheme of controversies that they are learning about. By discussing your place in the line-up of different schools, be it “hard-line” monetarist, or new Keynesian, or an eclectic mixture, you can be guaranteed of your students’ strong interest when you discuss this topic. You might also point out to the students that theories are not necessarily mutually exclusive. For instance, even though you may be, perhaps, a monetarist, this does not necessarily mean that you totally deny that the factors emphasized by real business cycle proponents are occasionally important. By identifying your point of view and also giving the students some instruction about your view as to the usefulness of the other approaches, you can not only interest them but also help give them an enhanced general understanding of macroeconomics. Mainstream Business Cycle Theory The mainstream business cycle theory regardless fluctuations in aggregate demand around a growing potential GDP (and hence constantly rightward shifting LAS and SAS curves) as the cause of the business cycle. Real GDP differs from potential GDP when money wage rates do not offset changes in the price level. • Keynesian Cycle Theory: The Keynesian cycle theory asserts that fluctuations in investment driven by fluctuations in business confidence—summarized by the phrase “animal spirits”—are the main source of fluctuations in aggregate demand. Money wage rates are assumed rigid. • Monetarist Cycle Theory: The monetarist cycle theory asserts that fluctuations in both investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money, are the main sources of fluctuations in aggregate demand. Money wage rates are assumed rigid. • New Classical Cycle Theory: The new classical cycle theory asserts that the money wage .

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rate and hence the position of the SAS curve are determined by the rational expectation of the price level, which depends on potential GDP and expected aggregate demand. Because the money wage rate changes with expected changes in aggregate demand, only unexpected fluctuations in aggregate demand lead to business cycle fluctuations. New Keynesian Cycle Theory: The new Keynesian cycle theory asserts that today’s money wage rates were negotiated at many past dates, which mean that past rational expectations of the current price level influence the money wage rate and the position of the SAS curve. Because the money wage rate does not change with newly expected changes in aggregate demand, both expected and unexpected fluctuations in aggregate demand lead to business cycle fluctuations.

Real Business Cycle Theory The real business cycle theory (or RBC theory) regards random fluctuations in productivity as the main source of economic fluctuations. • RBC Impulse: changes in the growth rate of productivity that results from technological change. A decrease in productivity growth brings a recession and an increase brings an expansion. Productivity shocks are measured using growth accounting • The RBC Mechanism: A change in productivity changes investment demand and the demand for labor. • If productivity falls, investment demand and hence the demand for loanabe fund decreases. In addition, the demand for labor decreases. The decrease in the demand for loanable funds means the real interest rate falls. According to RBC theory, the fall in the real interest rate decreases the supply of labor because of intertemporal substitution. Because both the supply of labor and the demand for labor decrease, employment decreases and the change in the real wage rate is small. Real GDP decreases. • Money plays no role in generating business cycles in the RBC theory; it affects only the price level. I like to motivate RBC theory by suggesting that economists, such as Lucas and Prescott, challenged our previous portrayal of the LAS curve as being a stable curve that the short run fluctuations revolve around. You can use your arm to suggest that the LAS curve itself might shift leftward and rightward because of technology continuously impacting productivity in unstable ways. Criticisms and Defenses of Real Business Cycle Theory • Critics assert that money wages are sticky and that intertemporal substitution is too weak to account for large fluctuations in the supply of labor, which are necessary for RBC theory to explain the empirical fact that there are large fluctuations in employment with only small fluctuations in the real wage rate. • A second criticism of RBC theory has to do with the direction of causality between productivity and business cycle fluctuations. RBC theory assumes changes in productivity cause business cycle fluctuations. Traditional aggregate demand theories suggest that measures of productivity change as a result of business cycle fluctuations. For instance, they assert that in expansions, capital and labor are used more intensely so that measured productivity increases, even with no change in technology. .

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What does it mean to use capital and labor more intensely? It is easy to see with labor hours. A firm could record the same number of labor hours in an expansion as in a recession. But, if the firm is trying to increase production to meet high demand in the expansion, workers will work harder and, therefore, be more productive in the expansion. This change in productivity is not related to technology but growth accounting likely will (erroneously) attribute the increase in productivity to a technological advance. •

RBC theory defenders point out that the theory is consistent with microeconomic evidence about labor supply decisions and labor demand and investment demand decisions.

II. Inflation Cycles Inflation is a process in which the price level is rising and money is losing value. Inflation is not a rise in one price—it is a broad increase in the price level. Inflation also is not a one-time jump in the price level. It is an ongoing process. There are many examples of one-time jumps in the price level that are not the same as inflation. In Canada, when the federal sales tax was changed in the early 1990s, there was a one-time increase in the CPI. Likewise, when the euro was introduced in 2001, there were one-time increases in many prices in some countries. Neither of these events led to a persistent rise in the rate at which the price level increased and measured inflation using the CPI fell to previous levels soon after the one-time events.

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Demand-Pull Inflation An inflation that results from an initial increase in aggregate demand is called demand-pull inflation. Any factor that increases aggregate demand, such as an increase in the quantity of money, an increase in government expenditure, or an increase in exports, can start a demand-pull inflation. • In the short run, an increase in aggregate demand raises the price level and increases real GDP. In the figure the aggregate demand curve shifts from AD0 to AD1 so that the economy moves from point a to point b and the price level rises from 100 to 110. • Real GDP exceeds potential GDP and so in the tight labor market the money wage rate rises. The rise in the money wage rate decreases short-run aggregate supply. In the figure, the SAS curve shifts from SAS0 to SAS1. As a result, the economy moves from point b to point c and the price level rises even more, in the figure to 120. Real GDP returns to potential GDP. • Inflation occurs only if aggregate demand continues to increase. And aggregate demand continues to increase only if the quantity of money persistently increases. Demand-Pull Inflation. The potential difficulty with both demand-pull and cost-push inflation stories is how the one-time increase translates into an inflationary process. It is relatively easy to come up with stories as to why aggregate demand might shift to the right, for example because of persistent government budget deficits. (However immediately tell the students that if the budget deficit does not constantly increase in size relative to GDP, it will not lead to a constant increase in aggregate demand.) What is a little harder is to provide a plausible story as to why the monetary authorities would continue to accommodate the budget deficit with continuous increases in the quantity of money. Point out that this has been rare in the United States, and has tended to happen when the political situation was such that the Fed was not willing to be blamed for an increase in unemployment. In other countries, particularly where the central bank is less independent than in the United States, it has been more common for the central bank to consistently monetize budget deficits. Cost-Push Inflation An inflation that results from an initial increase in costs is called cost-push inflation. The two main sources of increases in costs are an increase in money wage rates or an increase in the money prices of raw materials. • The cost hike decreases short-run aggregate supply, which raises the price level and decreases real GDP. In the figure the short-run aggregate supply curve shifts from SAS0 to .

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SAS1 so that the economy moves from point a to point b and the price level rises from 100 to 110. The combination of a rise in the price level and a fall in real GDP is called stagflation. One possible response to the decrease in real GDP is for the Fed to use monetary policy to increase aggregate demand. If the Fed increases aggregate demand, real GDP increases and the price level rises still higher. In the figure, this Fed policy shifts the aggregate demand curve from AD0 to AD1 and the price level rises to 120. Inflation occurs only if, in response to the higher price level, the force that initially decreased aggregate supply recurs so that aggregate supply continues to decrease and, at the same time, the Fed continues to increase aggregate demand.

Cost-Push Inflation. The text gives a good description of the first oil price increase in the 1970s as a cost-push inflation, and contrasts it well with the Fed’s refusal to accommodate the second oil price increase in 1979. An explanation of how cost-push can be a more widespread cause of inflation in other countries can be given in terms of countries where labor is highly unionized, and in effect there are attempts by different interest groups to obtain shares of GDP that add up to more than 100 percent, with accommodation by a weak monetary authority. Such a process of repeated wage increases, inflation, and monetary accommodation can give rise to continuing inflation. Analysts often “explain” the cause of inflation by focusing attention on the good or service whose price increased the most during the most recent time period. This is incorrect; inflation is the result of monetary growth. To explain inflation, economists are looking for an explanation that fits all cases not an explanation that focuses on specific prices of specific goods that differ from one inflation to another. Expected Inflation • When inflation is anticipated, the money wage rate changes to keep up with the anticipated inflation. So when the AD curve shifts rightward, increasing the price level, the money wage rate increases and the SAS curve shifts leftward. If the increase in the price level is fully anticipated, then the money wage rate rises by the same percentage so that the real wage rate remains constant. There are no deviations from full employment. The magnitude of the shift in A D equals that in SAS so that GDP remains equal to potential GDP and the economy moves up along the LAS curve, from point a to point c in the figures above. • If inflation is not perfectly anticipated, the money wage rate changes but by a different percentage than the price level. Some of the inflation is unanticipated, so as a result the real wage rate changes and there are deviations from full employment. If aggregate demand grows faster than anticipated, real GDP exceeds potential GDP and the economy behaves as if it were in a demand-pull inflation. If aggregate demand grows slower than anticipated, real GDP is less than potential GDP and the economy behaves as if it were in a cost-push inflation. • Because of the costs of unanticipated inflation, there are benefits to forming accurate forecasts of inflation. The best available forecast is the one that is based on all relevant information and is called a rational expectation. III. Deflation An economy experiences deflation when it has a persistently falling price level. .

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What Causes Deflation? • The starting point for understanding the cause of deflation is to distinguish between a one-time fall in the price level and a persistently falling price level. A onetime fall in the price level is not deflation. Deflation is a persistent and ongoing falling price level. The Quantity Theory and Deflation

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The quantity theory of money explains the trends in inflation by focusing on the trend influences on aggregate supply and aggregate demand. The foundation of the quantity theory is the equation of exchange, which in its growth rate version and solved for the inflation rate states: Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate • The quantity theory adds to the equation of exchange two propositions. • First, the trend rate of change in the velocity of circulation does not depend on the money growth rate and is determined by decisions about the quantity of money to hold and to spend. • Second, the trend growth rate of real GDP equals the growth rate of potential GDP and, again, is independent of the money growth rate. • With these two assumptions, the equation of exchange becomes the quantity theory of money and predicts that a change in the money growth rate brings an equal change in the inflation rate. What are the Consequences of Deflation?

The effects of deflation (like those of inflation) depend on whether it is anticipated or unanticipated. But because inflation is normal and deflation is rare, when deflation occurs, it is usually unanticipated. • Unanticipated deflation redistributes income and wealth, lowers real GDP and employment, and diverts resources from production. • Workers with long-term wage contracts find their real wages rising. But employers respond to a higher and rising real wage by hiring fewer workers, so employment and output decrease. • With lower output and profits, firms re-evaluate their investment plans and cut back on projects that they now see as unprofitable. This fall in investment slows the pace of capital accumulation and slows the growth rate of potential GDP. An Economics in Action explores the “Fifteen Years of Deflation in Japan.” The Economics in Action feature describes how the deflation was unexpected, which decreased Japan’s economic growth rate, and was the result of monetary growth that was kept too low. How Can Deflation be Ended?

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Deflation can be ended by removing its cause: The quantity of money is growing too slowly. If the central bank ensures that the quantity of money grows at the target inflation rate plus the growth rate of potential GDP minus the growth rate of the velocity of circulation, then, on average,

Money Growth, Not the Quantity of Money

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It takes an increase in the growth rate of the money stock, not a one-time increase in the quantity of money, to end deflation. Central banks sometimes increase the quantity of money and fail to increase its growth .

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rate. IV. Inflation and Unemployment:The Phillips Curve A Phillips curve shows the relationship between inflation and unemployment. There are two time frames for a Phillips curve: the short run and the long run. HISTORY NOTE: The Phillips Curve. As a description of how economics advances, I like to give the students a stylized history of the Phillips curve. The story I tell starts in 1958 when A. W. Phillips published his empirical work. At that time the mainstream economic model was quite different from the AS-AD model derived in the text. Essentially, it was similar to the simple aggregate expenditure model presented in Chapter 11. He had British data that covered a long period of time and so his results appeared to be a long run phenomenon. The model was based on the assumption that the price level was constant, making the inflation rate zero. This assumption was not too unrealistic immediately after World War II. By 1955, however, the inflation rate began to creep higher and averaged 2.7 percent per year between 1956 and 1959. Inflation was beginning to be perceived as a problem, one that a model with a “fixed price level assumption” was poorly suited to solve. In this environment, economists gladly welcomed the simple, short-run Phillips curve, for it gave them a handle on inflation. They believed that they could predict the unemployment rate from their standard model and then combine this unemployment rate with the Phillips curve to determine the resulting inflation rate. The vital assumption in this procedure is that the Phillips curve captures a fixed tradeoff between the actual inflation rate and the unemployment rate that is part of the economy’s structure. This type of analysis reached its peak of popularity during the early and middle 1960s. By 1967, however, it was under attack. On a theoretical level, economist Milton Friedman—among others—pointed out the flimsy justification behind the simple, fixed Phillips curve assumption. On an empirical level, the simple, fixed Phillips curve failed as the inflation rate rose toward the end of the 1960s and into the 1970s: the unemployment rate did not fall as predicted by the fixed Phillips curve. At this point the idea of a long-run Phillips curve (as distinct from the short-run one) was developed. The concept that aggregate supply is an important component of macroeconomics was taking hold, as was the idea that short-run Phillips curves shift because of changes in people’s expectations. Thus the profession advanced significantly between the initial discussion of the Phillips curve and what students learn today. This advance was the result of the interaction between theory, suggesting that the idea of a fixed short-run Phillips curve was inadequate, and empirical work that reinforced the point that the simple, early approach was deficient. The Short-Run Phillips Curve • The short-run Phillips curve (SRPC) shows the relationship between the inflation rate and the unemployment rate holding constant the expected inflation rate and the natural unemployment rate. The figure shows a short-run Phillips curve. Inflation and unemployment have a negative relationship in the short run, so moving along a short-run .

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Phillips curve, a higher inflation rate (holding constant the expected inflation rate) leads to lower a unemployment rate. The downward sloping short-run Phillips curve is equivalent to the upward sloping shortrun aggregate supply curve. When aggregate demand unexpectedly increases so that real GDP and the price level both unexpectedly rise, the increase in real GDP lowers the unemployment rate and the unexpectedly higher price level means there is unexpectedly high inflation. The short-run Phillips curve captures the relationship between the lower unemployment rate and higher inflation rate.

Use the board to create a scatter plot of observations that allow you to later “statistically fit” a line through the points as the Phillips curve. As you make the points on the graph, you can call them out as different years from 1950-1969. Now discuss how policy-makers embraced this model as getting to choose where they want to be on the Phillips curve. You can motivate this by picking two points and asking the students which one they thought would be preferred, high inflation and low unemployment or vice versa. As government started to think it could “fine-tune the economy,” we began to observe data points that had high inflation and high unemployment. Was Phillips wrong? Ask the students what might have happened and you may get someone to say it shifted! This answer is, of course, correct. Economists started to explore the effect of expected inflation as a factor that shifts the Phillips curve. You can now discuss the distinction between the long-run and the sort-run Phillips curve. The Long-Run Phillips Curve • The long-run Phillips curve (LRPC) shows the relationship between the inflation rate and the unemployment rate when the actual inflation rate equals the expected inflation rate. As illustrated in the figure, the long-run Phillips curve is vertical at the natural unemployment rate. • The short-run Phillips curve intersects the long-run Phillips at the expected inflation rate. In the figure the expected inflation rate is equal to 4 percent. • In the long run, higher or lower inflation has no effect on the unemployment rate. This result is analogous to the conclusion from the AS-AD model that in long run, a higher or lower price level has no effect on real GDP, which equals potential GDP so that the economy is at full employment.

The Phillips curve and the AS-AD model: Students can become confused about the tie between the Phillips curve and the aggregate supply/aggregate demand (AS-AD) model. Although this relationship is nicely developed in the text, some students will remain baffled. I do not think that a principles course is the appropriate place to derive the link between the two in much .

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detail. But I do think that my lectures are an appropriate place to convey the idea of the relationship. Thus I point out that the vertical long-run aggregate supply curve is analogous to the vertical long-run Phillips curve. If you graph the two side by side, identify potential real GDP and the natural rate of unemployment on the two graphs at the intersection of the long run curves and the horizontal axis. The point that the long-run aggregate supply curve is vertical means that a higher price level has no effect on real GDP and hence no effect on the unemployment rate. Similarly, the fact that the long-run Phillips curve is vertical implies that a higher inflation rate has no effect on the unemployment rate and hence no effect on real GDP. The analogy also carries over to the short-run curves: the positively sloped short-run aggregate supply curve shows that in the short-run an unexpected higher price level raises real GDP and thus lowers unemployment. In the same way, the negatively sloped short-run Phillips curve demonstrates that in the short-run an unexpected higher inflation rate lowers unemployment, thereby raising real GDP. Students find that the two diagrams actually complement each other. I think that this approach is preferable to having the two diagrams compete with each other! Shifts of the Phillips Curves • A change in the expected inflation rate shifts the SRPC vertically upward or downward by the amount of the change but has no effect on the LRPC. • A change in the natural unemployment rate shifts both the SRPC and the LRPC. An increase in the natural rate shifts the SRPC and LRPC rightward by the amount of the increase; a decrease shifts the curves leftward by the amount of the decrease. The U.S. Phillips Curves Because of changes in the expected inflation and the natural rate of unemployment, the short-run Phillips curve has shifted around a lot over time so that there is no single obvious negative relationship between inflation and unemployment. The concluding Economics in the News section studies the initial upward jump in prices in 2021 and the concerns about inflation and inflation expectations.

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Additional Problems 1. 2.

Has the U.S. economy experienced inflation or deflation during recent recessions? Explain. The spreadsheet provides information about the economy in Argentina. Column A is the year, Column B is real GDP in billions of 2000 pesos, and Column C is the price level. a. In which years did Argentina experience inflation? In which years did it experience deflation (a falling price level)? b. In which years did recessions occur? In which years did expansions occur? c. In which years do you expect the unemployment rate was highest? Why? d. Do these data show a relationship between unemployment and inflation in Argentina?

1 2 3 4 5 6 7 8 9 10 11 12

A 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

B 277 288 278 276 264 235 256 279 305 331 359 384

C 105.6 103.8 101.9 102.9 101.8 132.9 146.8 160.4 174.5 198.0 226.1 267.7

Solutions to Additional Problems 1,

The United States has experienced inflation during recent recessions, though there have been instances when the inflation rate fell during recessions. For instance in late 2018 the inflation rate fell as the economy moved into a recession. Inflation, however, generally continued because aggregate demand continued to increase during the recessions, though at a slower rate. 2. a. Argentina experienced inflation in 2010 and from 2012 through 2018. Argentina experienced deflation in 2008, 2009, and 2011. b. Argentina had recessions in 2009, 2010, 2011, and 2012. Argentina had expansions in 2008 and 2013 through 2018. c. The unemployment rate was probably high in all of the recessionary years. It was probably the highest in 2010 and 2012 when the recessions were at their worst. d. There is not a strong relationship between unemployment and inflation in the data. The unemployment rate would likely have been higher in the recession years of 2009, 2010, 2011, and 2012. In 2010 Argentina experienced low inflation and 2012 Argentina experienced high inflation. In 2009 and 2011 Argentina experienced deflation. But Argentina also experienced deflation 2008. So there is no consistent relationship between either inflation and high unemployment or deflation and high unemployment. There also is a similar lack of relationship between inflation and low unemployment or deflation and low unemployment.

Additional Discussion Questions

11. Some economists claim that inflation is always a “monetary phenomenon.” What do they mean by this claim and are they correct? This claim points to the .

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result that an on-going inflation requires the central bank to constantly increase the quantity of money. In the absence of continual monetary growth, the price level might rise but it would eventually stabilize. The price level will continue to rise, which means that on-going inflation will occur, only if the Federal Reserve constantly increases the quantity of money. Because inflation requires constant growth in the quantity of money, inflation can be thought of as a “monetary phenomenon.” 12. How can a higher price of oil create inflation? By itself a higher price of oil cannot create inflation. Taken by itself a higher price of oil can lead to a higher price level but after the adjustment is made to the higher price of oil, the price level stops rising—that is, inflation stops. A higher price of oil can lead to inflation only if the central bank “ratifies” it by increasing the quantity of money. If the central bank, the Federal Reserve in the United States, responds to the decrease in real GDP created by the higher price of oil by increasing the quantity of money, then inflation can result. The increase in the quantity of money will drive the price level still higher. In this situation oil producers might respond by again boosting the price of oil. If the Fed responds once again in turn, the process can continue indefinitely and a costpush inflation results. 13. What is the relationship between the short-run aggregate supply curve and the short-run Phillips curve? Between the long-run aggregate supply curve and the long-run Phillips curve? The short-run aggregate supply curve and the short-run Phillips curve are closely related. If aggregate demand increases, the economy moves upward along its short-run aggregate supply curve so that the price level and real GDP both increase. The rise in the price level means that inflation rises and the increase in real GDP means that unemployment falls. The rise in the inflation rate combined with the fall in the unemployment rate correspond to a movement upward along the economy’s short-run Phillips curve. Similarly the long-run Phillips curve and long-run aggregate supply curve also are closely related. In the long run an increase in aggregate demand moves the economy upward along its long-run aggregate supply curve so that the price level rises and real GDP does not change—it remains equal to potential GDP. The rise in the price level means that the inflation rate rises and the result that real GDP remains equal to potential GDP means that the unemployment rate remains equal to its natural rate. The rise in the inflation rate combined with the unemployment rate remaining equal to its natural rate correspond to a movement upward along the economy’s long-run Phillips curve. 14. Suppose the expected and actual inflation rates are 7 percent and the natural rate of unemployment is 6 percent. If the inflation rate falls to 5 percent while the expected inflation rate remains at 7 percent, what happens to the unemployment rate? If the actual inflation rate falls and the expected inflation rate does not change, the economy moves downward along a short-run Phillips curve so that the unemployment rate increases. 15. Suppose the expected and actual inflation rates are 7 percent and the natural rate of unemployment is 6 percent. If the inflation rate falls to 5 percent and the .

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expected inflation rate also falls to 5 percent, what happens to the unemployment rate? If the actual inflation rate and the expected inflation rate fall by the same amount, the economy moves downward along its long-run Phillips curve so that the unemployment rate does not change—it remains equal to the natural unemployment rate. 16. Suppose that the actual inflation rate is 7 percent and that the economy is at the natural unemployment rate. If the Fed announces that it is going to lower the inflation rate and people believe this announcement (so that the decline in the inflation rate is not a surprise), what happens to the unemployment rate? Suppose that people believe the Fed’s announcement and that the expected inflation rate falls, but then the Fed keeps the inflation rate at 7 percent. Now what happens to the unemployment rate? If the Fed follows through on its announcement, both the actual and expected inflation rate fall by the same amount so that the unemployment rate remains equal to its natural rate. However if the Fed actually does not lower the inflation rate, then the actual inflation rate exceeds the expected inflation rate. In this case the short-run Phillips curve shifts downward. The economy moves to a point on its new short-run Philips curve at the unchanged inflation rate and the unemployment rate falls. 17. How do you think recessions influence elections? Recessions have large impacts on elections. If an election occurs during (or near) a recession, the incumbent party suffers. This empirical result holds true for President Ford who lost his reelection bid in 1976; President Carter who lost his reelection bid in 1980; President Bush who lost his reelection bid in 1992; and Senator McCain who lost his election bid in 2008. All of these candidates were members of the incumbent party and all faced election either near or during a recession. President Obama’s re-election in 2012 was an unusual case in that the economy was in recovery but unemployment was still high near 8 percent.

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FISCAL POLICY**

The Big Picture Where we have been: This chapter extensively uses the aggregate supply-aggregate demand model introduced in Chapter 10. It also makes use of Chapter 11’s discussion of multipliers. The material on the labor market and potential GDP from Chapter 6 is important when discussing the supply-side effects of fiscal policy. Where we are going: Chapter 14 on monetary policy completes the material on macroeconomic stabilization policies. The discussion on debt and deficits from this chapter are good preparation for some of the monetary policy responses the Fed can use in the next chapter.

New in the Fourteenth Edition

This chapter is rich with data, which has all been updated to 2020. The Economics in the News detail that compared the U.S. corporate tax rate with those in other countries has been eliminated. The Economics in the News feature at the end of the chapter discusses the fiscal policy response to the Covid-19 pandemic, an issue that should really resonate with your students.

* This is Chapter 30 in Economics. .

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Lecture Notes

Fiscal Policy • •

Fiscal policy refers to changes in government expenditure and taxes. Fiscal policy impacts both aggregate supply and aggregate demand.

I. The Federal Budget The annual statement of the outlays and receipts of the government of the United States together with the laws and regulations that approve and support those outlays and receipts make up the federal budget. The use of the federal budget to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability is called fiscal policy. The Institutions and Laws • The President submits a budget proposal to Congress. Congress debates, amends, and enacts the budget. The budget operates within the framework of the Employment Act of 1946, which states: “… it is the continuing policy and responsibility of the Federal Government to use all practicable means … to coordinate and utilize all its plans, functions, and resources … to promote maximum employment, production, and purchasing power.” • The Council of Economic Advisers monitors the economy and keeps the President and the public well informed about the current state of the economy and the best available forecasts of where it is heading. Highlights of the 2022 Budget • Receipts come from four sources: personal income taxes ($2,039 billion), social security taxes ($1,462 billion), corporate income taxes ($371 billion), and indirect taxes and other receipts ($302 billion). • Outlays are classified in three categories: transfer payments ($4,018 billion), expenditure on goods and services ($1,688 billion), and debt interest ($305 billion). • Budget balance = Receipts – Outlays • If receipts exceed outlays, the government has a budget surplus. • If outlays exceed receipts, the government has a budget deficit. • If receipts equal outlays, the government has a balanced budget. The U.S. Budget in Historical Perspective and in Global Perspective • Since 1990, except between 1997 to 2000, the U.S. government has had a budget deficit. • Government debt is the total amount that the government has borrowed. A budget deficit adds to the government debt. • In 2021, all of the world’s major economies had a budget deficit. Germany had the smallest deficit while the United States, the United Kingdom, and Japan (in that order) had the largest deficits as a fraction of GDP. The U.S. deficit was about 16 percent of GDP. Deficit and debt. Many students need help with the distinction between the deficit and the debt (and with what happens to the debt when there is a surplus). Use the student loan or credit card analogy. Explain that the budget balance (the deficit or surplus) is just like a personal budget balance (the amount that a student borrows or pays back during a given year). The debt—the total amount owed by the government—is like the balance on a student loan or credit card account. Students (usually) have a budget deficit and increasing debt. And graduates with a job .

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(usually) have a budget surplus and decreasing debt. An interesting historical episode. During the mid-1830s—a long time ago—the U.S. government had virtually repaid all its debt. At that time the government faced a problem that doesn’t occur today: it had a surplus and didn’t know what to do with it. The decision was made to transfer money to the state governments. Each state was to receive $400,000 in four payments of $100,000 each. The first three payments were made, but the last one was postponed because of a recession in 1837 that lowered the federal government’s revenue and then was never made. In the 1970s, faced with a severe budget crunch, the State of New York sued to receive that last payment plus interest. The state lost the suit and so the last payment probably will never be made! (You might remark that $100,000 invested in 1837 at the average interest rate would have accumulated to about $30 billion by 2015!) II. Supply-Side Effects of Fiscal Policy The effects of fiscal policy on employment, potential GDP, and aggregate supply are known as supply-side effects. The Effects of Taxes on Full Employment and Potential GDP • The labor market determines the full employment quantity of labor, which, together with the production function, determine potential GDP. • The equilibrium quantity of employment is determined in the labor market. The first figure shows the labor market. In the figure equilibrium employment is 300 billion hours per year. This amount of employment is full-employment. • The second figure shows the production function. With employment of 300 billion hours, the production function shows that real GDP is $20 trillion. • An income tax decreases the supply of labor and shifts the supply of labor curve leftward. In the top figure, the LS curve shifts leftward. Because of the tax wedge, the level of employment decreases. In the bottom figure the decrease in employment decreases potential GDP. • An income tax drives a tax wedge between the before-tax wage rate that firms pay and the after-tax wage rate that workers receive. Other taxes, such as sales taxes, add to the tax wedge by effectively lowering the real wage rate. Some Real World Tax Wedges … Does the Tax Wedge Matter? Tax wedges vary across countries, being much higher in France than in the United States. .

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According to supply-side economists such as Ed Prescott, the tax wedge has a large impact on potential GDP. Potential GDP per person in France is 30 percent below that in the United States and Prescott asserts that the entire difference can be attributed to the difference in the countries’ tax wedges.

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Taxes and the Incentive to Save and Invest • A tax on interest income decreases the supply of saving and shifts the supply of loanable funds curve leftward. The tax drives a wedge between the after-tax interest rate received by savers and the interest rate paid by firms. The tax does not change the demand for loanable funds. The figure shows the result: the real interest rate paid by borrowers rises (from 3 percent to 4 percent in the figure) and the equilibrium quantity of loanable funds and investment decrease. • The decrease in investment lowers the growth rate of potential GDP. Tax Revenues and the Laffer Curve • The relationship between the tax rate and the amount of tax collected is called the Laffer curve. The Laffer curve shows that at a high enough tax rate, an increase in tax rates decreases tax revenues. Tax revenues decrease because individuals find ways to avoid the high taxes, including by working less. • Most economists believe that taxes have an effect on the supply of labor, but that in the U.S. economy, the tax rate is low enough so that an increase in the tax rate increases tax revenues. Laffer Curve and Napkins: Students get a kick out of the napkin roots of the Laffer Curve. The story that Laffer himself cannot deny nor confirm is that he first drew the Laffer curve on a napkin during one of his first attempts to persuade someone of his supply side theory. Draw the Laffer curve and ask what side of the curve are we on? Ask them what they think the highest tax rate was in the United States, they are usually shocked to learn that we had marginal rates in the 70% range as recently as the 1970. This a great discussion point on how high tax rates can deter work! Consumption Tax: Students enjoy exploring the controversial idea of abolishing the IRS in favor of a consumption tax. Whether you agree with it or not, the Fairtax plan (Google Fairtax plan to find the website) covers many issues from this chapter and is an awesome way to bring together many of the topics from the course. Students engage with the concept of a revenue neutral switch from our mixed tax system to 100% consumption tax. I assign a short paper for them to investigate one of the many sub-topics within the plan. III. Generational Effects of Fiscal Policy Generational accounting is an accounting system that measures the lifetime tax burden and benefits of government programs to each generation. Generational Accounting and Present Value To compare the costs and benefits that occur at different points in the future, which is necessary in generational accounting, the concept of present value is used. A present value is an amount of .

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money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account. Because there is uncertainty about the proper interest rate to use when calculating present values, plausible alternative numbers are used to estimate a range of present values. The Social Security Time Bomb • Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. In 2014, the fiscal imbalance was estimated to be $68 trillion and growing by about $2 trillion every year. The fiscal imbalance is high because of obligations under Social Security laws and Medicare. • There are four alternatives for redressing the fiscal imbalance: raise income taxes, raise Social Security taxes, cut Social Security benefits, or cut federal government discretionary spending. But the changes needed would be severe. It is estimated that income taxes would need to be raised by 69 percent; or Social Security taxes raised by 95 percent; or Social Security benefits cut by 56 percent. Generational Imbalance Generational imbalance is the division of the fiscal imbalance between the current and future generations assuming that the current generation will enjoy the current levels of taxes and benefits. It is estimated that the current generation will pay 83 percent of the fiscal imbalance and the future generations will pay 17 percent. IV. • •

Fiscal Stimulus A fiscal action that is initiated by an act of Congress is called discretionary fiscal policy. A fiscal action that is triggered by the state of the economy is called automatic fiscal policy.

Automatic Fiscal Policy and Cyclical and Structural Budget Balances • Tax revenues and needs-tested spending change with the business cycle. • The government sets tax rates. As incomes vary with the business cycle, the tax revenue collected changes. Tax revenue automatically falls in recessions and automatically rises in expansions. • Government expenditure on programs that pay benefits to people and businesses depending on their economic status is called needs-tested spending. Needs-tested spending automatically increases in a recession and automatically decreases in an expansion, helping to stabilize the economy. • Induced taxes and needs-tested spending mean that the federal budget deficit is countercyclical, with the deficit increasing in a recession and decreasing in an expansion. • The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit. • In 2017 the total U.S. budget deficit was $3,213 billion. According to the Congressional Budget Office (CBO) the structural balance was a surplus of $55 billion so the cyclical deficit was $3,268 billion. • The cyclical deficit skyrocketed in 2020. By their nature, automatic fiscal policy implies federal budget deficits in recessions as tax .

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revenues fall and spending increases. By contrast, balanced budget rules for state and local governments mean that these governments do not conduct stabilizing fiscal policy. In the 2008 recession, the sharp decline in state and local tax revenues meant that state spending programs had to be cut and, in some states, taxes raised. Such policies are the opposite of the policies that can be used to help stabilize the business cycle. •

Automatic fiscal policy helps stabilize the business cycle because it provides an automatic stimulus during a recession and an automatic contraction during an expansion.

Discretionary Fiscal Stimulus • The government expenditure multiplier is the quantitative effect of a change in government expenditure on real GDP. An increase in government expenditure increases aggregate expenditures setting in motion the multiplier process. • The tax multiplier is the quantitative effect of a change in taxes on real GDP. A decrease in taxes increases disposable income and hence consumption expenditure, setting in motion the multiplier process. • The effect on aggregate demand from a tax cut is less than that from a similar sized increase in government expenditure. A $1 tax cut generates less than a $1 increase in consumption expenditure since only a fraction (equal to the MPC) of the $1 increase in disposable income is spent on consumption expenditure.

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Fiscal Stimulus • Expansionary fiscal policy (an increase in government expenditure or a decrease in taxes) seeks to eliminate a recessionary gap. If timed correctly and of the correct magnitude, fiscal policy can be used to push the economy to potential GDP. • The figure shows the effect of expansionary fiscal policy on aggregate demand. At the initial equilibrium, $19 trillion real GDP and price level of 110, there is a recessionary gap. The expansionary policy increases aggregate demand and the multiplied effect shifts the AD curve rightward from AD0 to AD1. The recessionary gap is eliminated and the economy moves to its new equilibrium, $20 trillion real GDP (which equals potential GDP) and price level of 115. Fiscal Stimulus and Aggregate Supply The focus so far has been on only aggregate demand. But fiscal policy also impacts aggregate supply. • Government Expenditure: An increase in government expenditure increases the budget deficit. The demand for loanable funds increases, so the real interest rate rises and investment is crowded out. The decrease in investment offsets the expansionary effect from the increase in government expenditure. The crowding-out effect is strong enough so that the government expenditure is less than 1. • Tax Cut: A tax cut also has effects on aggregate supply. A tax cut increases the supply of labor and the supply of loanable funds, both of which increase aggregate supply. The supply-side effects make the tax multiplier larger than the government expenditure multiplier. There is quite a bit of controversy about the size of the multipliers and this controversy is nicely covered in an Economics in Action detail. Christina Romer, while working for the Obama administration, asserted that the government expenditure multiplier was 1.5. Robert Barro, of Harvard University, says his research shows the multiplier is 0.5. These differences are dramatic and students can appreciate their importance and real-world relevance. Highlight the RicardoBarro effect as a possible argument for smaller multipliers. Limitations of Discretionary Fiscal Policy In practice, discretionary fiscal policy is hampered by three time lags: • Recognition Lag: The recognition lag is the time it takes to figure out that fiscal policy actions are needed. • Law-Making Lag: The law-making lag is the amount of time it takes Congress to pass the laws needed to change taxes or spending. • Impact Lag: The impact lag is the time it takes from passing a tax or spending change to implementing the new arrangements and feeling their effects on real GDP. .

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Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. It is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long drawn out process. An increase in government expenditure shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the length of time it took the Congress to pass the 2002 “stimulus package” and the time it took in the Fall of 2008 to decide on a fiscal policy to be used after the initial “bailout package.” The law-making lag can be substantial and the outcomes questionable! The concluding Economics in the News box is a timely discussion of the fiscal policy response to the Covid-19 pandemic. The news article reports on the House of Representatives passing the $1.9 trillion coronavirus relief package. This bill was eventually signed into law in March 2021. The Economics in the News box presents an AD/AS analysis showing the initial effect of the pandemic, the initial recovery in 2020, and the on-going recovery in 2021 with an emphasis on the role played by the fiscal policy stimulus in 2020 and 2021. This box has significant realworld relevance!

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Additional Problems 1.

The government is proposing to lower the tax rate on labor income and asks you to report on the supply-side effects of such an action. Answer the following questions and describe what happens on the relevant graph. You are being asked about directions of change, not exact magnitudes. a. What will happen to the supply of labor and why? b. What will happen to the demand for labor and why? c. What will happen to the equilibrium level of employment and why? d. What will happen to the equilibrium before-tax wage rate? e. What will happen to the equilibrium after-tax wage rate? f. What will happen to potential GDP?

How Reagan Would Fix the Economy Many Republicans look at Reagan’s policies in the early 1980s and assert that tax cuts pay for themselves. That’s wrong—Reagan’s rate cuts for the rich paid for themselves, but the tax cuts for the poor, the middle class and corporations did not. The deficit increased. But there is a limit to the deficit. At some time the government debt grows so large that it starts to harm the economy through higher interest rates, bigger debt payments, a weaker currency, etc. Time, May 26, 2008 a. Explain why Reagan’s tax rate cuts for high income taxpayers may have paid for themselves, but cuts for lower-income and middle-income taxpayers did not. b. Explain the negative consequences of running persistently large budget deficits.

Explain why extending unemployment insurance benefits has both a supply-side and demand-side effect on real GDP and the price level.

Solutions to Additional Problems 1. a. The supply of labor increases. The supply of labor curve shifts rightward. The supply of labor increases because at each real wage rate, the after-tax wage rate received by workers will be higher given a decrease in the tax rate on labor income. b. The demand for labor remains the same. The demand for labor depends on the productivity of labor, which remains the same following the decrease in the tax rate on labor income. c. The equilibrium level of employment increases. With the rightward shift in the supply of labor curve, the real wage rate decreases and the quantity of labor demanded increases along the demand for labor curve. Equilibrium employment increases. d. The equilibrium pre-tax wage rate decreases. The rightward shift of the supply of labor curve leads to movement down along the demand for labor curve. e. The equilibrium after-tax wage rate increases. The decrease in the tax rate on labor income decreases the wedge between the before-tax wage rate and the after-tax wage rate. The before-tax wage rate decreases but not by as much as the decrease in tax. So the after-tax wage rate increases. f. Potential GDP increases. The equilibrium level of employment is the full employment .

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quantity of labor. So as full employment increases, potential GDP increases along the production function. 2. a. High-income taxpayers faced very high tax rates. For these taxpayers, the cut in tax rates probably lead to large increases in the quantity of labor they supplied so that the tax revenue from high-income taxpayers increased. But middle-income and lower-income taxpayers did not face such high rates. For these groups the tax cut increased the quantity of labor they supplied but by only a small amount so that the tax revenue from middleincome and low-income taxpayers decreased. b. Persistently running large budget deficits increases the government debt, which increases the interest the government must pay and contributes to larger budget deficits in the future. Budget deficits also crowd out investment, so persistently running budget deficits decreases investment and the capital stock is less than otherwise. Because the capital stock is smaller, U.S. potential GDP is lower. 3.

Extending unemployment insurance benefits increases the amount of time unemployed workers search for new jobs, which decreases employment. The decrease in employment decreases aggregate supply. Simultaneously extending unemployment insurance benefits increases the income received by unemployed workers. The increase in income increases consumption expenditure, which increases aggregate demand.

Additional Discussion Questions

11. What is the distinction between the government’s budget deficit and the government’s debt? The budget deficit is the amount the government is borrowing in any given year. The government debt is the total amount the government has borrowed over all the years. The budget deficit adds to the (total) government debt. 12. Suppose that the government increases its expenditures payments by $100 billion and pays for the increase by raising taxes by $100 billion. What is the effect on aggregate demand and real GDP of each change individually and of the two combined? The increase in government expenditure adds directly to aggregate demand so that aggregate demand and real GDP both increase. The increase in taxes indirectly decreases aggregate demand by decreasing consumption expenditure. The decrease in aggregate demand leads to a decrease in real GDP. The magnitude of the increase in aggregate demand from the increase in government expenditure exceeds the magnitude of the decrease from the increase in taxes. So when both effects are combined, on net aggregate demand increases so that real GDP increases. 13. Why does a change in income taxes have a different effect on aggregate supply than a change in government expenditures? A change in income taxes changes the tax wedge and affects people’s incentives to supply labor. The supply of labor changes, which affects employment and hence potential GDP. For example, if income taxes are boosted, the supply of labor decreases. With the decrease in the supply of labor, employment decreases so that potential GDP decreases. The decrease in potential GDP decreases aggregate supply. A change in government expenditures does not have this same incentive effect. Because it does not have this effect, it has no impact on aggregate supply. .

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14. Suppose because of a recession, most state governments experience reductions in tax revenues, and respond by reducing their expenditures and increasing their taxes to keep their state budgets in balance (a constitutional requirement in many U.S. states). Will this have any effect on the recession, and if so, what? This policy on the part of states deepens the recession. In a recession fiscal policy generally aims to increase aggregate demand because the increase in aggregate demand increases real GDP. Cutting state government spending and raising taxes decreases aggregate demand. A decrease in aggregate demand decreases real GDP and worsens the recession. 5. In 2012, the looming “Fiscal Cliff” meant that there would be an increase in taxes coupled with a decrease in government spending. Meanwhile the Federal Reserve was continuing “Quantitative Easing.” Discuss the combined effects of these events on the economy. The fiscal cliff is a combination of two contractionary fiscal policies which would decrease aggregate demand. Quantitative Easing is an expansionary monetary policy meant to increase aggregate demand. Chairman Bernanke stated during the fourth quarter of 2012 that the Fed was pursuing that policy in part to hedge against the negative effects of the fiscal cliff should it happen.

C h a p t e r

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The Big Picture Where we have been: Chapter 14 heavily uses material from Chapter 8, which was the first chapter dealing with money, and Chapter 10, which introduced the aggregate supplyaggregate demand model. The expenditure multiplier, covered in Chapter 11, plays a small role in this chapter. Playing a larger role is the loanable funds market, developed in Chapter 7. Where we are going: Chapter 14 is the last chapter dealing with macroeconomics. The next chapter, on international trade, will not use the material from this chapter and could be covered before you get into Chapter 4.

New in the Fourteenth Edition

This chapter has been heavily revised. The discussion of the 2 percent target inflation rate now reflects the Fed’s recent change to hit this target “on average” so that the Fed will permit the inflation rate to exceed 2 percent for a while to make up for time when it was below 2 percent. In this material, the text now refers to the personal consumption expenditure price index (PCEPI) rather than the core PCE deflator. The Fed’s goal of maximum employment is defined as the highest level of employment and lowest level of unemployment that can be attained while avoiding sustained inflation above the target 2 percent rate. The Fed’s monetary policy instruments are given as the quantity of reserves and then three interest rates: The federal funds rate, the discount rate, and the interest on reserves rate. The discount rate and the interest on reserves rate set an interest rate corridor that limits the movement of the federal funds rate. Figure 14.4 illustrates how the Fed uses this corridor to set the federal funds rate. A figure (14.3) showing how banks/ reserves have evolved since 2000 is presented, with the three QEs during the financial crisis and the Covid QE highlighted. In the discussion about the transmission channels of monetary policy, the effect of interest rate changes on the exchange rate has been removed.

* This is Chapter 31 in Economics. .

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The concluding Economics in the News section examines the Fed’s decision to “taper” its stimulus. The news article covers what was discussed at the FOMC meetings in June and July of 2021 and the following analysis focuses on the Fed’s goal for its policy.

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Lecture Notes

Monetary Policy • • • •

Describe the objectives of U.S. monetary policy and the framework for setting and achieving them Explain how the Federal Reserve makes its interest rate decision and achieves its interest rate target Explain the transmission channels through which the Federal Reserve influences real GDP, jobs, and inflation Describe the Fed’s actions and macroprudential regulations prompted by the 2008 financial crisis

I. Monetary Policy Objectives and Framework Monetary Policy Objectives The Fed’s mandate is that “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” • Goals: The goals in the mandate are “maximum employment, stable prices, and moderate long-term interest rates.” Achieving stable prices, keeping the inflation rate low, is the key. It is the source of maximum employment because low inflation rates mean that people make decisions without the confusion created by inflation. And, because the nominal interest rate equals the real interest rate plus the inflation rate, a low inflation rate means low long-term interest rates. • Operational “Stable Prices” Goal: The Fed uses the personal consumption expenditure price index (PCEPI). Price stability means an average PCEPI inflation rate of 2 percent a year. Because the Fed uses an average, the Fed will permit a period of time with inflation above 2 percent in order to offset a period during which the inflation rate was less than 2 percent. • Operational “Maximum Employment” Goal: The Fed strives for the highest level of employment that can be attained while avoiding sustained inflation above the target 2 percent rate. Responsibility for Monetary Policy • The Role of the Fed The Federal Reserve Act makes the Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) responsible for the conduct of monetary policy. The Fed has ultimate responsibility for monetary policy. The FOMC makes monetary policy decisions at eight scheduled meetings a year. • The Role of Congress Congress plays no role in making monetary policy decisions but the Federal Reserve Act requires the Board of Governors to report on monetary policy to Congress. • The Role of the President The formal role of the president of the United States is limited to appointing the members and the chairman of the Board of Governors.

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II. The Conduct of Monetary Policy The Monetary Policy Instrument A monetary policy instrument is a variable that the Fed can directly control or closely target. The Fed’s policy instruments are the quantity of bank reserves and three interest rates. • The quantity of reserves is vault cash held by banks plus the balance on their reserve accounts at the Fed. The Fed changes the quantity of reserves when it conducts an open market operation. • The interest rates the Fed uses are the: • Federal funds rate, the interest rate on overnight loans (of reserves) that banks make to each other. • Discount rate, the interest rate at which the Fed loans reserves to a bank. • Interest on reserves rate, the interest rate the Fed pays banks on their reserves held on deposit at the Fed. Interest Rate Corridor The discount rate and interest rate on reserves create a corridor that limits the movement of the federal funds rate. • Because a bank can borrow from the Fed at the discount rate, it will not borrow from another bank unless the interest rate is lower than or equal to that rate, which puts a cap on the federal funds rate. • Because a bank earns interest on its reserves, it will not lend reserves to another bank unless the interest rate is higher than or equal to the interest on reserves rate, which puts a floor on the federal funds rate. • The size of the federal funds corridor is 0.25 percentage points. • Within the corridor, the higher the federal funds rate, the greater the opportunity cost of holding reserves rather than loaning them. So the higher the federal funds rate, the smaller the quantity of reserves demanded, which means the demand curve for reserves is downward sloping. Monetary Policy Decisions Since 2008 the Fed has set a target range for the federal funds rate and takes actions to keep it within the range. • To slow inflation, the Fed raises the federal funds rate; to avid recession, the Fed lowers the federal funds rate. Prior to 2008, monetary policy was conducted with limited reserves, the minimum level of reserves at which a bank can function. The Fed paid no interest on reserves. During the 20082009 recession, the Fed began to conduct monetary policy with ample reserves, a volume of reserves well in excess of the volume needed to conduct business. The Fed started paying interest on reserves. • During the recession the Fed engaged in quantitative easing, huge open market purchases to increase the quantity of reserves. • After 2014, the Fed engaged in quantitative tightening, large open market sales to decrease the quantity of reserves. • With the Covid-19 pandemic, the Fed engaged in additional quantitative easing that increases to almost $4 trillion. .

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Hitting the Federal Funds Rate Target • In the federal funds market, the equilibrium federal funds rate sets the quantity of funds demanded equal to the quantity supplied. • The federal funds rate balances the quantities of banks reserves demand and supplied. • By conducting an open market operation, the Fed can change the quantity of reserves supplied and move the federal funds rate to its target level. In the figure, the corridor is from 0.25 percent to 0.0 percent. The Fed conducts an open market purchase of securities and increases the supply of reserves from $2.5 trillion to $4.0 trillion and lowers the federal funds rate from 0.125 percent to 0.0 percent.

An At Issue box discusses the views of the inflation doves and hawks at the July 2021 FOMC meeting. By the time you are using the book, you may know which side was correct! III.

Monetary Policy Transmission

Ripple Effects of Changing the Interest Rate Suppose the Fed lowers the federal funds rate by reducing the discount rate and interest on reserves rate, which immediately moves the federal funds rate lower. As a result: • Other interest rates: Other short-term interest rate falls. • The Fed engages in quantitative easing, which increases banks’ reserves. Banks increase their lending, which increases that the quantity of money and the supply of loanable funds. • Long-term real interest rate: The real interest rate is determined in the loanable funds market. In the short run, the increase in loans increases the supply of loanable funds and lowers the real interest rate. • Expenditure plans: Consumption expenditure and investment increase as a result of the lower real interest rate. • Aggregate demand: Aggregate demand increases with a multiplier effect so that the price level rises and real GDP increases. Unemployment falls and the inflation rate rises. Effects of Money on Real GDP and the Price Level: We bring in here the expenditure multiplier; it is important to ensure that students do not get confused between the multiplier impact of open market operations on the quantity of money, and the multiplier process that .

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magnifies autonomous expenditure changes. Additionally, when using the AS-AD model to explain the impact of deflationary monetary policy, it is important to stress the text’s point that the model is a stationary simplification, whereas in reality output and the price level both tend to grow, so that rather than reducing real GDP and the price level, the Fed’s anti-inflation policy would slow their growth. The Fed Fights Recession If the Fed believes that real GDP is less than potential GDP (a negative output gap), the Fed will undertake expansionary monetary policy: it lowers the federal funds target range and conducts open market sales. The monetary policy is transmitted as outlined above and real GDP increases. The Fed Fights Inflation If the Fed believes that real GDP is greater than potential GDP so that inflation is a problem (a positive output gap), the Fed will undertake contractionary monetary policy: it raises the federal funds rate target and conducts open market sales. The effect of the monetary policy is transmitted as described, only the directions of the changes are reversed. Real GDP decreases. Tying it All Together: Students often think that macroeconomics is difficult because there are so many different concepts introduced. Among others, students must learn about aggregate demand curve and the short-run and long-run aggregate supply curves; the aggregate production function; ; the demand for labor, the supply of labor, and the labor market; the demand for reserves, the supply of reserves, how Fed policy affects the supply of reserves, and the market for reserves; the demand for money, the supply of money, the money multiplier, and the market for money; and, the demand for loanable funds, the supply of loanable funds, the market for loanable funds, and government impacts on this market. This chapter offers a great chance for you to use the book’s very clear presentation and very straightforward presentation of monetary policy transmission to help the student see how all the parts interact. Use the book’s “four quadrant diagrams” (Figures 14.6a, 14.6b, 14.6c, and 14.6d as well as 14.7a, 14.7b, 14.7c, and 14.7d) to show the students how everything they learned ties together to give a complete and coherent view of the otherwise exceedingly complex macroeconomy. Don’t hesitate to refer back to earlier chapters to remind the students what they learned in those chapters and how that is now being used to explain how our economy functions. Loose Links and Long and Variable Lags • In reality, the ripple effects of monetary policy are not as precise as outlined above. • The long-term real interest rate that influences expenditure plans is linked only loosely to the federal funds rate. And the response of expenditure plans to the real interest rate also is not tight. • The transmission channels described above take time to operate and the time can vary from one episode to the next. •

In the United States, when the federal funds rate rises relative to the long-term bond rate, two years later real GDP growth generally slows.

Policy Strategies and Clarity Two alternative decision-making strategies have been proposed. Both strive to create greater openness and certainty about the Fed’s monetary policy.

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Inflation Rate Targeting • Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and to explain how its policy actions will achieve that target. Other countries (England, New Zealand, Canada, Sweden, and the EU) have successfully used inflation targeting rules to keep their inflation rate low. Taylor Rule • The Taylor rule uses a formula to set the target federal funds rate. The Taylor rule sets the federal funds rate (FFR) at the equilibrium real interest rate, assumed to be 2 percent, plus amounts based on the inflation rate (INF) and the output gap (GAP) according to: FFR = 2 + INF + 0.5(INF − 2) + 0.5GAP John Taylor says that the Fed has come close to following this rule but if it had followed it precisely the economy would have performed better. • Supporters argue that rules are important because rules enable households and firms to form more accurate inflation expectations. Markets work best when inflation expectations are most accurate and rules allow accuracy in inflationary expectations. Effects of Money on Real GDP and the Price Level Revisited: You might want to remind the students that the effects of monetary policy on real GDP and the price level so clearly discussed in this chapter are short run effect. In the long run, the quantity theory covered in Chapter 8 rules the roost. You can point out to your students that in the long run, the impact on real GDP dissipates and the only long run effect is on the price level (or the inflation rate). In the late 1970s and early 1980s, several central banks targeted the quantity of money to successfully lower their inflation rates. However, central banks eventually abandoned this procedure as financial innovations made the demand for money (and velocity) mush less stable than in the past. IV.

Financial Crisis: Cure and Prevention

The Key Elements of the Crisis The financial crisis of 2007-2008 started in the United States in August 2007. Banks were at the center of the crisis which eventually led to the largest recession since the great depression. • Banks were put under stress from three sources: • A Widespread Fall in Asset Prices: The so-called “housing bubble” burst and house prices rapidly switched from rising to falling. Sub-prime mortgage defaults occurred and these assets as well as derivatives based on these assets lost value. Banks suffered losses which reduced their equity. • A Large Currency Drain: Depositors started to withdrawal their deposits at money market mutual funds. This process created concern among banks that similar withdrawals would occur and that bank runs might start. • A Run on the Bank: When depositors lose confidence in a bank, massive withdrawals of deposits occur. Banks’ desired reserves increased so banks increased their reserves by calling in loans. • The widespread fall in asset prices threatened banks’ solvency; the currency drain threatened their liquidity; and, the potential run on the bank threatened both solvency and liquidity. • Banks’ efforts to shore up their balance sheet severely decreased the supply of loans and .

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•

commercial paper, so these markets essentially closed. Because the loanable funds market is worldwide, these problems immediately spread throughout the world. The drastic decrease in the supply of loanable funds started to affect the real economy.

The Policy Actions • Policy actions responding to the crisis were slowly implemented: • Open Market Operations: The Fed undertook massive open market operations to give banks more liquidity. The federal funds rate was lowered (in December to between 0.00 and 0.25 percent). • Purchase of Mortgage-Backed Securities: The Fed purchased significantly riskier assets, in particular mortgage-backed securities, from a wider range of depository institutions than before in exchange for assets or reserves. This policy allowed depository institutions to swap risky assets for safer assets or reserves. • Extension of Deposit Insurance: Deposit insurance was extended by Congress to other institutions, such as money market funds. This policy was aimed at preventing runs. • Troubled Asset Relief Program (TARP): With Congressional approval, the TARP was conducted by the U.S. Treasury. The TARP was funded with $700 billion of government debt. Under it, the U.S. government took direct equity stakes in major depository institutions. This action directly increased these firms’ equity and reserves. In December of 2008 some of the TARP funds were used to assist major automakers. Macroprudential Regulation Macroprudential regulation is financial regulation to lower the risk that the financial system will crash. • The global financial crisis of 2007–2008 brought this type of regulation to center stage. • Glass–Steagall: The U.S. Banking Act, 1933—the Glass–Steagall Act—was an early example of macroprudential regulation. To lower the risk of bank failure, the Act required the separation of commercial banking and investment banking. This Act was repealed in 1999 and mega-banks that did not separate commercial and investment activities emerged. • Dodd–Frank: The Dodd–Frank Wall Street Reform and Consumer Protection Act, 2010, also known as the Financial Stability Act of 2010, or as Dodd–Frank, created the Financial Stability Oversight Council (FSOC) and made wide-ranging changes in financial regulation. Its two highlights are • The Volcker Rule: The Volker Rule (proposed by Paul Volker, a former Fed Chairman) is a restriction similar to the prohibition of combined investment and commercial banking in the Glass–Steagall Act. The rule restricts the amount that a banks may invest in hedge funds and private equity funds to a maximum of 3 percent of their capital. • Orderly Liquidation Authority: Dodd-Frank established the Orderly Liquidation Authority, which empowers the FOSC to determine that the liquidation of a financial institution is necessary for the stability of the financial system. The concluding Economics in the News section examines the Fed’s decision to “taper” its stimulus. The analysis uses what was discussed at the FOMC meetings in June and July and the Fed’s goal for its policy. .

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Additional Problems 1.

In Freezone, shown in Figure 14.1, the aggregate demand curve is AD, potential GDP is $300 billion, and the short-run aggregate supply curve is SASB. a. What are the price level and real GDP? b. Does Freezone have an unemployment problem or an inflation problem? Why? c. What will happen in Freezone if the central bank takes no monetary policy actions? d. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?

Suppose that in Freezone, shown in problem 1, the short-run aggregate supply curve is SASA and a drought decreases potential GDP to $250 billion. a. What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b. What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c. Do you recommend that the central bank lower or raise the federal funds rate? Why?

Figure 14.2 shows the economy of Freezone. The aggregate demand curve is AD, and the short-run aggregate supply curve is SASA. Potential GDP is $300 billion. a. What are the price level and real GDP? b. Does Freezone have an unemployment problem or an inflation problem? Why? c. What do you predict will happen in Freezone if the central bank takes no monetary policy actions? d. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?

Suppose that in Freezone, shown in problem 3, the short-run aggregate supply curve is SASB and potential GDP increases to $350 billion. a. What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b. What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c. Do you recommend that the central bank lower or raise the federal funds rate? Why?

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China Raises Reserve Requirements The People’s Bank of China, the country’s central bank, raised the reserve requirements of its top commercial banks to put a squeeze on the credit market following a spell of robust economic growth. Source: International Business Times, October 11, 2010 a. If the United States had the economic performance of China, what monetary policy actions would the Fed’s most likely take. b. How would you expect China’s monetary policy of squeezing the credit market to influence aggregate demand in China. Would you expect it to have a multiplier effect? Why or why not? c. What actions might the People’s Bank of China take to slow the economy?

Solutions to Additional Problems 1. a. The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve. The price level is 110 and real GDP is $400 billion. b. Freezone has an inflation problem because its real GDP, $400 billion, is greater than its potential GDP, $300 billion. In this case if no action is taken Freezone will suffer from inflation. c. If the central bank takes no monetary policy action, the nominal wage rate and other resource costs will eventually rise so that short-run aggregate supply decreases. Ultimately in the long run the economy will reach equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will rise to 120. d. The central bank can take a contractionary monetary policy by raising the interest rate. This policy decreases aggregate demand, which decreases real GDP, lowers the price level, and decreases inflation. Decreasing real GDP, however, will increase the unemployment rate. 2. a. Freezone’s price level is 130 and its real GDP is $200 billion. Freezone has an unemployment problem because its real GDP is less than its potential GDP. If the central bank lowers the federal funds rate and buys securities, aggregate demand will increase. The increase in aggregate demand will raise the price level and increase real GDP, helping solve Freezone’s unemployment problem. b. If the central bank raises the federal funds rate and sells securities, aggregate demand decreases. As a result, the price level falls and real GDP decreases, which worsens Freezone’s unemployment problem. c. Freezone should lower the interest rate and buy securities because this policy will help solve Freezone’s unemployment problem. 3. a. The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve. The price level is 130 and real GDP is $200 billion. b. Freezone has an unemployment problem because its real GDP, $200 billion, is less than its potential GDP, $300 billion. c. If the central bank takes no action, the nominal wage rate and other resource costs .

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4. a.

c. 5. a. b.

eventually fall so that the short-run aggregate supply increases. Ultimately in the long run the economy will reach an equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will fall to 120. The central bank can take an expansionary monetary policy by lowering the interest rate. This policy increases aggregate demand, which raises the price level and increases real GDP. Unemployment decreases. Raising the price level, however, increases the inflation rate. Freezone’s price level is 110 and its real GDP is $400 billion. Freezone has an inflation problem because its real GDP is greater than its potential GDP. If the central bank lowers the federal funds rate and buys securities, aggregate demand increases. The increase in aggregate demand increases real GDP and further raises the price level, worsening Freezone’s inflation problem. If the central bank raises the federal funds rate and sells securities, aggregate demand decreases. As a result, real GDP decreases and the price level falls, which will decrease inflation and help solve Freezone’s inflation problem. Freezone should raise the federal funds rate and sell securities because this policy will help solve Freezone’s inflation problem. The Fed most likely would undertake contractionary monetary policy, as did the People’s Bank of China. China’s policy is designed to decrease the supply of loanable funds in China, thereby raising the real interest rate in China and decreasing investment and consumption expenditure. Aggregate demand decreases because both consumption expenditure and investment decrease. The overall impact of this policy might be smaller than expected because foreign loanable funds will flow into China to take advantage of the higher Chinese real interest rate. This increase in the supply of loanable funds will moderate the rise the interest rate. Even so, it is likely there will be a small multiplier effect if aggregate demand decreases because there will be some induced decrease in consumption expenditure. The People’s Bank of China could raise the Chinese interest rate or, as it has done, increase reserve requirements.

Additional Discussion Questions

1. Suppose events in the rest of the world cause net exports to increase when the U.S. economy is at full employment. How should the Fed react in order to maintain macroeconomic stability? Why? The increase in net exports increases U.S. aggregate demand and will, if left alone, create an inflationary gap. The Fed should conduct a contractionary monetary policy by raising the federal funds target rate. The contractionary monetary policy decreases U.S. aggregate demand and offsets the incipient inflationary gap. 2. What limits the Fed’s ability to steer the economy to avoid both recession and inflation? The Fed can offset fluctuations in aggregate demand because its monetary policy affects aggregate demand. So, for instance, if aggregate demand decreases the Fed can undertake expansionary monetary policy to increase aggregate demand, thereby offsetting the original decrease. However the Fed .

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cannot offset fluctuations in aggregate supply without either creating more inflation or more unemployment. For instance, if aggregate supply decreases, the price level rises and real GDP decreases. If the Fed combats the higher price level (and rise in inflation) by using contractionary monetary policy, real GDP decreases even more. And if the Fed combats the decrease in real GDP (and rise in unemployment) by using expansionary monetary policy, the price level rises still higher. 3. Why is there a difference between the short-run and long-run effects from an increase in the quantity of money? In the short run the price level rises and the money wage rate does not change, so the economy moves along its short-run aggregate supply curve and real GDP increases. Real GDP can be different from potential GDP. But in the long run the money wage rate rises to adjust to the rise in price level. Once this adjustment takes place, real GDP returns to potential GDP. When that occurs in the long run, the effect of the increase in the quantity of money has worn off. 4. What are the benefits of using rules to conduct monetary policy? Rules have one major benefit: People can understand them. The point is that members of the economy need to make decisions about what to supply and what to demand. On average these decisions will be better the less uncertainty faced. One source of uncertainty is monetary policy. If monetary policy is erratic and takes people by surprise they will often find that they have made sub-optimal decisions that they regret. If monetary policy follows rules—especially easily followed and easily understood rules—then this source of uncertainty is removed from people’s calculations. As a result, following rules will help members of the public make better economic decisions which means the economy will function better.

C h a p t e r

INTERNATIONAL TRADE POLICY

The Big Picture Where we have been: Chapter 2 introduced the gains from trade in a simple model with a linear PPF’s. This chapter continues the explanation of the gains from trade by looking at individual markets using the demand and supply model, first developed in Chapter 3. The chapter also reviews the effects of, cases against, and reasons for trade restrictions and protection with a focus on the loss resulting from trade restrictions. You might want to do this chapter after Chapter 2 and 3 before getting into traditional Macro topics. It could be especially helpful background information to have prior to discussing exchange rates in Chapter 9. It can also be helpful to assist the students in Chapter 4’s discussion of net exports.

New in the Fourteenth Edition

The chapter has been updated to incorporate new data about U.S. trade and trade patterns with the rest of the world. The closing Economics in the News article has been changed. This chapter closer shows why the trade war with China hurts U.S. and Chinese producers and consumers.

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Lecture Notes

International Trade Policy • • •

Comparative advantage means that all countries can gain from trade. Society gains from international trade. There are many arguments in favor of restricting international trade, but restricting free trade results in loss to society. I. How Global Markets Work The Big Assumption: Counties cannot be identical! Of all the assumptions economist make this one is easy to swallow. The basis for international trade is simply recognizing that countries are different and then exploiting those differences to benefit all countries involved. Ask your class how countries differ (quality and quantity of resources, climate, etc.) Now point out to them that one reason to trade is to acquire goods that you cannot make yourself. A tougher question is why we want to trade for goods that we can make ourselves. •

The goods and services that we buy from people in other countries are called imports. The goods and services that we sell to people in other countries are called exports.

International Trade Today The United States is the world’s largest international trader and accounts for 10 percent of world exports and 13 percent of world imports. • In 2020, total U.S. exports were $2.1 trillion, which is about 10 percent of the value of U.S. production. • Total U.S. imports were $2.8 trillion, which is about 13 percent of total expenditure in the United States. • The value of exports minus the value of imports is called net exports. In 2020, U.S. net exports were negative $0.7 trillion. (Exports were $2.1 trillion and imports were $2.8 trillion.) What Drives International Trade? • The fundamental force that generates international trade is comparative advantage. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than any other country. By specializing in producing the good for which each country has comparative advantage, both countries gain from international trade. For more data on international trade: Data on U.S. international trade can be accessed at the Bureau of Economic Analysis web site www.bea.gov/international/index.htm. Key facts worth emphasizing are the enormous growth in volume of trade over time and huge two-way trade in manufactures. Explain that the balance of trade results from spending and saving decisions in the United States and the rest of the world and is independent of the forces that generate the volume of trade, which this chapter covers.

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U.S. Exports • The United States will export goods for which it has comparative advantage. In the figure the world price of coal is $60 per ton and the price in the United States before trade is $40 per ton. The United States has a comparative advantage in producing coal because the price before trade is lower than the world price. In this case the United States will export coal. • In the figure, before international trade the price of coal in the United States was $40 per ton and at that price the United States produced 3 million tons of coal per year and consumed 3 million tons per year. With international trade the price in the United States rises to the world price, $60 per ton. At that price the United States produces 5 million tons of coal per year, consumes 1 million tons per year, and exports the difference, 4 million tons per year. U.S. Imports • The United States will import goods in which it does NOT have a comparative advantage. In the figure, the world price of automobiles is $20,000 per car and the price in the United States before trade is $40,000 per car, so the United States does not have a comparative advantage in producing automobiles. In this case the United States will import cars. • In the figure, before international trade the price of a car in the United States was $40,000 per car and at that price the United States produced 3 million cars per year and consumed 3 million cars per year. With international trade the price in the United States falls to the world price, $20,000 per car. At that price the United States produces 1 million cars per year, consumes 5 million cars per year, and imports the difference, 4 million cars per year. Winners and Losers From International Trade • When a country starts to export goods, its domestic price rises to the higher world price. Therefore, exports raise the U.S. price of the good or service domestically. With the higher price domestic consumers lose and domestic producers gain. On net, society gains because the winners’ “wins” are larger than the losers’ “losses.” • When a country begins importing, its current domestic price falls to the lower world price. Therefore, imports lower the U.S. price of the good or service. With the lower price .

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domestic consumers win and domestic producers lose. On net, society gains because the winners’ “wins” are larger than the losers’ “losses.” The Fable of Adam Blackbox: There is an enormously rich heritage of stories, parables, fables, and satires that you can use to enliven your classes on this topic. The following fable, inspired by James Ingram (from International Economic Problems, John Wiley, 1970) is a powerful way to begin. Make up your own version with local flavor and embellishment. Adam Blackbox announces that he has discovered an amazing way to produce low-price, highquality automobiles. He sets up a plant on a large tract of land along the coast of Massachusetts, hires 10,000 employees, swears them to secrecy, and begins delivering his low-price, highquality autos to the nation’s showrooms. Adam Blackbox is hailed as an American industrial hero. Blackbox Enterprises floats stock and Wall Street booms. Consumers love him. His automobiles are better and cheaper than those they could buy before he came along. Automakers hate him, but their attempts to pass laws to restrict his operations fail. The president and Congressional leaders explain that economic adjustment is an inevitable consequence of technological advance. And Adam Blackbox’s new technology for delivering lowprice, high-quality automobiles is clearly part of the process of achieving greater prosperity for all. The press becomes increasingly curious about what is going on in the giant New England auto plant. Investigative journalists create endless hours of speculative television programming on the amazing new technology. Then a tabloid journalist with a big checkbook finds a worker who is willing to talk. Adam Blackbox's secret is revealed. Nothing is produced at the plant. Adam Blackbox is a trader, not a producer. He buys grain from American farmers, exports it to Japan, and imports automobiles from Japan. His secret revealed, Adam Blackbox is hauled before Congressional committees on fair trade and denounced as an evil destroyer of American jobs. The president makes a special State of the Union speech in which he denounces Adam Blackbox, praises a vigilant press for saving Americans from the threat of cheap foreign labor, and announces a new budget initiative that will spend $50 billion on research in technologies to produce low cost, high-quality automobiles. Ask your students why the president and Congress accepted Adam Blackbox initially but then changed their tune. Was Adam Blackbox hurting America or helping America? II. International Trade Restrictions • Governments restrict international trade to protect domestic industries from foreign competition using tariffs, import quotas, other import barriers, and subsidies Tariffs • A tariff is a tax that is imposed by the importing country when an imported good crosses its international boundary. • A tariff increases the price of the good in the nation. As a result, the following occur: • Consumers buy less of the good and producers increase the quantity supplied; • Government collects tariff revenue equal to the tariff times the quantity imported .

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of the good; • Less of the good is imported; • A social loss results. These results are shown in the figure. The government imposes a $10,000 per car tariff on imported automobiles so the U.S. price rises to $30,000. U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million so that imports decrease from 4 million per year to 2 million. The government gains tariff revenue.

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Import Quotas • An import quota is a restriction that limits the maximum quantity of a good that may be imported in a given period. • A quota increases the price of the good in the nation. As a result, the following occur: • Consumers buy less of the good and producers increase the quantity supplied; • The importers collect additional profit; • Less of the good is imported; • A social loss results. • These results are shown in the figure. The government imposes a 2 million per year import quota on automobiles as shown. With this quota the supply curve becomes the U.S. supply curve below the world price of $20,000 per car and then the U.S. curve plus the 2 million import quota at prices above the $20,000 world price. The U.S. price rises to $30,000 per car. As a result U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million. Imports decrease from 4 million per year to 2 million. Other Import Barriers • Although they are not designed to limit international trade, health, safety, and regulation barriers have that effect. • Voluntary export restraints, while not common, act like a quota and exist if a country voluntarily limits its exports. Export Subsidies • An export subsidy is a payment by the government to the producer of an exported good. Although export subsidies are illegal under many international agreements, the United States and the European Union pay subsidies to their farmers that result in increased domestic production, some of which is imported. III. The Case Against Protection Arguments for protection include the following: • Helps an infant industry grow: The so-called infant-industry argument for protection is that it is necessary to protect a new industry to enable it to grow into a mature industry that can compete in world markets. The idea relates to dynamic comparative advantage in comparative advantages change over time due to learning-by-doing (from Chapter 2). However, the infant industries argument only applies if the benefits of learning-by-doing spill over to other industries. • Counteracts dumping: Dumping occurs when a foreign firm sells its exports at a lower price than its cost of production. Dumping might be used by a firm that wants to gain a global monopoly. However, it is difficult to measure the cost of production so whether .

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dumping is taking place is difficult to determine. And charging a different export price than domestic price is not necessarily evidence of dumping because firms often sell goods and services for different prices in different markets. Saves domestic jobs: The argument that trade protection saves jobs is flawed. International trade changes the type of jobs in an economy, but it does not decrease employment in the aggregate because jobs lost in one sector are offset by jobs created in other sectors. Allows us to compete with cheap foreign labor: The argument that trade protection allows us to compete with cheap foreign labor is flawed. Differences in real wage rates generally reflect differences in productivity, and competitiveness is determined by both differences in wages and differences in productivity. Penalizes lax environmental standards: The argument that trade liberalization leads to a “race-to-the-bottom” in environmental standards is weak. Many poorer countries have comparable environmental standards and should not be targeted. And environmental standards are positively related to income (they are a normal good). The best way to encourage improved environmental standards is to allow trade and the economic benefits it brings to poorer countries. Prevents rich countries from exploiting developing countries: The argument for protection to prevent people of the rich industrial world from exploiting the poorer people of the developing countries is wrong. While wage rates in many developing countries are very low, they would be even lower without foreign demand for the goods that these countries produce. Reduces offshore outsourcing that sends good U.S. jobs to other countries: When U.S. firms send jobs that could be done in America to another country, they are offshoring. If U.S. firms buy finished goods from other U.S. or foreign firms, they are outsourcing. Offshoring brings gains from specialization, but those who have invested in human capital to do a specific job that has now gone offshore will be hurt. The actual number of jobs lost to offshoring is small but these people are hurt even though the overall economy gains.

Offshore Outsourcing • When U.S. firms send jobs that could be done in America to another country, they are offshoring. If U.S. firms buy finished goods from other U.S. or foreign firms, they are outsourcing. • Offshoring brings gains from specialization, but those who have invested in human capital to do a specific job that has now gone offshore will be hurt. Does free trade exploit workers in developing countries? Students might be somewhat familiar with the terminology of “exploitation.” Have the students think about what “exploitation” means in the context of voluntary trade. If I benefit from someone I trade with, did I exploit them? Did they exploit me? If trade is voluntary, how did I manage to exploit the person whom I traded with? Is it because I am smarter than the other person? This seems to be the condescending assumption of those who talk about exploitation of workers in developing countries. Indeed, representatives from many developing countries do not see trade as exploitation, but rather see it as a way to improve standards of living. When these representatives are upset at WTO meetings, it is usually about the trade restrictions rich countries place on imports from developing countries keeping developing countries poor. There .

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are some good short videos that introduce students to some great issues. Search YouTube for “Does Capitalism Exploit Workers?” to find one that suits you. Why is International Trade Restricted? Despite arguments against protection, trade is still restricted because key economic interests benefit from protection. • Tariff revenues provide a relatively inexpensive way for the government to collect revenues. • Rent seeking is lobbying and other political activity that seek to capture the gains from trade. While the benefits from liberalized trade are large in the aggregate, they are widespread across all consumers. Meanwhile, the costs are concentrated on a smaller number of producers. It is in the interests of those who pay the costs of liberalized trade to undertake a large quantity of political lobbying to promote protection. • If the gains from free trade exceed the losses, it is possible to compensate the losers so that everyone is in favor of free trade. To some extent, unemployment compensation and job-retraining programs are designed to serve this purpose. However, providing compensation is difficult because it is hard to identify exactly who has lost a job as a result of free international trade and not because of other reasons. Another fable: There is also a rich heritage of stories, parables, fables, and satires on protectionism. But it is hard to beat Bastiat’s. Claude Frederic Bastiat (1801–1850) is a very interesting French economist. An ardent advocate of free trade, he wrote articles with Richard Cobden (the famous English free trader and opponent of the Corn Laws). His most wonderful piece is his satirical “Pétition des marchands de chandelles …” “Petition from the Manufacturers of Candles, Tapers, Lanterns, Sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting,” to give it its full title. The basic idea is that the sun creates unfair competition for candle merchants and a law must be passed to ban all windows and other openings that enable it to shine its light inside buildings. You can have a lot of fun with it not only in the context of trade, but also to talk about opportunity cost and production possibilities. For further reading: If you haven’t already done so, read this nice little book and use its basic ideas to illustrate and illuminate the analysis of the false arguments of protectionists: Russell D. Roberts, The Choice: A Fable of Free Trade and Protectionism, Updated and Revised Edition, 2000, Prentice Hall (ISBN: 0130870528). The book tells the story of David Ricardo being granted God’s permission to return to Earth and meet with Ed Johnson, a 1950s U.S. television manufacturer. Ricardo has some powers that enable him to create counterfactuals and to travel through time. The dialog between Ricardo and Johnson provides a powerful commentary on the benefits of free trade and the costs of protectionism. Unrestricted international trade benefits all the countries involved with trade. Emphasize the key benefits from unrestricted international trade: --The gains from international trade arise from the diversity of opportunity costs of production across countries. The source of prosperity in free trade arises from each country generating gains from specialization in their comparative advantage, minimizing its own opportunity cost of production, and sharing in each of the other country’s gains. .

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--Both exporting and importing domestic industries benefit from free trade. Free trade liberates each country’s consumption possibilities from the bonds of their own production possibilities frontier, enabling the consumers in both the importing and exporting country to enjoy consumption bundles of goods and services that would be unobtainable without trade. --Restrictions on international trade hurt the importing firms, the consumers of imports, the domestic exporting firms, and even the non-exporting firms. Protecting domestic industry from international competition backfires: i) it increases the relative price that other countries pay for domestically produced goods and services that are exported; ii) it raises the price of the imported goods consumed by domestic consumers; and iii) it lowers the income of producers of the goods for which the country has a comparative advantage in production by more than the increase in the incomes of those industries that gain from trade restrictions. Together, these influences decrease the total demand for domestic goods and services in the country imposing trade restrictions by more than the increase in demand for those domestic goods and services in industries for which the country does not have a comparative advantage. International trade is a “win-win” situation for all countries involved in trade. This is the most important message that can be delivered from this chapter. All legitimate counterpoints are rooted in the concern over unequal distributions of the gains from trade that are created. Emphasize that economic efficiency and economic prosperity can be achieved only through free trade among nations, and that the gains generated are more than sufficient to reimburse those individuals whose lives are made worse off from free trade. Point out that it is the difficulties of implementing such a reimbursement program are what prevent such programs from being established on a large scale. There is no good economic argument in support of trade restrictions. Dispel the many myths surrounding various justifications for imposing trade restrictions. The section of the chapter entitled “Cases Against Protection” contains concise and complete counter-arguments to the often heard justifications for restraining international trade. Emphasize that economists are overwhelmingly agreed that there is no good argument against free trade. The chapter ends with a new Economics in the News on the impacts of the U.S./China trade war. It focuses on the economic impact of the tariffs each side has imposed on the other and how both sides will win if the tariffs are removed.

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Additional Problems 1.

Suppose that the world price of bananas is 18 U.S. cents a pound and that when Australia does not trade bananas internationally, their equilibrium price in Australia is 12 U.S. cents a pound. If Australia opens up to international trade, does it export or import bananas? Explain how the price of bananas in Australia changes. How does the quantity of bananas consumed in Australia change? How does the quantity of bananas grown in Australia change?

Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China. a. Explain how the tariff on textiles will change the price of textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States. b. Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain?

In the 1950s, Ford and General Motors established a small car-producing industry in Australia and argued for a high tariff on car imports. The tariff has remained through the years. Until 2000, the tariff was 22.5 percent. What might have been Ford’s and General Motor’s argument for the high tariff? Is the tariff the best way to achieve the goals of the argument?

Use the information below to answer the following question U.S. Expands China Paper Anti-Dumping Tariff Responding to a case brought by the NewPage Corporation of Dayton, Ohio, the U.S. Commerce Department announced it was imposing a tariff of 99.65 percent on imported glossy paper from China. Glossy paper is the type of paper used to manufacture art books, high-end magazines, textbooks, and annual reports. In 2006 imports of glossy paper from China was estimated to be $224 million. Reuters, May 30, 2007 a. What is dumping? Who in the United States loses from China’s dumping of glossy paper? b. What argument might NewPage Corp. have used to persuade the U.S. Commerce Department to impose a 99.65 percent tariff? c. Explain who, in the United States, will gain and who will lose from the tariff on glossy paper. How do you expect the prices of magazines and textbooks that you buy to change?

Solutions to Additional Problems 1.

With no international trade, the price in Australia is less than that in the world, so Australia has a comparative advantage in producing bananas. As a result, if Australia opens up to international trade, it will export bananas. With international trade, the price of bananas in Australia rises. The higher price leads to a decrease in the quantity of bananas consumed in Australia. The higher price also leads to an increase in the quantity of bananas grown in Australia.

2. a. Higher tariffs increase the price U.S. consumers pay for textiles imported from China. Because the price of Chinese imported textiles rises, the quantity imported decreases. The quantity of textiles produced in the United States increases. .

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b. This trade restriction means that the U.S. and Chinese gains from trade definitely decrease. Textile workers and owners of textile firms will gain from the higher price. Textile consumers will lose from the higher price. 3.

Most likely the argument in favor of the tariff was the infant-industry argument. According to proponents of this argument, protection is necessary to a new industry to enable it to grow into a mature industry that can compete in world markets. Alternatively, Ford and General Motors might also have argued that a high tariff was necessary to protect Australian jobs. Protection is not the best way to achieve these goals. A more efficient way to protect infant industries is to subsidize the firms in the industry. And the jobs lost in the auto sector will be regained in other sectors devoted to exporting Australian goods.

4. a. Dumping is when a foreign firm sells its exports at a lower price than the cost of production. U.S. producers of glossy paper lose from China’s dumping of glossy paper. b. Dumping is illegal under the rules of international trade, so dumping is regarded as a justifiable reason for a temporary tariff. NewPage might have argued that Chinese exporters of glossy paper were charging a price of (approximately) one half the cost of production. In this case a tariff of 99.65 percent will (approximately) double the U.S. price of the imported glossy paper, thereby raising the price to the (alleged) cost of production. c. The U.S. producers of glossy paper (such as NewPage!) will gain. The U.S. government also will gain because it will receive additional tariff revenue. U.S. consumers of glossy paper will lose. The higher price of glossy paper increases the costs of magazine and textbook publishers. The supply of magazines and textbooks decreases so their price rises.

Additional Discussion Questions

1. How can we know that the benefits to the economy from free trade are greater than the benefits accruing to the domestic industry that is protected from foreign competition? Stress to the students that if unrestrained international trade creates the efficient outcome for both countries involved, it also must mean that prosperity for each country is maximized. • Emphasize that free trade between nations encourages each country to pursue specialization in production in those industries for which the country has a comparative advantage relative to other countries. • If the total quantity of goods and services consumed in each country after international trade is greater than without international trade, then total incomes accruing to individuals must be greater, which means the prosperity of each nation’s economy as a whole is greater under free trade. 2. How will countries know which domestic industries have a comparative advantage in order to allocate resources towards specialization in producing those goods and services? Specialization and gains from international trade will arise naturally through relative price changes on the world market. • When domestic firms within an industry have a lower opportunity cost of production than firms in other countries, these firms discover that the price they can receive from foreign buyers (importers from other countries) is higher than the price they can receive from domestic consumers. These domestic firms .

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•

increase output, demand more labor, capital, and raw materials, and resources flow toward these industries. When domestic firms within an industry have a higher opportunity cost of production than firms in other countries, domestic consumers discover that the price they must pay to foreign sellers for a good than the price they must pay domestic producers. Domestic consumers switch their purchases to foreign imports. The domestic firms producing this good decrease output, decrease their use of labor, capital, and raw materials, and resources flow away from these firms. Each country’s economy naturally becomes specialized in producing output in those industries for which the country enjoys a comparative advantage. However, for each country to gain, each country must allow consumers and producers to have free access to foreign markets.

3. Shouldn’t we protect the workers of those industries that are hurt by foreign competition? Point out that protecting the workers in industries for which our country does not have a comparative advantage is akin to making everyone in the economy suffer a lower level of prosperity than under unrestricted trade—all to ensure that a small minority of people does not suffer the economic losses associated with relocating to another community and finding employment in another industry. Use some specific examples in recent history: • In 2002, President George W. Bush signed into law a tariff on foreign steel by some 30 percent. In 2017 President Trump imposed similar tariffs. They effectively cost the hundreds of millions of American consumers tens of billions of dollars in higher prices for the myriad of goods containing steel, as well as those goods and services requiring transportation in trucks, trains, airplanes, and ships that are made from steel. They did this seeking political support from those states with a large presence of steel workers who work for firms that could not make a profit at the unregulated world market price of steel. Both presidents used the same defense: Other nation’s steel industries were receiving subsidies and had an “unfair “ advantage in production costs, effectively “dumping” steel in the U.S. markets at prices below production costs. Ask the students: What is “unfair” about having foreign governments effectively subsidizing the purchase of automobiles, trucks, and rail and air transportation by hundreds of millions of American citizens? Point out it is only “unfair” to the tens of thousands of steel workers who stand to face job relocation costs of finding work in another industry. • Emphasize that in each of these cases of trade restrictions, the economy as a whole would have gained from free international trade, but the autoworkers and the steel workers are groups of people that are much more easily organized and stand to benefit much more individually from trade restrictions than the wide-spread American consumers. The result is successful lobbying efforts to restrict trade to the detriment to all consumers in the American economy.