CHAPTER I

The CORE of Economics

The Economic Problem
- Human wants that exceed the resources available to satisfy those wants
- Scarcity
- Resources are always insufficient relative to wants
- Used by economists to summarize nature of human existence
- Economics = Science of Scarcity
- Humans are limited by their income and their time
- Business if limited also
- United Airlines has a limited number of planes and pilots, and therefore the management of the airline must choose the
cities they fly to and the number and times of the flight
- Humans wants are unlimited while having many resources being highly limited
- Scarcity is therefore a fundamental fact of life as it requires humans to make choices
What is Economics?
- Economics is the study of how people, business, and governments deal with the problem of scarcity
- The study of mankind in ordinary business of life
Big Idea
- People maximize their happiness
Consumers and Scarcity
- Utility is the economist’s term for happiness or satisfaction
- Positive Utility = eating good food
- Negative Utility ( Disutility ) = listening to music we don't like, car breaks down etc
- An economic bad is a bad that is so plentiful that someone is willing to pay to get rid of it.
- An economic good is a good that is so scarce that someone is willing to pay for it.
- A good is something that creates utility for a person
Economists classify resources into four basic groups or factors of production:
- Natural Resources
- Capital (human made goods that are used to make other goods airplanes trucks trains restaurant overs)
- Labor (workers)
- Entrepreneurship (creating a business)

Globalization
- The partial economic integration of the world
- Trade means shipping goods from one country to another
- When one economy of a country cannot function without the economy of the other i.e. US and China
- Increases variety
Consumers
- Allows consumers to choose from a wider variety of goods and services
Business
- Means that businesses can use natural resources, labor, and capital from many countries not just one
Workers
- Opportunity to sell skills i.e. computer programming
Government
- Globalization lessens the economic power of government
Scarcity and opportunity cost
- What we give up is called opportunity cost which could be money as well as other implicit costs
Margin
- Good decisions are made by considering the value of adding one more, is called the margin
Costs and Benefits
- Calculating explicit is easy
- Implicit is difficult
- Economics is a like science in many ways as there are many reliable tests that can be run to evaluate possible economic events
Issues with Science
- Not 100%
- Ceteris Paribus = errors of assumed causality
Economists and Models
- A model is a mathematical or statistical theory that explains one or more economic concepts through a simplified representation of the
world
 CHAPTER V
- Exports and Imports
- Export: Ay international transaction that causes money to flow into a country
- I.E. US Oranges to Japan
- Paycheck that comes from Italy to the employee of a shoe company who works in the United States
- Import: Any international transaction that causes money to flow out of a country
- I.E. Import of Coffee from Ecuador
- Paycheck that goes from Wynn Resorts in Las Vegas to an employee who works in Macao
- Exchange Rate
- Price of currency, always expressed in some other currency
- I.E. Yen roughly equals a penny in US currency
- Exchange rate is always changing
- Balance of Payments
- When a transaction causes money to flow in to a country is called a credit (+)
- When a transaction causes money to flow out of a country is called debit (-)
- Current Accounts Contents
- Exports and IMports of goods and services (e.g. cars, oils, tourism, and banking services)
- Primary Income (e.g. interest on government bonds owned by foreigners, wages paid by companies to workers in other
countries
- Secondary Income (money sent by a person to someone in another country)
- Part of the current account is easy to see
- We import auto parts and oil (both are visible)
- We also buy an insurance policy from a foreign insurance company
- Someone in Europe uses an american bank
- Since the US tends to have trade deficit this means that countries such as China and Japan have surpluses
- US tends to have a deficit in physical goods but a surplus of service
- Capital Accounts
- Capital Transfers (i.e. payments from foreign insurance companies to pay for damage caused by a hurricane, mineral rights
payments, some borrowing/lending between people in different countries, payment to use a trademark, certain types of
leases, or licenses)
- Financial Account Contents
- Net acquisition of financial assets (ford builds a factory in Mexico)
- Net incurrence of liabilities (Sony buys a movie studio in the US)
- Financial Derivatives
- This category is primarily the purchase of physical assets such as business, land, or houses, and the purchase of
stocks and bonds
- China buys large numbers of US government bonds each year
- Derivatives are financial instruments created from other financial instruments, such as a bond backed by a
mortgage (routinely sold between countries)
- The sum of all three accounts should be 0
- But due to data problems this will prevent these things from happening
- Values
- The government adds a category called statistical discrepancy, which is always equal to the difference between the
accounts and makes them add up to zero
 When Fiat purchases Chrysler the transaction will positively affect the capital account and bring money into the US in the short
run but over time this will start to benefit italy as the profits from chrysler will start to be sent to italy

Exchange Rates
- Just as goods trade for money, money can be traded for money
- Exchanging dollars into yen or euros
Terminology
- Appreciation: Supply and Demand (the market) cause a currency to rise in value
- Depreciation: Supply and Demand (the market) cause a currency to fall in value
- Revaluation: The government causes a currency to rise in value
- Devaluation: The government causes a currency to fall in value
Fixed versus Floating
- In reality, the system has become a “managed” or “dirty” float, in which we let our currency move to some extent, but stop it from
moving when it is going further than we like.
- I.E. the US and Japan often work together to control the dollar versus the yen, which have spent about 20 years fluctuating
between about 80 and 120 yen to the dollar
- This control helps keep prices constant in both countries, and helps keep trade flowing
- China controls their exchange rate with the United States, which leads to america to be unable to get out of the deficit hole
Trade Manipulation
- Leaders are intent on increasing the economic power of the nation without regard to its impacts on their partners
- A country can manipulate the value of its currency, the exchange rate, to make it easier for people from other countries to buy its
goods
- Barriers to trade, which make it difficult for goods from other countries to enter
- Tariffs
- Quotas
- Licensing Requirements
- A country may require businesses to have a license or permit to sell products within its borders
- Health and Quality standards
- Countries may limit products from other countries by setting high standards for health concerns or minimum standards for
the quality of products that ender
- Subsidies
- This is the positive way where the other four try to stop imports, subsidies are used to encourage exports. A payment from
the government to a business when that business exports
- Exchange Rates
- Ownership Restrictions
- Many countries limit foreign ownership of business
 CHAPTER VI​ ​GDP
- Income
- Income of a person or country is the amount of money it herbs or creates during a period of time
- Income is not necessarily cash
- Wealth
- Having $10,000 in the bank account is called wealth not income
- Does not mean it is cash
- Flow
- Anything measured over a period of time
- Stock
- Anything measured at an instant time
- If a farmer has 200 bushels of wheat in his barn that is his stock if he adds 20 bushels per day is his flow
- Leakages and Injections
- Consumption
- Purchase of goods or services
- Domestic Consumption
- Only purchases of goods and services produced in the united states
- Saving
- Any income not consumed
- Taxes
- Go into the hands of various governmental units and are not available for spending by households
- Imports are consumption, but with an important difference. When american goods are consumed, that money remains with
domestic business
- Savings, taxes and imports are all leakages. The name is relatively self explanatory. For an economy to function
effectively, income must flow from hand to hand. Suppose a household earns $100. It might take that $100 into the store
and buy groceries. That $100 is now income for the store, just as it was for the household. Then the store pays the $100 to
one of its employees. The same $100 has become income for this person, and has been income for three people. The
income can flow on and on, letting many people spend and respend it. What happens if the first household doesn't spend
the income? The store doesn't earn $100, so it can't pay it to its employees, and so on. The $100 has dropped out of the
flow, and is no longer contributing to economic activity. The people down the line are poorer because the flow was
interrupted, and the nation as a whole is poorer. The leakages constitute a drain on the economy, pulling income out.
- Injections are capable of pumping income into the economy, involumes that may equal or even exceed leakages
- Investment is the creation of new capital, that is plant and equipment, by business. Common folk generally refer
to the purchase of stocks or bonds as investments but that is just a financial transactions and does not mean a
result of capital
- Most investing done by households is actually saving
- Government Spending is the second injection
- Leakage of taxes can be offset by the injection of government spending
- Third INjection: Exports
- Money that had been outside of the economic flow is brought in from foreign sources, this injection
can balance the leakage of imports
- Economy is circular which means that everything that goes around comes around
- You pay taxes that go to the government and then the government gives money to businesses which pays your
wage which is the cycle that keeps the flow of money circular
- Increase in injections compared to leakages causes the national income to grow
Injections versus leakages
Injections = Leakages [Equilibrium]
Injections > Leakages [Income Rises]
Injections < Leakages [Income Falls]
GDP
- GDP = Consumption + Savings + Taxes
- GDP = Consumption + Investment + Government Spending + Net Exports
- GDP = C + S + T = C + I + G + (X-M)
- The market value of all final goods and services produced in a given year
Market Value
- GDP as it is valued at sale
- Market value can drop
- GDP measures the production of goods and services in the economy, but only those that pass through the market. If two men stay
home and are house husbands, the work they do does not count in GDP. If they clean each other’s houses, and pay each other $50,000
per year to do it, then GDP will rise by $100,000
- The part of the economy not measured by GDP that could be is called the “underground economy.”
Final Goods and Services
- Means that we add up the value of everything in the last condition it was in during the year
In a given year
- If a car dealer finances another used car in 2009 that transaction would not count in GDP because it’s an “old” item, and you fix it up
it does not count as “new” production
Recession
- When the real GDP falls for two or more consecutive quarters
GDP Components and Read GDP
REAL GDP IS ADJUSTED FOR INFLATION
Per Capita GDP
- Per Capita or per person
- Used to measure standards of living
- Does not measure quality of life in a country than might be assumed
National Income and Product Accounts
- (NIPA) The system that is umbrella for GDP
Business Cycle
- A business cycle is the normal economic pattern of boom and bust, expansion and recession
- Every period of growth has ended with a period of decline and vice versa
- Unemployment of people follows the business cycle
- It increases during the contraction and declines during expansion
- No regular pattern between the business cycle and inflation
 CHAPTER VII - INFLATION AND UNEMPLOYMENT
- What is meant by inflation and how it is measured
- What effects inflation has on the economy
- How someone becomes officially unemployed, and how you can have no job, but not be unemployed
- Why unemployment is not always a bad thing
Employment and Unemployment
- Not everyone is a worker
- Children
- We do not expect children to work under the age of 16 so we do not count them as potential workers
- People Institutionalized
- Includes people in jail, in the hospital, or a full time student
- Does not mean these people cannot be employed or not considered unemployed if they have a job
- Subtracting the non-institutionalized from the population you arrive at ​Non-Institutionalized Population
- If we consider military to be institutionalized, then we create the ​Civilian Noninstitutionalized Population
which subtracts everyone in the armed forces
- Every person in the Non-Institutionalized Population is placed into one of 3 categories
- Anyone employed or is actively seeking employment is a part of the ​Labor force
- Everyone else is said to be ​Out of the Labor Force
- Employed
- Anyone who receives pay outside of the home for at least one hour a week
- Unemployed
- People who do not work and are actively seeking employment
- Out of Labor Force
- Whatever is left
- Part time employment is counted the same as full-time employment (i.e. unemployment will not change if
everyone goes part time)
- Don't account for the type of work people do
- But if a physicist is a janitor they are said to be ​UNDEREMPLOYED

- DISCOURAGED WORKERS
- People who are no longer counted for unemployment because they are not actively seeking
unemployment
- They are a problem because they have stopped looking for a job an we stop counting them as labor
force
- THE POPULATION OF THE UNITED STATES IS SUBDIVIDED AS FOLLOWS:
- Children and Institutionalized
- Employed
- Unemployed
- Out of the Labor Force
- The employed and unemployed add up to the labor force
- The ​UNEMPLOYMENT RATE​ equals the percentage of the labor force that is unemployed
- Has quite a few variants
- Varies from state to state and city to city
- Nevada may have an unemployment rate below the national rate one year and
a rate higher than that for the country the next year
- Race is also a variation
- African American and Hispanic persons have higher
unemployment rates than other groups
- Teenagers have higher unemployment rates than older
women
- Persons over about 55 years of age have higher
unemployment rates than workers between 20 and 54
- Women have lower unemployment rates than men
- Some blame the differences on
- Discrimination
- Education and Training
 - Social Issues (Where people live, their access to transportation, the likelihood
of their staying in a job for a period of years
- The correct answer is a combination of all these explanations and
some others as well
- US Government calculates six different unemployment rates, called U1 through U6
- U3 is the one most often quoted
- U1 and U2 include fewer people
- U4 through U6 count people who are less connected to the labor force such as
discouraged workers
- TYPES OF UNEMPLOYMENT
- CYCLICAL UNEMPLOYMENT
- Caused by the business cycle and rotates from high to low unemployment
- FRICTIONAL UNEMPLOYMENT
- When employees voluntarily quit their jobs to find another and are briefly unemployed
- Shows a strong economy because people are leaving current jobs for better ones
- SEASONAL UNEMPLOYMENT
- Life guards and construction workers are employed only in the summer time or mall santas only work during
the winter time
- STRUCTURAL UNEMPLOYMENT
- The infrastructure is not good or they lack some necessary skills like reading or writing
- NEGATIVE EFFECTS OF UNEMPLOYMENT
- Significant social effects
- Increases in unemployment lead to increased suicide, domestic violance, crime, admissions to mental hospitals,
- People who lose their jobs and people who are worried about losing their jobs live with the uncertainty of
potentially being unable to support their situation
- CALCULATIONS
- LABOR FORCE = EMPLOYED + UNEMPLOYED
- UNEMPLOYMENT RATE = UNEMPLOYED/ LABOR FORCE
- INFLATION
- Sustained increase in the general price level.
- When prices rise they will stay high
- 2 main measurements of inflation
- Consumer Price Index (CPI)
- Measures changes in prices paid by consumers
- Producer Price Index (PPI)
- Measures changes in prices of the raw materials bought by a business
- Each of the measures in an index number which means it compares base year to all other years
- An index of 200 means that prices doubled since the base year
- An index of 80 means prices have fallen 20 percent since the base
- Currently the CPI is about 250 with a base year of 1982-84, which means
prices today are around 2.5 times as high they were in 1982
- Prices change at different rates in different countries
- INDEX NUMBERS
- MARKET BASKETS
- SHOPPING BASKET
- The shopping basket of the typical urban american household is created and then prices for the items
are obtained
- They contain
- Housing
- Medical services
- Cars
- Any Other item purchased by the household
- By comparing the prices now to the base price we find the index
- CPI = (Basket Today/ Base Basket) x 100
- PPI uses basket of producer goods i.e. raw materials
- PPI is a leading economic indicator which helps us predict the future or pricing
- i.e. if PPI goes up that means businesses are having to pay higher prices for raw materials
 - No good way to measure accuracy of CPI
- NEGATIVE EFFECTS OF INFLATION
- Understood to be a worse long-term issue than unemployment to many economists
- If prices are rising, consumers develop expectations of the future that change their buying habits. If I think that
cars will be more expensive next year, I will be more likely to buy one today. If inflation is going to be high, I
will tend to spend all my money now, and not save
- Creates a live for today mentality
- Stable prices allow for consumers to plan for the future while inflation does not allow for this to happen
- Investment will struggle during inflation given the uncertainty of the market
- USING THE CPI
- First CPI calculates inflation rate or the percentage in which prices has risen for each year and the total percentage of
increase over a period of time
- INFLATION RATE = (CPI TODAY x 100/ PRIOR CPI) - 100
- Second, takes the price from any year and converts it into modern pricing
- COMPARING VALUES
- PAST EQUIVALENT = CURRENT PRICE x PAST CPI/ CURRENT CPI
- CHANGE PAST PRICE TO CURRENT EQUIVALENT
- CURRENT EQUIVALENT = (PAST PRICE X CURRENT CPI)/ PAST CPI
 CHAPTER VIII AGGREGATE SnD
THE COMPONENTS OF AGGREGATE DEMAND
THE REASONS THE AGGREGATE DEMAND CURVE MAY SLOW DOWNWARD
THE COMPONENTS OF AGGREGATE SUPPLY
THE REASONS THE AGGREGATE SUPPLY CURVE MAY SLOPE UPWARD
THE EFFECTS OF CHANGES IN ECONOMIC VARIABLES ON THE PRICE LEVEL AND OUTPUT
- AGGREGATE DEMAND AND AGGREGATE SUPPLY
- Aggregate is simply the word used for total in the economists world
- Aggregate supply & Aggregate Demand mean total demand and total supply in the economy
- Does not mean they are the sum of all the regular demand and supply curves for the markets that
make up the economy
- AGGREGATE DEMAND
- Total quantity of output that will be purchased in the economy at different levels of prices
- It shows us the total expenditure that will occur as the general level of price change
- Investment is spending by businesses on capital goods
- Government spending is government spending
- Exports
- Imports are negative spending a leakage like saving and teces
- The amount that people can spend is limited by the money supply, and therefore, a change in the supply of money will
change the relative position of aggregate demand.
- The money supply may also affect aggregate demand indirectly because it affects interest rates, as we shall see later on.
- CHANGES IN AGGREGATE DEMAND
- Aggregate Demand Factor To Increase Aggregate Demand To decrease aggregate demand
- Consumption Increase Decrease
- Exports Increase Decrease
- Investment Increase Decrease
- Government Spending Increase Decrease
- Money Supply Increase Decrease
- Savings Decrease Increase
- Taxes Decrease Increase
- Imports Decrease Increase
- Aggregate demand aids us in making economic predictions
- The effect of lowering taxes on the economy
- Raise aggregate demand because it will increase consumption spending by
households ceteris paribus
- SHORT RUN AGGREGATE SUPPLY
- Aggregate supply represents the total production of goods and services in the economy
- Aggregate supply is fundamentally about costs
- If everything being equal a change in costs will change the profit potential from the production of goods and services
- Whatever raises or lowers the cost will raise or lower the aggregate cost
- The cost of the factors of production will affect aggregate supply
- Change in costs of labor
- Change in costs of natural resources
- Move the AS curve
- Aggregate supply now represents the total productive capacity of the economy
- Factors such as technology that impact the entire economies ability to produce will impact supply
- Sometimes these changes take the form of “supply shocks”
- SUPPLY SHOCK
- Is an event beyond our control that impacts the productive capability of the economy
(usually negative)
- I.E. if california were wiped out by earthquake the total production at any
price level in the US would decline
- This geological shock would create a supply shock and affect aggregate
supply
- Why is SRAS sloped upward
 - When prices rise and businesses temporarily earn more profit and raise output
but the LRAS will not be upward sloping
- SRAS to increase SRAS to Decrease SRAS
- Costs Decrease Increase
- Productivity Increase Decrease
- Technology Improve Lessen
- LONG RUN AGGREGATE SUPPLY
- LRAS the long run equilibrium condition of the economy and the LRAS representing full
employment in the economy
- LRAS is the amount of output that will be produced if the economy is at the natural rate
of unemployment. That is, LRAS is the output level that occurs at full employment. So
the amount of output that is produced if the economy is on its LRAS curve is Full
Employment Real GDP or the Natural Rate of Real GDP.
- WHen the economy has a downturn it turns away from LRAS and turns to SRAS
- Economy should always be heading towards LRAS
- AGGREGATE SUPPLY AND AGGREGATE DEMAND TOGETHER
- The intersection of these is equilibrium for the economy as a whole
- At equilibrium, total spending in the economy on goods and services equals the total
production of goods and services.
- Aggregate Demand and Short Run Aggregate Supply together represents where the economy is at
the equilibrium
- LRAS tells us the full employment Real GDP level of the econome\y
- AD and SRAS tell us where we are and LRAS tells us where we want to be
 CHAPTER IX CLASSICAL ECON
MACROECONOMICS THEORIES
- Macroeconomics studies the economy as a whole
- Tells us why today there are 5 million unemployed people in the united states not why an individual in unemployed
- Why on average all prices seem to rise over time not why any one price goes up
- Why the total income of a country is rising not why the income of a single person is rising
- Tells us why some countries are rich and some countries are poor not why some people are rich and some people are poor
- Any macroeconomic theory needs to explain three things
- Why recessions and unemployment occur
- Why inflation occurs
- How economies grow over time
- Macroeconomic theories tend to be based on either aggregate supply or demand but not both
MACROECONOMICS & MICROECONOMICS
- Macroeconomics theories MUST have microeconomic explanations
- Macroeconomic theories depend on the behavior of individuals, and the behavior of individuals and the behavior of business
- Some macroeconomics may not explain why one person is unemployed but it will explain the behaviors of people that led to the
unemployment
- By itself macroeconomics is a “black box” that explains without understanding
CLASSICAL ECONOMICS
- Classical economics is a theory whose development took many decades, and is based on the work of many individuals
- Essentially classical economics begins with Adam Smith’s ​The Wealth of Nations ​in 1776
- Remained the dominant economic theory until the Great Depression
- Smith Started an economic doctrine that relies on the power of competitive markets to function for the benefit of all
- You can identify their faith of markets to achieve the best solutions, and a belief that government can only be an
impediment to those solutions
ECONOMIC CONDITIONS
- In Smiths world there are many small businesses
- There is only a few large companies usually owned or sponsored by the King
- Preponderance of production in the economy is created by very small business operating in a highly competitive
environment
- Few regulations that control or limit business
- No labor laws
- No labor unions
- Or long term labor contracts
- Markets might be able to function freely
- When factory system begins to emerge the owners of the factories had an advantage over their employees because until the
1900s factory workers where day laborers
SAVINGS, INVESTMENT AND CONSUMPTION
- Classical economists noted that savings and investment were both tied to interest rates
- The saver was encouraged to save by the return they might receive
- The higher the interest rate the more a person wished to save
- The investor (one who purchases capital goods) was encouraged by low interest rates, since the investor most often
borrows the money needed to invest
 - If we do not need to borrow money to invest we could have loaned it to someone else, or bought bonds, or otherwise used it
to earn money in the financial markets
- Investment depends on interest rates
- Savings increases and interest rates rise
- Investment decreases as interest rates rise
- Interest Rate are above equilibrium (r) people will save more than business wish to invest
- Interest rates will equate savings and investment
- Basic assumption of classical economics: savings will always be equal to investment because the free market will make it
so

SAY’S LAW
- Supply creates its own demand
- When GM builds a car, it pays the workers when the good is made
- When goods are produced, how do we know they will be sold
- SAY’S ANSWER the production of the good creates the income needed to buy it
- Says law means that when we produce goods we create income which can be used to buy the goods
- Will consumers actually turn their income into consumption
- Classical answer of Say’s law is yes
- This will happen for several reasons
- Wages tend to be lo, so low that most consumers will need to spend all their income to get by
- Interest rates adjust to balance savings and investment
- Savings get turned into investment through loans, and the rest of income must be consumed
- Workers only have 2 choices to save or consume, all income is converted to spending
- In recessions there is unemployment and some goods are not sold
- Say’s law suggests that recessions are impossible
- Everything that is produced will be sold, so that there cannot be a surplus of goods on the market

- In economy in this graphic is a CLOSED ECONOMY, meaning that there is no trade

- The same thing would occur if trade were allowed and imports and exports were balanced
- CLASSICAL VIEWS THAT ALL INCOME BECOMES SPENDING
- Households only have 2 choices for their income, consumption or savings
- Classical economists would argue that savings will always equal investment and consumption is
always directly spend in business
- Classical economists believe that Say’s Law holds the circular flow is always in equilibrium
- WHAT HAPPENS IF CONSUMERS SAVE MORE AND CONSUME LESS?
 - Investment suddenly is less than savings, interest rates will fall, investment will rise, savings will fall,
equilibrium returns and the economy sails off happily into the sunset
POPULATION THEORY
- Population theory contends that the population of a country will tend to grow faster than the ability of the economy to support and feed
them
- The only downside that matters to the people is that the labor force will always be large and competitive which means wages will
always be low
FLEXIBLE WAGES & PRICES
- Given the nature of classical economy wages and prices will be flexible
- Meaning that wages and prices can move freely both up and down
- Workers might be paid $1 per hour today, $0.97 tomorrow and $1.07 per hour the day after
- Business can always sell their goods because they can lower the price until buyers appear
- People who want jobs can always find them as well because they can offer themselves to work at a lower wage than is
being paid
- No one is unemployed in classical world because they believe that you can offer to work for less which in turn would mean
that people are only unemployed by choice
CLASSICAL DICHOTOMY
- In macroeconomics we are concerned with 2 basic variables
- Price level
- Total output
- Classical economy theory contends that the two are unrelated in the long run (LRAS is vertical)
- They believe that aggregate demand factors, including the money supply and government spending and taxes, affect only prices
- They believe that supply factors such as costs and productivity determine output
- Known as Classical Dichotomy
- To be classical there are real variables there are nominal variables
- Real variables are things like output and the prices of goods measured in other goods
- Nominal variables include the money prices of goods and the money wage the workers are paid
- To a classical economists the nominal and real variables are unrelated, a belief we call the Classical Dichotomy

- Aggregate demand increases from AD to AD2, which changes the price level fromP1 to P2. The nominal variable, price, changes. The
real variable, output, remains unchanged at Q1.
- Classicalists argue that people care about the real values, and that nominal values are generally irrelevant
- Workers care about purchasing power of their wage (real wage), not the money value (nominal wage)
- Business care about the real output they produce not the dollar value of their sales
- If every wage and every price in the economy doubles a classical economists would argue that nothing else would change,
because no one would be better or worse off than they were before
- Suppose that a loaf of bread is $2 and a pound of cheese is $2
- In real terms 1 loaf of bread = 1 pound of cheese
- If both prices rise to $4 the NOMINAL PRICE has changed, but in REAL TERMS, one loaf of
bread still equals one pound of cheese
- If a salary is originally $4 per hour, an hour of work is equal to 2 loaves or two pounds of cheese
- REAL WAGE - the ability to buy
RECESSION
- Not possible in classical theory because wages and prices are flexible
- When the economy heads south, wages and prices drop
 - Wages fall as workers lower wage demands to remain employed
- Prices fall necaise nissomess need to sell their goods.
- The business remains profitable, however, despite the lower prices because wages fell
- The economy simply moves to a new equilibrium, with lower wages and prices, and the same output (Real
GDP) as before
- Workers are no worse off because their wages are lower and so are the prices of good they buy are
- If wages and prices both fall 10% the workers real wage, adjusted for inflation, is unchanged
- FLEXIBLE WAGES AND PRICES
- THE ECONOMY IS STABLE AND SELF-CORRECTING
- Classicalists believe that recessions don't happen because it only happens when people buy something they don't plan on
consuming
INFLATION
- Recession in classical view is all about aggregate supply
- Inflation is about aggregate demand
- Classical economists will argue THE ONLY CAUSE OF INFLATION IS AN UNWARRANTED INCREASE IN THE SUPPLY OF
MONEY
- QUANTITY THEORY OF MONEY
- Based on historical observations, the direct relationship between the quantity of money and level of prices
- Money supply doubles tonight, prices will double tomorrow
- To a classical economists the way to prevent inflation is to simply to control the money supply and inflation around
aggregate demand
AGGREGATE DEMAND & AGGREGATE SUPPLY
- Recessions = aggregate supply
- Inflation = aggregate demand\
- Suppose the economy is in a recessionary gap. What will happen? Wages will fall. Businesses are interested in maintaining their
profits, and will lower wages as the economy begins to head into a recession. Prices will also fall and the economy will return to full
employment.

- Wages will fall, which shifts the SRAS curve to the right. Everything else equal, lower wages mean higher profits, which increases the
amount of output the firm wishes to produce. Prices simultaneously fall, and the real equilibrium occurs at a price level of 80, and full
employment real GDP at $7 trillion. There is no involuntary unemployment, and workers are not unhappy that their nominal wages
have fallen, because prices have fallen as well.
- Inflationary gap = wages will rise
- Businesses want to produce more, which requires them to hire more workers
- However, at the prevailing wage, there are no more workers available for hire
- Businesses will raise wages to attract workers into the labor market
LONG RUN
- The Classical economists imagined a beautiful world in the long run. Without defining how long we have to wait for the long run, but
with the idea that it would not be too long, these economists argued that the long run meant a future of economic stability. We would
find an equilibrium where the basic economic variables such as output and employment were relatively constant, where everyone who
wanted a job had one, and where prices were relatively stable. Economists refer to this as a “Stationary State.” Basically, an economic
situation where the economy functions like a clock, each gear turning in unison, never too fast, never too slow. The Classicals
envisioned this as a very nice place to live.
 CHAPTER X
FUNDAMENTALS OF KEYNESIAN
WHY KEYNES THOUGHT SAVINGS AND INVESTMENT MIGHT NOT BALANCE
WHY EXPECTATIONS ARE IMPORTANT IN ECONOMICS

THE GREAT DEPRESSION

- 12 years the US had unemployment rates above 10 percent of the labor force
- Wages fell, banks failed, investment approaches zero, the unemployment peaked at 25%
- In spite of classical economists these problems do not correct themselves and there is no explanation or rationale for 12 years of
economic downturn
- The depression ended when WWII ended and the US economy turned to a new theory to explain economics in the 1930s
KEYNESIAN ECONOMICS
- John Maynard Keynes a british economist
- Largely based in classical economics with a variation
- Work was observed by POTUS Franklin Roosevelt
CONSUMPTION AND SAVINGS
- Classical economists believed that interest rates equated savings and investment
- Consumption was the difference between the income people earned and the amount they decided to save
- Keynes argued that people decide how much to consume first based on their income and that savings os the difference between the
income people earn and the amount they spend
- Keynes views that there is no factor that automatically equated the amount of savings and the amount of investment
- Argued that investment was the most important of the factors in the circular flow, and that lack of sufficient investment
would cause a recession
CONSUMPTION AND INCOME
- AUTONOMOUS CONSUMPTION occurs whether or not we have income
- Minimal consumption necessary to sustain us
- INDUCED CONSUMPTION
- Consumption created by income
- Keynes say that each person has MARGINAL PROPENSITY to CONSUME (MPC)
- MPC is the additional consumption that is created for each additional dollar of income
- Opposite of MPC is MARGINAL PROPENSITY to SAVE (MPS)
- Additional dacings that will result from another dollar of income
MPC + MPS =1 ​ALWAYS
- A homeless man finds a dollar on the street he will spend 100% therefore the MPC of the homeless person is 1
- If a billionaire finds the same dollar on the street they will likely consume none of it and have an MPC of 0
- The billionaire spends more than the homeless person but does not spend more if their income rises
- Most people are somewhere inbetween
- If someone is given a pay raise, most people will consume some now and save some for later
- US citizens statistically are poor savers as a $1 pay raise will result in an addition 95% of consumption
- Japan has a MCP of 80% so 20% goes to savings
- Total income we consume is called AVERAGE PROPENSITY to CONSUME (APC)
- Proportion of our total income we save is called AVERAGE PROPENSITY to SAVE (APS)
FORMULAS
Y = Income
C = Consumption
S = Savings
APC = C/Y
APS = S/Y
APC + APS = 1
MPC + MPS = 1

Enrique made $1,000 this week in income. He spent $800. Last week he made $950 and spent $770. What are his APC, MPC, APS and MPS?
APC = 800/1000 = 0.8
MPC = (800-770)/(1000-950) = 30/50 = 0.6
APS = 1 - APC = 1 - 0.8 = 0.2
MPS = 1 - MPC = 1 - 0.6 = 0.4
CONSUMPTION AND THE FLOW OF INCOME
- Income is not stationary because it moves through the economy
- Each act of consumption in the economy is tied to the income of someone else (and usually more than one person)

EXAMPLE
- A college student gets a $100 allowance and that the country he lives in has an MPC of .9 he will spend $90 and save $10
- The college student joins a gym at the song of $90 a month which they view as income and pays the trainer $90
- The trainer view the $90 as income and will spend $81 and save $9
- Suppose the trainer gets their hair done every month and a boujee salon and it costs $81
- The hair stylist will view that $81 as income and will spend $72.90 and save $8.10
- Total income
- Student $100
- Trainer $90
- Hair Stylist $72.90
- Total $262.90
- If the hairdresser saved all the money she earned the students $100 a month increase the total income of society
by at least $262.90
- If the student stopped receiving an allowance everyone would suffer the trainer hair stylist and gym
THE MULTIPLIER
- MULTIPLIER tells is the total change in income that will occur in the economy from a change in consumption
- Multiplier is based on the MPC and its formula
- K = 1/(1-MPC)
- K=Multiplier because it comes from Keynes, the multiplier times the change in consumption is the
change in income
EXAMPLE
- Student who gets $100 allowance every month
- Y = (1/(1-0.9))x$100 = 10 x $100 = $1000
- MPC of 0.9 creates a multiplier of 10 which means the students $100 will create a total of $1,000 of new
income for the economy
- Multiplier acts as the reason on the interconnectedness of spending and income and how a change in one persons
consumption affects the incomes of many others
INVESTMENT
- The purchase of capital
- Investment means building new factories or buying new equipment
- Southwest buys an airplane and expects it to fly 20 or more years
- Keneys says BUSINESSES ONLY INVEST WHEN THEY EXPECT TO MAKE A PROFIT
FROM THEIR INVESTMENT IN THE FUTURE
- Contrasting theory from many classical theorists because they believed that economy was
a game on the present
- Keynes reasons that no matter how low interest rates become no one will invest
- No one will invest because they cannot sell everything they are making with their
existing equipment
 - In the great depression they believed that they would not be able to sell anything form a
new factory if they cant fully use the output from the old factory
- If southwest flew once a day to boston and only was half full, what interest rate could
make them want to buy another plane and add a second flight
-In a Keynes world
- Savings might be larger than investment
- Investment might be larger than savings
- Savings will be determined by the desire to consume, and investment jointly by business
expectations and interest rates
- Both will never cross paths
THE MARGINAL EFFICIENCY OF CAPITAL
- Keynes term for the investment demand curve MARGINAL EFFICIENCY of CAPITAL (MEK) using K for capital since C is
consumption
- Bussinesses that wish to incest will follow a siple rule
- Buy capital when the expected return (MEK) is larger than the interest rate
- Keynes brings into macroeconomics the idea that the expectations of the future are the most
important factor in making investment decisions.
- Interest rates matter, but only after the business person has decided the future is bright.
- If Ford thinks demand for its cars will decline in the future, they are not going to build a new factory
no matter how low interest rates become.
- Suppose United Airlines is thinking about buying a plane. They have the $40 million in
cash ready to buy it. They expect to make a 5 per cent per year return on the plane. At the
same time, suppose banks are loaning money at 7 percent. If United is really interested in
maximizing its profits, it should loan the money out at 7 per cent, rather than buy a plane
which will return only 5 per cent. From a business perspective, people might think it
strange if United loaned American $40 million so American could buy a plane! But from
a profit perspective, if United thinks the loan is better than the plane and American thinks
the plane is better than the loan, both are making sound business decisions. And, both
could turn out to be right, or wrong, expectations do not always turn into reality.
- The amount of investment that occurs in the economy will depend on the the level of the MEK curve (which is based in
expectations) and the interest rate
- If interest rates are 9 per cent, any investment that returns less than 9 cents will not be profitable
- But if interest rates stay at 9% but the expectations of business people improve than the MEK will
shift rightward and investment will increase without any change in the interest rate
- According to keynes investment in highly volatile
- Had little to no faith in business people and for them to make smart decisions and would stop investing unnecessarily at
times and would be reluctant to start investing again
- Keynes reasoned that at times interest rate required to make savings equal to investment would be negative
- Banks would have to pay to get investment going and they cannot do that and make a profit
- In those circumstances only the government can make investment happen
- In the 2007-09 recession banks have been giving out trillion dollars of new money yet they are not
making loans to businesses
SAYS LAW
- According to Keynes it is possible that goods will be produced that no one will buy
- Not because no one can but because the CHOSE not to
- There can be goods on shelves that no one will buy regardless of price
- If all consumers decide to save more and consume less a classical economist would say that the increased
savings will lower interest rates, stimulate investment and the total spending in the economy will stay in balance
- Keynes would disagree
- When consumers stop buying goods and save more investment will fall not rise
- Businesses do not need to build new factories when demand for their goods is
decreasing
- The decrease in consumption will cause the MEK to shift to the
left
- Investment will fall and output will fall
- The economy will reach a new EQUILIBRIUM when real GDP
lower than before
 - PARADOX THRIFT
- When most consumers try to save more
income will fall and they will end up saving
less in total
QUALITY
- Classical economists believe in price adjustment
- Recessions cause changed in the price of labor (the wage) and the prices of goods
- These price changes keep output at equilibrium
- Keynes believed that these changes would not have the effect imagined
- They believed that wages and pries are sticky downwards and they do not fall easily
- Keynes did not believe in Classical DIchotomy
- He argued instead that workers worried more about their nominal wage than their real wage and the falling
wages or lack thereof,
- This supposes that businesses will be quantity adjusters. In a time of recession businesses will react
by laying off workers. In a time of recession the business will react by lowering output. It is
production and employment that are flexible in an important way in Keynes’ world, not wages and
prices.
- Classical theory is supply oriented and Keynesian theory is demand oriented, and Keynes
does not believe in an LRAS, or Natural Rate of Unemployment (though the Keynesians
of today do).
RECESSION
- According to Keynes recessions are caused by lack of spending, an insufficiency in aggregate demand, or an “effective demand
failure”
- Businesses are quality adjusters and react by cutting employment and cutting output
- In turn it cuts people's incomes
- Equilibrium can settle at any point from the peak of the economy or the bottom of the recession
- Suppose that business are happily investing in plant and equipment then they get word that they is a recession
coming
- They would move to lower spending because the future is not promising
- The companies investment in new factories created jobs in construction and building materials
- Now those people no longer have jobs
- Unemployment will rise and the business person will see a recession come
INFLATION
- Keynes would say that large increases in aggregate demand from any source will be inflationary
AGGREGATE DEMAND & AGGREGATE SUPPLY
- Classical economists see a division between aggregate demand (prices) and aggregate supply (output)
- Keynes approaches with a more general view that both aggregate supply and demand affect prices and output (real GDP)

- a Keynesian recession. Aggregate demand falls from AD2 to AD, output falls from Q2 to Q1 and the price level falls from P2 to P1.
To Keynes, there is no automatic mechanism that will restore the economy to a Real GDP of Q2. The new position is an equilibrium in
the true sense.
RECESSIONARY GAPS AND INFLATIONARY GAPS
- Keynes saw the real world and understood that both recessionary and inflationary gaps would occur
- Keynes believes that changes in aggregate demand are required to eliminate a gap
 - Keynes believes thatthe required change in AD will not be automatic
- Someone must make an intentional decision to spend
- Keynes sees the world with millions of customers, businesses, but only one government and will conclude that the simplest way to
move AD is for the government to do so
- When aggregate supply increases, prices fall. When aggregate demand is increased, prices rise.
- Classicals see falling prices and Keynesians rising prices as the recession ends
THE LONG RUN
- He wrote that the Classical attitude of waiting for the economy to fix itself was like telling the captain of a ship, taking on water during
a hurricane, not to bail, because the ocean will be calm again once the hurricane is past. In other words, it does no good to wait for the
economy to fix itself, or your boat may sink to the bottom of the ocean before the hurricane ends. He argues for intervention in the
economy to make it work properly, as we will see in a later chapter.
 CHAPTER XI
MODERN MACROECONOMIC THEORIES
WHAT HOLES EXIST IN CLASSICAL AND KEYNESIAN THEORIES
HOW SUPPLY SIDE ECONOMICS TIRED TO CHANGE THE WORLD
HOW THE NEW CLASSICALS HAVE TRIED TO SAVE CLASSICAL ECONOMICS
HOW THE NEW KEYNESIANS HAVE TRIES TO SAVE KEYNESIAN ECONOMICS

MACROECONOMIC THEORIES
- Any macroeconomic theory needs to explain three things
- Why recessions and unemployment occur
- Why inflation occurs
- How economics grow over time
- Classical and Keynesian economics attempted to do these things
- Classical economics was THE theory until the Great Depression and stated that recessions fix themselves quickly cannot
stand a 12 year long depression
- Keynes theory does not allow for a calculated approach
- It was messy and was not about everything being calculated or quantifiable
- Keynesian theory worked extremely well until the 1970s and the OPEC stopped oil shipments to the US for three months
- Keynesian theory assume recessions come from the demand side, and the theory offers no real answer to a
supply recession
MACROECONOMICS AND MICROECONOMICS
- Macroeconomic theories all should have microeconomic explanations
PHILLIPS CURVE
- An australian economist named AW Phillips observed the world, and understood Keynesian theory
- he invested a curve that says a basic prediction of keynesian theory is that there is a tradeoff between inflation and
unemployment
- A decrease in aggregate demand will raise unemployment (it lowers output) and lower inflation
- An increase in aggregate demand will lower unemployment (it raises output) and raise inflation
- Since recessions are caused by decreases in aggregate demand, a recession should have lower inflation to go
wth the higher unemployment
Milton Friedman wanted to revive __________ economics.
- Classical
The Phillips Curve says that to get less unemployment, we have to have more inflation.
- True

Who talked us into have an LRAS and an SRAS as separate curves?

- Friedman
The creator of supply side economics is
- Laffer
The Laffer curve predicted that when Ronald Reagan lowered tax rates, the government would collect more money.
- True
Every Republican president or presidential candidate since 1996 has proposed or implemented supply side tax cuts.
- True
A New Classical would say that recessions happen because of
- Supply Shocks
New Classical economics believes in __________ expectations.
- Rational
A New Keynesian would say that wages or prices might be sticky because of:
- Menu Costs, long term labor contracts, efficiency wage theory
Keynes believed that the key to macroeconomics is ________________.
- Spending
If I made $1,000 last week and spent $1,000, and I made $1,200 this week and spent $1,100, my MPC is:
- 0.5
Keynes believed that business people were generally smart, and always made the correct investment decisions if left to the market.
- False
Keynes argued that investing in the stock market was most like being in a(n):
- Casino
Keynes argued that, in bad economic times, the government would probably have to intervene to make the economy get better.
- True
Keynesian believe that savings is primarily determined by interest rates.
- False
Keynesians believe that interest rates are determined by:
- Supply and demand for money
Keynes believed there is a multiplier effect in the economy, Classicals do not.
- True
Keynesians believe that investment is mainly a function of:
- Expectations
 CHAPTER XIII
Banking
Banks and Money
- Financial institutes exist in many various forms
- Purpose is to intermediate between borrowers and leaders
- People who take money from one grouped is (depositors or investors)
- People who get the money lent to them (Borrowers)
- Depositor Duties
- Facilitate transactions
- Institution can protect their money
- Institution may pay them for its use by paying them interest
- Institution performs other services such as life insurance
- Financial Institution charges borrower more than it pays the depositor or investor securing their profit
- 2 Purposes can be served by this
- People and business can get loans
- Banks add money to the circulation of the economy
- Banks and Most financial institutions must have a charter to operate
- A charter is just a license to operate and allows them to accept deposits and make loans or other financial transactions
- In the US states and the Federal government issue charters
- Bank creates money
- If you deposit $1000 into the bank and they tell you you have $1000 in your bank account but someone the next day asks
for a $800 loan and they qualify for it and they now have $800 in their checking account
- M1 currency outside banks and checkable deposits
- When the bank loans money they create money
- Most money in the world is created by banks through the process of loans
- This type of banking is called fractional reserve banking system
- In this system the bank is permitted to loan out a fraction of the deposit made
- In the US banks are required to hold 12% of most deposits made
- This is called required reserve ratio
- They must keep the money in cash or at the local federal reserve banks
- This system has an advantage because the government does not have to create
all the money used in the economy
- Disadvantage is that the bank cannot pay all its customers should they come
looking for their money
- A RUN is when the bank occurs when customers all try to get their money out
at the same time
- Value of money is based on the faith we have in our financial system and that banks are only stable if we have faith in the system
LITTLE ACCOUNTING
- World of accounting divides everything into two categories ASSETS & LIABILITY
- An asset is something you own
- Liability is something that you owe
- ASSETS = LIABILITIES + OWNER’S EQUITY
- Owners equity is that part of the assets of the company that are owed to the owner of the company
- ASSETS FOR A BANK
- cash/reserves
- Loans
- Securities
- LIABILITIES FOR A BANK
- Deposits
- The total reserves of the bank are called its ACTUAL RESERVES
- The amount of reserves it must keep in the bank is called REQUIRED RESERVES
- The difference between the two is called EXCESS RESERVES
- How much money that can be loaned out is called the money multiplier and is 1/ the Required Reserve ration (12% of
liabilities)
- Which means that for every dollar OF RESERVES into the bank equals $8.33 IN BANK DEPOSITS
 - MOST MONEY IS CREATED BY BANKS MAKING LOANS
MONEY AND PRICES
- Equation of exchange
- MV = PQ (GDP)
- M = money supply
- V = velocity of money
- Average number of times each dollar is used during a given year
- M1 is about $1,400 billion while the GDP is $14,000 billion each of these dollars had to
be used about 10 times
- P = Price level of the whole country
- Q = the quantity of output (Real GDP) produced by the nation
- Price level is the Y Axis on the aggregate demand and supply graph
- When money supply rises the velocity and quality fixed the equation can only stay in balance if prices rise
- Increases in money supply will lead to raising prices (inflation)
- QUANTITY THEORY OF MONEY
- The quantity theory of money says that there is no direct relationship between the money supply in the economy
and the prices of goods and services
- As money supply increases so will the level of prices in economy
- If we doubled the money supply in the US tonight prices would skyrocket in the US
- This is because there would be more money available to spend without more goods being available
- What happens when there are small money supply increases
- A small money supply increase could be offset by a small change in either
velocity or output
- A small change in money is not necessarily inflationary in the short term
- Since the money supply is part of aggregate demand, it is possible that in the
short run increases in the money supply increase both output and prices
- We can summarize the the relationship between money and prices as follows
- LArge increases in the money supply always cause inflation
- Small increases in the money supply may increase output in the short run, but will
increase prices in the long run.
MONEY AND OUTPUT
- The quality theory of money says that when M rises, price rise
- When M falls price does not nezsecarily fall
- Prices are relatively sticky
- Money supply is apart of aggregate demand, a decrease in money supply should cause both prices and output to
fall
- Money supply is related to interest rates
- If the money supply decreases interest rates increase
- When interest rates rise businesses are less likely to borrow therefore there will be lower investment
- It is not a clear cut increase in the money supply that affects output and than the function of money
supply lower interest rates
- Raising money supply lowers interest rates which should increase investment and income
- Some economists believe that this will just increase inflation
- DIFFERENCES BETWEEN MONEY AND OUTPUT
- Decreases in the money supply may decrease output, in part because of the indirect effect of the increase in interest rates
caused by the change in money supply
- Increases in the money may increase output for a brief period, but in the long run will be neutral with respect to output
CENTRAL BANKING
- Government owned or government sponsored banks
- The federal reserve is the bank for the US
- Bank of Japan is the central bank of Japan
- CENTRAL BANKS HAVE 5 MAIN FUNCTIONS
- Clearning houses for checks
- Regukate banking system
- Bankers to Banks
- Control the money supply, interest rates and exchange rates
- Lended of last resort
CONTROLLING THE MONEY SUPPLY AND INTREST RATES
- The Fed buys bonds to increase the money supply
- The Fed sells bonds to decrease the money supply
FEDERAL RESERVE SYSTEM