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CHAPTER 1 Demand, Supply, and Market Equilibrium
Firms and Households: The Basic Decision-Making Units
The fundamental decision-making units in a market economy are firms and households. A firm is an entity that produces goods or services. Using labor, capital and other inputs, firms take resources and transform them into products that people or other firms wish to purchase. Firms include obvious examples, such as automobile producers that take labor, tires, sheet metal, machinery, and other inputs and transform them into cars and trucks. Firms also include less obvious examples, such as video rental stores. These take videotapes purchased from other firms and combine them with a store, cash registers, shelves, advertising, and personnel to bring those videos to you. Firms are the primary producing units in a market economy. Each firm started out as the dream of one or a few individuals. People who are responsible for taking new ideas or new products and turning those ideas into successful businesses are known as entrepreneurs. Entrepreneurs are also often responsible for organizing, managing, and assuming the risks of a firm. To get an idea of some of the responsibilities that entrepreneurs assume, look over the various aspects of starting and running a business provided in "Starting Your Business." Another good site information and discussion on entrepreneurs is the "Young Entrepreneurs' Organization" site. It provides a good starting point for those who are interested in going beyond our discussion of entrepreneurs. In addition to firms, households form the other fundamental component of market economies. Households can range from individuals living alone and single parent families to college friends sharing a house as well as extended families living together. Households are described in the text as the primary consuming units in an economy. While such a description does not capture the richness of what households can be, it does describe one of their primary roles in the economy.
Input Markets and Output Markets: The Circular Flow
So far, we have described firms primarily as producing units and households as consuming units in the economy. Let us look a bit closer at these basic ideas. Firms sell the goods and services they produce in product or output markets. The resources they purchase in order to make their outputs are bought in input or factor markets. Where do firms get these inputs? From households! Think about when you or some other member of your household goes off to work. Where are you (or they) going? You (or they) are probably going to a firm! Household members supply the labor that enables firms to produce their outputs. In addition, households supply the funds that firms use to purchase land, factories, office buildings, and equipment. How do they do this? When members of a household save for the future by putting money in a bank, or buy stocks or corporate bonds, they are supplying firms with funds to finance such expenditures. y An input market is where the resources used to produce goods and services are exchanged. y A labor market is the input market in which households supply work for wages to firms that demand labor.
y A capital market is the input market in which households supply their savings to enable firms to buy capital goods. y A land market is the input market in which households supply land or other real property to firms. Households are not just the consuming units of the economy. As seen by the descriptions of the different types of input markets, we can see that households are the ultimate suppliers of inputs to firms. Firms are producing units, but are also consumers of labor, land, and other inputs produced by households. Each fundamental unit of the economy acts both as producer and consumer. This relationship is shown by the circular flow diagram. This diagram illustrates the interaction of firms and households in markets for outputs and inputs.
To understand how markets work, we will first build a theory of demand that describes a relationship between the demand of the quantity of a product and different market prices. We will then build a theory of supply that describes a relationship between the quantity of a product supplied and the different market prices. Then we will put them together in order to show how the production and consuming sides of the economy interact and how prices are determined.
Demand in Output in Product/Output Markets
A household s decision about how much of a product to buy, or whether to buy any of a given product, depends on a number of factors. We will call these factors the "determinants of demand." The primary determinants include the price of a product, the household's income, the household's accumulated wealth, the prices of related products, the household members' tastes and preferences, and their expectations about the future. Let us relate this to the real world for a moment. Perhaps a member of your household is thinking about getting a new pair of skis. People are more likely to buy new skis if they are on sale than if they are not (price is a factor).
Doing so. and expectations are factors). Finally. The law of demand says that when the other determinants of demand remain constant. People are more likely to buy when they have just gotten a high-paying job than if they have been laid-off (income is a factor). we can represent the relationship between them graphically. A demand schedule for a representative consumer named Anna is listed as follows: As we can see. and vice versa. as the price per call increases. If we list a series of prices and the corresponding quantities demanded. Anna makes fewer calls per month and her quantity demanded declines. as price goes up. will let us know how much of a product households are willing to buy at different prices. Note that price is on the vertical axis and quantity demanded is on the horizontal axis. we get the demand curve for the product. If one variable goes on the vertical axis and the other goes on the horizontal axis. The circular flow diagram shows that every act of buying and selling is linked to other acts of buying and selling in the economy. A demand schedule. Suppose you buy a new pair of jeans. Similarly. it is just a fancy way of stating what we already know: that people are more likely to purchase an item at lower prices than at higher prices. there is a negative (or inverse) relationship between the quantity of a good demanded and its price. Because new bindings. we get a demand schedule. We can represent the demand for a product in another way. and their income is partly determined by your demand for the products they produce. Your income is determined by other people's demand for what you produce. Demand curves slope downward The relationship between the price of a product and its quantity demanded is known as the demand for the product. like the one shown here. people will buy new skis if they love skiing and are expecting a great season (tastes. it is more likely that someone will buy if they have just inherited a large chunk of change from Aunt Zelda (wealth is a factor). people will buy more of a good when it goes on sale! If the price goes up. This is the way we draw demand curves. preferences. What does this mean? Basically. quantity demanded goes down. poles. and boots are also necessary to go along with new skis. What you do depends on the actions of others. The demand curve for Anna's phone calls is given below.The amount of take-home pay will also play a role. Trace the effect of this purchase on other markets and other people's buying and selling. According to the law of demand. 4 . people will tend to buy less of a product. price and quantity demanded move in opposite directions. As managers of even the smallest stores know. Note that we have two variables here: price and quantity demanded. It is a representation of the demand for a good. Price and quantity demanded: The law of demand The amount of a product that households would buy in a given period of time at the current market price is called the quantity demanded of the product. one is less likely to buy skis if these related products are very expensive than if there is a great deal on them (the prices of related goods are factors).
The intersection at the vertical axis means that there is a price above at which Anna will not make any phone calls. you would not spend all your time on the phone! Other determinants of household demand Remember when we discussed the various factors that influence how much of a good people want to buy? We discussed how income and other factors are. Recall that is just what the law of demand claims! As the price of the good goes down. Think about this in terms of making phone calls." slopes downward to the right. For example. With limited income. people will only consume so much of it. We can show this by shifting the demand curve up and to the right. In other words. If making long distance phone calls became prohibitively expensive. people might write letters or send an e-mail rather than make a phone call. Even if they were free. she used to make 3 calls per month. we just move along the demand curve to determine the quantity demanded at the new price. as the price gets lower the corresponding number of phone calls per month increases. At a price of $7 per call. This shifting of the demand curve is called a change in the demand for the good. such as income. Such a shift in demand is called an increase in demand for the product. her quantity demanded is higher. people are more likely to buy when their incomes are high rather than low. This 5 . important determinants of quantity demanded. Note what is going on here! A change in the price causes a movement along a demand curve and results in a change in the quantity demanded. If Anna's income goes up. even if the good is free. How can we represent this on a demand curve? Let us do so using the example of Anna's phone calls. in addition to price. people simply cannot afford to buy certain goods if the price gets too high. causes a shift of a demand curve. This graph shows a negative relationship between the price and quantity demanded of phone calls. At each price.Note that the curve labeled "Demand. she can afford to make 12 calls per month at that price. In other words. The price at which consumers will no longer purchase a product is called the reservation price of the good. A change in some other determinant of demand besides price. The intersection at the horizontal axis means that. Now that her income is higher. she will make more calls per month than when her income is low. she will respond by making more telephone calls. in buying new skis. at each price per call. Notice also that the demand curve intersects both the vertical and horizontal axes.
the demand for the good will increase. catsup. however. An example of inferior goods would be used cars. or hamburger. wealth. Such a shift shows that quantity demanded will be less at each price. the prices of related products. Similarly. boots. and steak instead. the price of an overall ski package increases and fewer skis will be bought. For other goods. Such was the case for our ski example and for Anna's demand for phone calls. Recall that we mentioned how a change in the price of ski bindings. Now let us consider how the price of related goods can change the demand for a good. and poles could affect the demand for skis. an 6 . For example. and expectations can each cause a change in demand. If an increase in the price of a related good causes a decrease in the demand for a good. Changes in income. an increase in income will result in a decrease in demand. tastes and preferences. Such goods are called normal goods. frozen macaroni and cheese casseroles. if income increases. demand for these products goes down as people buy new cars. This is represented by the demand curve shifting to the left. when ski bindings are expensive. Complementary goods are often goods that go together when people consume them. Goods for which an increase in income results in a decrease in demand are referred to as inferior goods. As incomes increase. The following figure shows how demand changes as well as how the demand curve shifts for normal and inferior goods as a result of an increase in income. For some goods.is called a change in demand for a good. those goods are called complementary goods. the price of buns. restaurant meals. or other related goods can change the demand for hamburger. On the other hand. The difference between a change in quantity demanded and a change in demand is an important distinction and one that ought not to be overlooked.
If the price of hamburger increases.increase in the price of snowboards will make it more likely that people will buy skis rather than snowboards. Substitutes can often be used in place of each other. for which an increase in the price of one good causes an increase in the demand for another good. we are usually concerned with the overall demand for products rather than the demand on the part of individual households. people can substitute chicken for hamburgers. we can expect people to substitute chicken for hamburger. resulting in an increase in the demand for chicken. we just need to add up the quantities demanded at each price for all the households that are consuming the good. are called substitute goods. To get the market demand for a good. For example. The effects of an increase in hamburger prices on a substitute and a complement are shown in the figure below: From household demand to market demand In economics. Such goods. Consider the following illustration: 7 .
let us determine how much coffee will be purchased per month at a couple of different prices. on the other hand. firms. Now. the quantity demanded for this market will be 20 (8 + 3 + 9). a total of only 8 pounds per month will be purchased in this market (4 + 0 + 4). 8 . Household B will buy only 3 pounds.50 per pound. and Household C will buy 9 pounds.50 per pound. we can breeze through the concept of supply rather quickly. at $1.50 per pound. After all. At $1. prefer higher prices and are willing to supply more of a given product at a higher price than at a lower one. most firms are in a business to make profits and profits are generally higher when prices are high.We simplify things by assuming that only three households consume coffee and we show their demand curves. Supply in Product/Output Markets Now that we have covered demand in some detail. Similarly. we can figure that at a price of $3. Household A will buy 8 pounds per month. While consumers are less willing to purchase goods at high prices compared to low prices. So.
publishers are willing to produce more books at any given price than before. This relationship is known as the law of supply. For example. The supply curve for a product is shown below: Just as certain factors can change the demand for a product and result in a shift in the demand curve. For example. profits are higher and. the quantity supplied increases. This shows there is a positive relationship between these two variables. so too can certain factors change the supply for a good. therefore some producers will cut back production or shift resources into producing other goods for which labor costs have not risen. This is shown in the following schedule: In plotting price and quantity supplied on a graph. For example. Because of these savings. If we list different combinations of prices and quantity supplied for a product. an increase in wages in an industry can make a product less profitable to produce. the development of computers has enabled books to be published in a much less labor-intensive manner. as a result. As a result. Technology can also affect a producer s willingness to supply certain products. if the price of shorts goes up dramatically. the same way we did with demand. we get the supply schedule for the good. 9 .Price and quantity supplied: The law of supply The supply of a product is the relationship between its price and the quantity supplied. manufacturers of pants may devote more resources to making shorts and fewer resources to making pants. If it is a positive relationship (a price increase). resulting in substantial cost savings. A change in the costs of production will change supply. we get a line that slopes upward to the right. as stated by the law of supply. the supply of pants will decrease. Prices of related products can also affect supply.
This is shown by a shift of the supply curve to the right. Why do you think it is difficult to use actual observations of buying and selling to draw a supply or demand curve? (Think in terms of the ceteris paribus assumption. The market supply of a product is the sum of all the quantities of a good or service supplied per period by all the firms selling that good or service. A decrease in supply will cause the supply curve to shift to the left. market supply is the summation of the individual firms supply curves at each price. In general.Changes in production costs. and other factors can cause a change in supply. technology. causes the supply curve to shift. such as production costs or technology.) From individual firm to market supply The supply of a good or service can be defined for an individual firm. A change in the price of a good will result in a change in quantity supplied and is represented by a movement along the supply curve. An increase in supply due to technological progress is shown below: Economists like to know the supply and demand curves for particular products. A change in other factors. causes a change in supply which is represented by a shift of the supply curve. or it can be defined for a group of firms that make up a market or an industry. The same distinction applies here as with the concept of demand. which. decreases in production costs or improvements in technology will cause supply to increase. in turn. As with market demand. prices of related goods. as shown by the following figure: 10 .
000 bushels (50.Market Equilibrium The operation of the market depends on the interaction between suppliers and demanders. As you might remember from your chemistry classes. are generally about the equilibrium prices. the equilibrium price is stable under the existing market conditions. Agricultural products such as apples.25. and other conditions). consumers compete with each other in order to grab the good deals.50 per bushel. At low prices. state of technology. producers are willing to produce more of the product. When a market is in equilibrium. Now consider what happens when the market price is above the equilibrium level. there is no tendency for the market price to change.000). At high prices. of the product. When farmers hear the farm report on the radio in the morning. Market equilibrium exists when quantity supplied is equal to quantity demanded. but consumers are willing to buy less than at the equilibrium price. In this case there is an excess supply. Consider what happens when the market price is below the equilibrium price. and causes a shortage of the product. When the market price is below the equilibrium price.50 per bushel. This puts upward pressure on the market price. or other items. the market price of soybeans will be $2. Imagine the situation at your local market if the minute supplies of the product came in. This creates an excess demand. That is exactly the case. the soybean market depicted in the following figure: Under the existing conditions of supply and demand (the existing incomes for consumers. frantic consumers immediately would scoop them up! What is the manager of the store likely to do in such a situation? The manager would most likely raise prices. or surplus. for example. Note that there is just one price where this is true! The equilibrium price is the price that will generally prevail in a perfectly competitive market that is not subject to governmental intervention. input prices. Such pressure will cease when the market price reaches the equilibrium price. the price of soybeans will be quoted as being $2. bread.000 . If the equilibrium price is the price that is stable under existing conditions. prices of related goods. In this case. that must mean other prices will tend to be unstable. there is a shortage of 25. The amount of the shortage is the difference between quantity demanded and quantity supplied at that price. producers supply less and consumers want to buy more than at the equilibrium price. The shortage resulting from the price being below the equilibrium level is shown in the following figure at the price of $1. Excess supply. a system is in equilibrium when there is no tendency for it to change under existing conditions. In other words. the condition where quantity 12 . Consider.75.
As inventories pile up on the back shelves. managers will put the product on sale in order to unload some of it. Sketch out this situation on your scratch paper. The excess demand. If a change in one (or more) of these factors causes supply to decrease. Do you see what happens to the equilibrium price and quantity? The price falls and so does the quantity. What happens to the equilibrium price? What happens to quantity? If you have done it correctly. When demand falls. will result. Draw a quick sketch of this situation on a piece of scratch paper. and corresponding equilibrium quantity exchanged. Note that this must result in a change in the market conditions affecting supply. technology. only these "nonprice" factors will shift the supply or demand curves. The amount of the surplus is the difference between quantity supplied and quantity demanded at that price. Now let us consider a situation where the demand for a product decreases. such as production costs. This makes sense. the supply of a product changes. the demand curve shifts to the left. as well as the competition among buyers trying to purchase coffee. Note that in order for either supply or demand to change. there was excess demand at the old market price of $1. If for some reason (a change in tastes and preferences. or both. you should see that price will rise and quantity will fall.supplied exceeds quantity demanded at the current price.20 per pound. the supply curve will shift to the left. Market Equilibrium Changes in equilibrium The equilibrium price. pushed the price of coffee up to the new equilibrium price of $2. As a result. market forces will pull the price down toward the equilibrium price.40. there will be fewer strawberries sold and their price will be higher than before the floods. Let us first consider what happens when there is a change in supply. will change when the demand for a product changes. A similar situation is shown in the following figure for the coffee bean market after a frost damaged much of the coffee crop: After the freeze. there must be a change in some factor other than the price of the good! Remember. Now imagine what happens at your local store. If we read in the papers that large floods in California have wiped out much of the country's strawberry crop. or the prices of related goods. 13 .
income. When demand changes. Decrease in demand ® P ¯ & Q ¯ Increase in demand ® P & Q The changes resulting from changes in demand are shown in the following figure: 14 . such as household tastes. and the resulting changes in price and quantity. and resulting lawsuit. Changes in supply result from changes in factors affecting producers. that stemmed from the statement made on the Oprah Winfrey show that eating beef could infect people with "mad cow" disease. Do not try to memorize all of this! The best way to practice is to visualize the changes in the supply and demand curve and the resulting changes in price and quantity. Values. or some other factor) consumers do not want a product as much as they did before. the demand for beef dropped sharply. Demand and Supply in Product Markets: A Review Here is a summary of the changes to equilibrium price and quantity that result from changes in either supply or demand. technology. price and quantity change as follows: Change in conditions affecting demand. Seasons. wealth. When supply changes. are shown in the following figure: Changes in demand stem from changes in factors affecting consumers. income. Advertising. as did the amount of beef sold in the United States. As a result of the show. You might recall the furor. or price of goods that are either substitutes or complements in consumption. etc. price and quantity change in the following manner: Supply decrease ® P & Q ¯ Supply increase ® P ¯ & Q Changes in supply. or prices of goods that are related in production. the price falls and fewer units are exchanged. such as production costs.
How do you think the shortage manifested itself? What happened? 15 . Some years ago. there was a shortage of Cabbage Patch dolls.Even people who are not economists can tell when there is a shortage in a market.
You can have a particular good if you are willing and able to pay the market price. Supply and Demand. There are fewer lobsters to go around.CHAPTER 2 The Price System. not everyone who wants a good will be able to get it. or at least not eating as many as they were before. For a good to be freely available. and Elasticity The Price System: Rationing and Allocating Resources We know that the interaction of supply and demand in a market system creates prices for the goods and services exchanged. you look for some alternative. This price rationing function answers the third basic question that economic systems must address: who gets the goods and services that are produced. Let us look at each of these in more detail. determining which goods and services are produced and how they're produced. prices perform a means of rationing scarce goods and services. Because there is not enough to go around freely. Who decides which people will be cutting back and by how much? We do! As a result of the decrease in supply. virtually all of the millions of goods and services exchanged in any economic system are not freely available. and 2. Remember. If not. fewer lobsters will be harvested. such rationing is done by price. which means there must be some mechanism for deciding who gets some of the goods and who does not. there must be enough to go around freely to everyone who wants it. Such goods must be rationed. A shifting of the supply curve to the left indicates this decrease in supply. Since some of the lobster waters are closed. rationing the available goods and services. goods are not freely available (there is no free lunch). Prices perform two major roles in market systems: 1. which means some people that used to eat lobsters will not be eating any. In market systems. Price rationing First. there is an increase in 16 . While this may be true for a handful of goods. Consider the following figure that shows the effects of closing some of the lobster waters off the coast of Maine in order to reduce over-harvesting.
In the case of gasoline. the total cost will actually be higher for most consumers than the equilibrium price! 17 . Remember. young people will be discriminated against. When the opportunity cost of this time is added to the money price. we discriminate against people who are unwilling or unable to pay the market price. the federal government stepped in to keep the price of gasoline artificially low. Note that whatever mechanism we use to ration. When the supply of gasoline was reduced. Fewer people will be willing and able to pay the new. This form of price control. Does it really keep the total price of a good low? It does not when the opportunity cost of time is considered! In the case of the price ceiling on gasoline. It is the price itself that rations the available lobsters. Rationing by queuing is often used because it is perceived as being fairer than rationing by price. as a result of the OPEC embargo during the 1970s. However. but they also had to wait in line for long periods of time. that other mechanism was waiting in line. in an unregulated market. the price was constrained to a little more than a third of its market clearing level. We could ration by age. increase dramatically. Many people lined up near gas stations for hours before getting to the gas pumps. People want to buy much more gasoline at the low price than is available. Constraints on the market and alternative rationing mechanisms Note that there are various possibilities for rationing goods. If we ration by age. The price of a product is sometimes kept below the equilibrium price on the grounds that it makes the good more affordable to people with a low ability or willingness to pay. is termed a price ceiling. higher price for lobster. At the controlled price of $0. We could ration by height or by weight. the price of gasoline would. This is illustrated in the following figure: Rather than let the price of gasoline rise. in which a maximum price is set below the equilibrium price for a good. short people will be discriminated against. some people will get the goods and some people will not. discriminating on the basis of price seems unfair and other rationing systems are employed. so that older people get the goods. Sometimes. price is not fully performing its rationing role.57. goods must be rationed somehow! If price is not fully rationing a good. When we ration by price.price. We could draw straws. consumers not only had to pay the money price. some other rationing mechanism must perform the rest of the rationing function. If we ration by height. Quantity demanded greatly exceeds quantity supplied. This means that all rationing systems discriminate against some people.
was greater than the quantity supplied? What rationing system was used to deal with this shortage? Did this system seem fair to you? Why or why not? Would you be in favor of a free market in organs. farming is generally more mechanized. Let us assume that. Now let us consider a change in consumers' desires. farming activities such as planting. it is price that transmits this information from consumers to producers. weeding. people do not want as many typewriters as in years past. prices also address the other two basic questions that must be answered by economic systems: what gets produced and how does it get produced. at the going price. In addition to what gets produced. there is a price for using less foreign oil! The price of gasoline to United States consumers will be higher as a result of the oil import fee. producers will substitute capital for labor and become more capital intensive. the price of oil will begin to increase. the question of how things are produced is addressed by prices. A producer could use a capital intensive production method or. Let us use agriculture as an example. The situation is shown in the following figure: 18 . This view stems from the fact that the United States produces less of its own oil and imports much more from foreign sources than in the past. bridges. use a labor-intensive method. Consider an increase in resource scarcity. whereby a person was paid a market determined price for an organ? What would be the pros and cons of such a system? Prices and the allocation of resources In addition to rationing goods and services. That is also what we would like to see happen! It is the rising price that provides these incentive for both producers and consumers. Again. Some roadways. because of the proliferation of personal computers. The concern with the United States' dependency on foreign oil has led to a number of policy recommendations aimed at reducing the amount of oil imported into the United States. As the price of labor increases. and harvesting are done by hand. One such recommendation is an oil import fee. A crucial role performed by prices is providing information. However. Are tolls collected primarily to deal with shortages? Supply and Demand Analysis: An Oil Import Fee You have probably heard commentators claim that the United States is overly reliant on foreign oil. alternatively. This would enable domestic producers to supply a larger share of the oil consumed in the United States and reducing the reliance on foreign oil. on the other hand. There are a lot of different ways to produce any particular good. In response. In the United States. That is just what we would like to see occur people conserving a scarce resource! The rising price also signals producers to try to find more oil as well as to develop alternatives. What will happen if the world's supply of oil begins to get exhausted? In an unregulated market. This signals consumers to use less of it and to switch to substitutes that are relatively more abundant. while others do not. Part of the reason for the different farming practices being used is that the price of labor is much lower in less developed countries. Prices transmit information about changing resource scarcity and changing consumer values. How does this information get transmitted to producers? The decrease in the demand for typewriters will cause the price to decrease. A tax on imported oil would make foreign oil relatively more expensive than domestically produced oil. so fewer resources are devoted to making them. Identify some that do and some that don't. and tunnels have tolls on them. such as solar power. quantity supplied will also go down. It works out nicely! People want fewer typewriters. Such a tax on imported goods is known as a tariff. In less developed countries. which amounts to a tax on imported oil.Have you ever tried to buy something when the quantity demanded.
consumption of oil in the U. This is shown by the second graph. where total quantity demanded at $18 is 13.0 million barrels) per day. falls from 13. United States producers supply only part of the overall United States demand.S. The way an economist determines the sensitivity of quantity demanded to a change in price is called the price elasticity of demand. production of oil.6 to 12. At that price. the world price of oil is $18. In addition. less oil and gasoline will be used. If prices are raised and a lot of business is lost. The problem with this approach is that the law of demand states that less of a product will be demanded at a higher price. The price elasticity of demand lets us know the percentage change we could expect in the quantity demanded for a 1% change in price. then you will likely make more money. there is tax revenue that goes to the United States government. the price of oil in the United States rises to $24. However. the third graph shows that U. With an oil import fee. and reduces the amount of oil consumed in the United States. are more expensive. If you lower prices. then you will most likely make less money. Because each barrel of oil imported into the United States is taxed. the law of demand states that you will sell more coffee but will not make as much on each cup sold.Before the tax on imported oil. The problem seems to be in the pricing.S. you will make more money on each cup of coffee that is sold. because oil and its derivative products. raises the price of oil in the United States. such as gasoline.S. What is the overall result of such a policy? As we have shown. the oil import fee increases U. The formula for the price elasticity of demand is: price elasticity of demand = (% change in quantity demanded) / (% change in price) 19 . There are other effects as well. in response to the higher price. as shown by the first graph. reduces the amount of oil the United States imports from other countries. Should you raise prices or should you lower prices? What you really need to know is how much will the quantity demanded change when the price changes. Elasticity Let us say you have opened a coffee shop and find you are losing money after your first year in business.6 million barrels per day. This will help reduce air pollution in the United States. This helps reduce the budget deficit (or adds to the budget surplus). At a price of $24.7 to 9. producers supply more oil (from 7. If you raise prices.2 million barrels per day. If you raise prices and only lose a little business.
Note that the law of demand implies that the price elasticity of demand is always negative. Since the sign is always negative. we say the price elasticity of demand between point A and point B is 3. And since we are ignoring the negative sign. let us begin by finding the percentage change in price. Therefore. 20 . so the percentage change in price is -1/6. We will first examine the formula using percentage changes. the price elasticity of demand is (1/2)/(-1/6) = -3. Let us look at two other points on this demand curve. it is easier for to ignore the sign of price elasticity of demand and treat it as a positive number. The general formula for percentage change is % change = (change) / (starting point) So the change in price moving from A to B is -1 and the starting point is 6. Consider the following demand curve: To find the percentage changes in price and quantity demanded moving from point A to point B. since a positive change in price implies a negative change in quantity demanded and visa versa. There are two methods for computing elasticity using percentage changes and using the midpoint formula. The change in quantity demanded moving from A to B is 1 and the starting point is 2. so the percentage change in quantity demanded is ½.
The change in quantity is 1 while the starting quantity is 7. therefore the percentage change in price is -1/2. so the percentage change in quantity is 1/7. The change in price is -1 and the starting price is 2.5. Instead of computing a percentage change as (the change) / (starting point). We get an approximation of the true price elasticity of demand by using the midpoint formula. The change in price is 1 and the average of the starting and ending prices is ½(6 + 5) = 5. When we started with C. As you move to the right along a demand curve the price elasticity of demand will always fall. the elasticity was 2/7. we get a different answer.Let s find the price elasticity of demand when we move from point C to point D. the midpoint formula computes percentage change as (the change) / (the average of the starting point and the ending point). Thus the price elasticity of demand between point C and D is (1/7)/(-1/2) = -2/7 or 2/7. To find the price elasticity of demand between point A and B using the midpoint formula. but it was 2/7 between C and D. while the elasticity is not the same everywhere on the demand curve. Notice that the slope of the demand curve is -1. first. The solution to this problem is to make the two points on the demand curve infinitely close together. It was 3 between A and B. 21 . This slope is -1 everywhere on the demand curve. There is a significant difference between slope and elasticity! This appears to be a problem! When we want to find the price elasticity of demand over the same range. It is important to notice that the price elasticity of demand changed when we looked at a different point on the demand curve. but using different starting points. but when we start with D the elasticity is 1/8. Demand curves are more elastic at higher prices and less elastic at lower prices. the percentage change in price must be found. The midpoint formula for the price elasticity of demand uses a slightly different method for finding the percentage change.
5) = -0. Thus. The price elasticity of demand is the ratio of two percentages.So the percentage change in price is 1/(5. the elasticity of demand is . If demand is elastic then it will change more in response to smaller changes in price. So the price elasticity of demand is 0. we can expect a 2. we say the demand curve is elastic between point A and point B. Such a curve is shown below: Unitary elasticity is when the price elasticity of demand is exactly equal to one. The extreme case of an elastic demand curve is called perfectly elastic. There is no obvious reason to use one formula over the other.4/0. the quantity demanded will change by the exact same percentage.18 = 2. This means that when price changes by some percentage. The change in quantity demanded is 1. Since this is clearly bigger than one. so it has no units. meaning that even a small change in the price will cause the demand to completely disappear. So when the price elasticity of demand is 2.4.22. Price elasticity of demand The price elasticity of demand falls into three general categories: y Elastic y Unitary Elasticity y Inelastic The price elasticity of demand is elastic in a given range of the demand curve if the price elasticity of demand is strictly bigger than one. but notice it does not matter which point is the starting point when using the midpoint formula. In this case.5) = 0 . and the average of the starting and ending quantities is ½(2 + 3) = 2. 22 .22. In the above example. This is a slightly different number than that from using the other formula. the percentage change in quantity demanded is 1/(2. Another way of thinking of the definition of elastic is that the percentage change in quantity demanded is bigger than the percentage change in price.18.22 for a one percent change in price. there was a price elasticity of 2.5.22 percent change in quantity demanded.
23 . and the smaller the elasticity of demand. so the price elasticity of demand is zero. the flatter the demand curve. A perfectly inelastic demand curve will show no change at all in the quantity demanded when the price changes. An example of a perfectly inelastic demand curve is shown below. Inelastic demand occurs when the percentage change in quantity demanded is less than the percentage change in the price. The extreme case of inelastic demand is called perfectly inelastic. Generally speaking. the greater the elasticity of demand. the steeper the demand curve.The price elasticity of demand is called inelastic over the range of a demand curve where the price elasticity of demand is strictly less than one. Inelastic demand will not change much when the price changes.
24 .With some exceptions. like the perfectly elastic and inelastic curves. all demand curves are elastic at the top of the curve and become inelastic eventually as you move down the curve.
Now it is time to examine the flip side of the economic coin the role of the firm. The firm takes the inputs. Households supply the inputs and demand the outputs of the production process. We will begin to examine the profit-maximizing behavior of firms in this chapter. which illustrates the role of the household. 25 . Firms are motivated by one thing profit. and puts them together to make a good (or service) that is wanted by households and provides utility to people. It is the firm that does the very production that makes up the core of our economy. and we will continue examining this behavior for the following seven chapters. we examined the right half of the circular-flow diagram. the pieces.CHAPTER 3 The Production Process: The Behavior of Profit-Maximizing Firms The Role of the Firm In the last chapter.
since there are so many buyers. We will slowly remove these restrictions from the market and determine how firm behavior changes along with the assumptions. 26 . So at any other price. more realistic. If the market is easy to get into and out of.The environment in which a firm operates determines the rules by which the firm plays. this is a very restrictive set of assumptions. the demand curve for the firm is simply a flat line at the market-determined price (shown on the right below). no one firm can change the market price. you will see many startup firms. Thus. We will be using the perfectly competitive model as a benchmark to compare to other.e. this means that the price is determined by the market supply curve and market demand curve (shown on the left below). Furthermore. at the market equilibrium price. It is for this reason that we will consider each of these different business environments (or market organizations) separately. The typical example is agricultural markets. If the firm is the only one who is producing a particular good (a monopolist). The final assumption of easy entry and exit allows firms to start up and close down with relative ease. then when there are profits to be made in this market. and very few "real world" markets satisfy these conditions. For a market to be characterized as perfectly competitive there are a number of conditions that must hold true: y There are a large number of firms (suppliers) and a large number of households (demanders) y Each firm produces the exact same (homogeneous) product y Firms have easy entry into the market and exit from the market y The Role of the Firm (cont. The firms will find customers only when they sell at the market equilibrium price.) y Clearly. y The first and second assumptions imply that the firm is a price-taker. it will lose business to another firm that is making the same product. The firm must take whatever is the "going price" for a good. it will behave differently from a firm that is competing against a large number of similar firms. producing an identical product (i. firms can sell as much of the product as they want at the going price. This assumption will become important as we examine the long-run behavior of firms. there is no demand. y Each individual firm faces a different demand curve than the market curve. market organizations. a perfectly competitive firm). Also.. Since each firm makes the exact same thing. there will be demand for any possible quantity. The first type of market organization we will examine is called perfect competition. Because each firm is such a small part of the market. Graphically. if one firm tries to raise its price.
It is the number of units sold multiplied by the price. 27 . 2. The riskier the investment." Firms also use resources in the production of goods. and average product Marginal product and the law of diminishing returns Another way of defining the marginal product of labor is the extra goods that could be made by hiring another worker. Profits and economics costs Even though the firm is a price-taker. than making a smaller quantity. There is no bill for the cost of rent. the firm must decide: 1. it will not attract investment dollars. marginal product. Part of economic cost is the money that is used to pay the firm's bills. The problem is that there are different costs associated with making different quantities. because if the firm can not pay this cost. we will start with dissecting the concept of profit. what decisions can the perfectly competitive firm make to maximize its profit? Without the option to change the good's price.The Behavior of Profit-Maximizing Firms Since firms are motivated by profit. if the firm is using a building that it already owns for production. Normal rate of return Firms often require a financial investment to begin operation. Money also has an opportunity cost. 3. the firm must offer a high rate of return on the money. It might be that making a large quantity is a lot more costly. Profit is defined as: economic profit = total revenue . One might think that you should produce as much as possible to make as much profit as possible. Sometimes these resources are paid. is a bit more complicated. Let us address these three decisions separately. The Production Process Production functions: Total product.economic costs (total costs) Total revenue is simply the money that comes in from the firm's sales. For an investor to put funds into a firm. Economic cost. For example. So there is an opportunity cost of using the resource. The opportunity cost of using the money to invest in the firm is the outside investment opportunities. How to produce (What method to use). such as the worker wages. on the other hand. per unit. and sometimes these resources are not paid. though it could be renting the building out to another firm. How much of each input to demand. it must be earning a profit that is more enticing than the outside investment opportunities. This profit is called the normal rate of return. The normal rate of return is a basic cost of running a firm. and so the profit is larger with a smaller quantity. then it is not paying rent. the higher the interest rate needed to bring in investment. called "accounting cost. This opportunity cost is part of the economic cost of operating the firm. How much to produce. To begin to understand these complex decisions. only an opportunity cost. the decision of how much to produce is very important. For the firm to entice the investor to put money in the firm.
The law of diminishing returns says that. A firm could choose to produce in a labor-intensive manner or it could invest in machines that operate without any human contact. 28 . When you have some fixed input. Consider the table below. What happens after the each additional worker is added? The third worker will produce an additional 10 units of production. in the short run. In fact. The choice depends upon the cost of labor and the cost of capital. So. as you continue to add a variable input to a fixed input. specialization tends to increase the marginal product. We can also think of the earth as fixed input.As you add workers. the additional output from the variable input will eventually decline. eventually each additional person would add so little output (specifically. This phenomenon is called law of diminishing returns and can be seen clearly when the production function and the marginal product of labor are graphed. Think about how an assembly line works with one worker and then two. food) that we would all starve to death. and so on. a renowned 18th and 19th century economist and political scientist. the fourth gives five. Thomas Malthus. used the law of diminishing returns to make a grim prediction for the world. then adding more workers does not allow for additional production. and the fifth will produce two additional units! Therefore. given that technology. and then three. the benefits of specialization are exhausted. He basically argued that we could think of the increasing world population as the increasing of a variable input (labor). it is possible that the marginal output would become negative as the workplace becomes cluttered with too many workers. Do you think he was correct? Should we be limiting population growth based on his argument? Choice of Technology The simultaneous decisions that firms have to make in regards to technology are to choose a technology for production and to choose the quantity of inputs to demand. as we keep increasing the population.
The firm then multiplies the amount of capital used times the price of each unit of capital to get the total capital cost. a firm can choose from the five different production technologies using different amounts of labor and capital. 29 . while countries where labor is inexpensive have more labor-intensive production. The right two columns calculate the firm s total cost by multiplying the amount of labor times the price of labor (the wage rate) to get the total cost of labor. The total labor cost is then added to the total capital cost to get the total cost of production. we will find out how perfectly competitive firms choose the profit-maximizing output. not surprisingly. When labor is cheap (column 4). Notice that the cost-minimizing production technology depends on the prices. it should choose the capital-intensive technology. When capital is cheaper (column 5). In the next chapter. given their choice of technology and inputs. the firm will choose a more labor-intensive technology. We can use the insight from this model to gain a better understanding of the technologies used for production in the United States versus the technologies used for production elsewhere. Countries with higher wages tend to conduct a more capital-intensive production.According to the table.
The basic strategy developed in this chapter will be used for other types of market organizations later on in the course. The fixed cost is the cost of the table and the two knives. Fixed costs The total amount of fixed costs (TFC) and the total amount of variable costs (TVC) are added together to yield the total cost of production (TC). For instance. by definition. A variable cost. that monthly rent does not change if the firm is making one unit or 1. For many firms. on the other hand. We also know that. the more labor you use. The profit of the firm is the total revenue less the total cost (economic cost). We will examine each of these elements in detail and then put them together to find a strategy for profit maximization in the short run. In this chapter. while it can not set the price of the product that it is selling.CHAPTER 4 Short-Run Costs and Output Decisions Costs in the Short Run A perfectly competitive firm has a limited number of actions that it can take in order to maximize profits. Following is a graph of the total fixed cost curve for a sandwich company. The short-run. is a cost that does change with amount produced. it can decide how much to produce and what type of technology to use for that production. if a firm is paying monthly rent for office space. we will develop a detailed strategy for how a perfectly competitive firm makes these choices to maximize short-run profit. Generally speaking. the more you produce. Notice how the cost is fixed at $20 regardless of whether 0 or 40 sandwiches are produced. 30 . is made up of two kinds of cost fixed costs and variable costs.000 units. Costs are related to the choice of input used for production. labor is a variable cost. A fixed cost is a cost that does not change with the amount of output produced.
but eventually the law of diminishing marginal returns kicks in. total cost will rise. as production rises even more. This was because. The reason for this rise is that when adding workers. If no sandwiches are being made. each worker will add more and more output. let us follow the story that made up the total product curve. The law of diminishing returns applies to the addition of any variable cost. When the marginal product falls. as well as the cheapest input combination. since more workers will need to be paid. then the total cost will be rising by less. Let us recall part of the output table from the previous lecture to determine total variable cost by assuming each worker is paid a lump sum of $10 for their work. not just labor.The shape of the total variable cost curve is rooted in the production function. then there is no reason to pay the workers. the cost of making more will rise. when we are drawing the total variable cost curve we are putting output on the horizontal axis and total variable cost on the vertical axis. Eventually. there will be too many workers and the marginal product will fall. let us graph the total variable cost. as you first add workers (or capital) they can specialize and produce more. Recall that the total product curve had an "S" shape to it. The choice of technology to be used for production. determines the production function. Labor Units 0 1 2 Total Product 0 10 25 Total Variable Cost 0 10 20 3 4 5 6 35 40 42 42 30 40 50 60 Now. variable cost is zero. If we are paying the workers the same amount. When no product is being produced. and the product does not rise as much when workers are added. As output increases. Remember. Since we are interested in how total variable costs change as we want to produce more. 31 .
Remember that total cost (TC) = TFC + TVC.Note that the total variable cost curve also has an "S" shape. So the "S" shape of the total variable cost curve is determined by the law of diminishing returns. The TC curve looks just like the TVC curve. but it is shifted up by the amount of the TFC. when there is specialization and the marginal product is rising. This shift upwards happens when the TVC and TFC are added together. 32 . Now let us draw the total cost curve. The TVC curve then gets steeper when diminishing returns sets in and marginal product is falling. It gets flatter at first.
Output (Q) 0 10 25 35 40 42 42 Total Variable Cost (TVC) Total Fixed Cost (TFC) 0 10 20 30 40 50 60 20 20 20 20 20 20 20 Total Cost (TC) 20 30 40 50 60 70 80 Average Fixed Cost (AFC) 2. We will put dollars on the vertical axis and output (Q) on the horizontal axis. then the AFC will always get smaller as Q increases.47 The AFC curve is shown below. The formula for AFC is given below.8 0.5 0.6 0. AFC = TFC/Q Because the TFC does not change as Q increases. 33 . the first of which is the average fixed cost (AFC) curve.47 0. We will compute the AFC using data from the previous example of the sandwich shop.) Average fixed cost (AFC) The next set of cost curves that will be developed are the average cost curves.0 0.Fixed costs (cont.
80 0.00 0. The decreasing of the AFC curve is sometimes called spreading overhead. Variable costs Average variable cost (AVC) The second average cost curve is the average variable cost (AVC) curve. The formula for the AVC is: AVC = TVC/Q The graph of the AVC is as follows: Output (Q) 0 10 25 35 40 42 42 Total Variable Cost (TVC) Total Fixed Cost (TFC) 0 10 20 30 40 50 60 20 20 20 20 20 20 20 Total Cost (TC) 20 30 40 50 60 70 80 Average Variable Cost (AVC) 1.19 1.43 34 .The average fixed cost is getting smaller and smaller due to the fact that the fixed cost ($20) is being spread over a large number of units produced.00 1.86 1.
67 1.66 1. Output (Q) 0 10 25 35 40 42 42 Total Variable Cost (TVC) Total Fixed Cost (TFC) 0 10 20 30 40 50 60 20 20 20 20 20 20 20 Total Cost (TC) 20 30 40 50 66 70 80 Average Total Cost (ATC) 3 1. The formula for the ATC is ATC = TC/Q Using the data from above.50 1. we can graph the ATC along with the AFC and the AVC.9 35 .43 1.Total costs Average total cost (AVC) The final average cost curve is the average total cost (ATC).
Marginal costs The final and most important curve is the marginal cost (MC) curve. The MC then rises because of the law of diminishing returns. The two curves get closer together because the ATC = AVC + AFC. 36 . the limitations created by the fixed input come into play. Since the AFC is getting smaller. it looks like the graph below. When the marginal cost curve is graphed along with the ATC. as production increases more and more. AVC.Notice that the ATC and AVC get closer together as the output increases. The formula for marginal cost is: MC = (change in TC)/(change in Q) Again using the data from the sandwich shop. we can derive the marginal cost for each quantity: Output (Q) 0 10 25 35 40 42 42 Marginal Product 10 15 10 5 2 0 Total Variable Cost (TVC) 0 10 20 30 40 50 60 Total Fixed Cost (TFC) 20 20 20 20 20 20 20 Total Cost (TC) 20 30 40 50 60 70 80 Marginal Cost (MC) 1 0. The marginal cost starts to rise because. This relationship between marginal product and marginal cost is due to the fact that the MC will fall as production becomes more specialized.67 1 2 5 - Notice how the marginal cost goes down and then back up again? By looking at the marginal product at the same time as the marginal cost. This distinction is a very important point. you can see that the marginal cost is going down while the marginal product is going up and visa versa. Marginal cost is the additional cost from producing one more unit. and AFC curves. the AVC and ATC must be coming closer together.
and Profit Maximization Total revenue (TR) and marginal revenue (MR) We now have a complete understanding of short-run costs. we need to look at the other half of the picture revenue. With the inclusion of the Internet as a way of conducting business. how will that change the strategy of the firm? Output Decisions: Revenues. For further discussion on marginal cost as well as sunk cost. The marginal cost is the cost of making one more unit. Total revenue (TR) is calculated as price multiplied by quantity. If they receive a C (2. the average will fall. the average cost must be rising. as long as it charges the marketdetermined price. When the marginal cost is above the average cost. Costs. when the marginal cost is below the average cost. The MC curve will always cross the ATC and AVC at the bottom of those curves.0) in the class. Would a firm that is using the Internet to do business have higher fixed costs and lower marginal costs than a firm that is using a typical storefront? If a firm produces software and is delivering their product through the download of software over the Internet. We can see this rule illustrated by a student's grade point average (GPA).0 and they get an A (4. It works the same way for costs." It illustrates these concepts through an experiment involving the auctioning of one dollar bills. When the marginal grade is above the average grade. the GPA is the average grade over all classes you have taken. does this firm have any marginal cost? If not. This is no coincidence.Note that the MC curve crosses the AVC and the ATC curves at the bottom of each of those curves. TR = P x Q We know that the perfectly competitive firm can sell as many units as it wants.0) in their next class. then the GPA will rise. view the Internet Exercise entitled " Sunk Cost and Marginal Cost: An Auction Experiment. the average cost must be falling. the average will rise and visa versa. the average will rise. If the marginal grade is below the student's average grade. When the marginal cost is above the average. The total revenue (TR) curve is then drawn as an increasing straight line. In order to examine profit. the GPA will fall. Just like the ATC is the average cost over the whole quantity produced. economists are interested in how the costs of doing business have changed with this new technology. If a student has a GPA of 3. thus illustrating a simple rule. The marginal grade would be the grade from taking one more class. where the slope of the 37 .
How can a firm find this profit maximum without drawing TR and TC curves? 38 . From the graph. The firm will choose the quantity where profits are maximized. the firm is actually losing money since the TC is more than the TR. The total revenue for 10 units is $20. For a product with a market price of $2. and so on. the total revenue curve is as follows. The perfectly competitive firm must decide how much to produce. profit maximum occurs when 40 units are produced. then the quantity to produce is found where the difference between the TR and TC curves is the largest.line is equal to the market-determined price. it is clear that the difference between TR and TC is smaller than at a quantity of 40. If the total revenue and total cost curves are drawn on the same graph. At a quantity of 10 units produced. How does the firm find that quantity? We know that profit = total revenue .total cost. At a quantity of 20 or 30 units. the total revenue from 30 units is $60.
If MC>MR. To use marginal analysis. The profit maximizing strategy is for a firm is to find out if the additional money she it gets from selling one more unit is more than the cost of making one more unit. the MC will be bigger than the MR. then the firm would want to make one more because it will make money on that additional unit. 39 . then the cost of making one additional unit is more than the amount of money received from selling one additional unit. As long as the MR is bigger than the MC. the profit-maximizing quantity is where MC = MR. because if it increases production. The formula for marginal revenue is: MR = (change in TR)/(change in Q) The marginal revenue for a perfectly competitive firm is simply the market price. The marginal revenue (MR) is the additional revenue the firm gets from selling one more unit.Finding the profit maximum requires the use of the economic tool of marginal analysis. is the marginal revenue more than the marginal cost? If the answer is yes. The flat demand curve for the firm insures that the firm s price is always the market price. would you suggest advertisement for a perfectly competitive firm? Can you think of an example of a perfectly competitive good being advertised? Total revenue (TR) and marginal revenue (MR) (cont. Thus. The marginal revenue curve is as follows: If you were an advertising executive. the firm should produce more. Once MR = MC the firm will want to stop production. we will need to introduce one last term and curve marginal revenue.) You can think of marginal revenue as the amount of money a firm gets from selling one more unit. This is because the firm can sell as many units of the good as it pleases without changing the price. In other words.
You can also see the profit maximum by looking at the tables created during this lecture. When the slopes of the two curves (TR and TC) are equal. 40 . Output (Q) 0 10 25 35 40 42 42 Marginal Cost (MC) Marginal Revenue (MR) 1 . and the slope of the total revenue curve is the marginal revenue. you can see that profit maximization occurs at a quantity of 40 units. The slope of the total cost curve is the marginal cost.By looking at the previous graph.67 1 2 5 5 2 2 2 2 2 2 Total Revenue (TR) Total Cost (TC) 0 20 50 70 80 84 84 20 30 40 50 60 70 80 Profit -20 -10 10 20 20 14 4 The profit maximum can be found by looking at the total revenue and total cost or the marginal revenue and marginal cost. Note how these two methods are related. then profit is at a maximum.
and so people buy more of other goods with higher marginal utility per dollar. This is how economists think in the short-run. you will find that the rule of producing where MR = MC is used in other market organizations. the MC curve tells the profit-maximizing firm how much to supply. a perfectly competitive firm will find out what the price is and then it will look at its marginal cost curve to find the quantity to produce. Profit-maximizing firms use the marginal cost curve as a supply curve because marginal cost will equal marginal revenue at that quantity. 41 . then a perfectly competitive firm will produce where P = MC. The marginal cost curve is the (short-run) supply curve for a perfectly competitive firm! The supply and demand curves were introduced in an earlier lecture and it was shown without reason that the supply curve slopes up and the demand curve slopes down. In other words.Comparing costs and revenues to maximize profit As we study other forms of market organization besides perfect competition. It was learned in the previous lecture that the demand curve slopes down because of utility maximization¾when the price of a good rises. What is unique about perfect competition is that the MR = P (market price). If given a price. p. the marginal utility per dollar falls. Since MR = P and a profit-maximizing firm produces at a quantity where MC = MR. it was shown that the supply curve slopes up because the marginal cost curve slopes upwards. In this lecture.
This lowers the costs of doing business for producers and they respond by lowering prices and increasing output. Keynes maintained that wages are "sticky. Moreover. Because fewer goods are demanded. Not only are people more reluctant to take pay cuts than pay raises. are only temporary. the economy will be at full employment without the problems of unemployment inflation. The lower wages and increased output leads to more workers being hired. Keynes put forth the notion that the government can intervene to improve the economy. This view seemed self-evident during the 1920s because jobs were plentiful. operations. The economy can languish in a state of low demand. the economy's self-correcting feature does not work well. the economy was growing strongly. beginning the construction of dams. Keynes believed that the government could stimulate demand and get the economy moving. the output of the economy and the unemployment rate return to their original level. Keynes believed that the reason economies decline in the short run is that the overall level of demand falls. Thus. 42 . Interest. Because the economy may not be able to correct itself. producers are not likely to re-hire workers and increase production.CHAPTER 5 Introduction to Macroeconomics The Roots of Macroeconomics During the first two decades of the twentieth century. it was believed. this was not a temporary downturn of the economy. but many workers are subject to long-term labor contracts in which wages are set. low incomes. President Franklin Roosevelt and Congress began to stimulate demand by creating federal job programs. After several years in the depths of a severe economic downturn. Recent macroeconomic history It is hard to overstate the influence that Keynes had on economics and on policy makers of many industrialized countries. roads. In the United States. Because of this. The output of the economy plummeted. The Great Depression At the end of the 1920s. In the long run. government buildings. economy began a steep and prolonged decline. The economy languished in this sorry state of affairs year after year. most economists thought there was little need for the government to try to influence the state of the economy. and a host of other "New Deal" programs. primarily for military hardware. Conditions were ripe for a different vision of how the economy operates. In turn. and Money. the U. however.S. incomes fall and unemployment rises. For example. Recall that this self-correction relies on wages falling during slowdowns. with the advent of the Great Depression. Eventually. when the economy slows down and unemployment rises. All of this changed. To counter the fall in overall demand. especially during an economic downturn. downturns in the economy. Unemployment began to soar from about 5% in 1928 to over 25% by 1933." especially in the downward direction. During such a downturn. fewer workers are needed. and prices were stable. fewer are produced. and personnel associated with the United States involvement in World War II. (Take a look at the New Deal Network.) The end of the Great Depression saw massive increases in government spending. and high unemployment. Banks failed and many people saw their jobs and their wealth evaporate. That vision was provided in a path-breaking book by British economist John Maynard Keynes entitled The General Theory of Employment. wages would fall as unemployment rose because the decrease in demand for labor would push wage rates down. the belief that the economy would fix itself seemed incorrect. during which the economy slows down and people get laid off. most economists believed that the economy was able to correct itself. wages are not likely to fall appreciably. In Keynes' view. In turn.
Overly rapid expansions can cause inflation and its resulting problems. These cycles consist of short-term booms and declines in the aggregate output of the economy. we have talked about changes in relative prices. employment. Workers demanding higher wages can cause producers to raise prices even higher and a wageprice spiral can result. people lose much of their purchasing power and living standards decline. refer to the Economic Statistics Briefing Room at the White House. Roosevelt and the Great Depression. During the post-war period.For more on Franklin D. in order to influence the state of the economy. This rosy view was shattered by the oil shocks of the 1970s. and stability. During the Kennedy and Johnson administrations. One thing to keep in mind is that nearly all macroeconomic concerns are interrelated and attempts to prove one of these concerns invariably affects the others. This crisis in macroeconomic thought led to the development of new theories and ways of looking at the economy. occur in every country. The worst inflation in recent years was the doubledigit inflation when prices rose at an annual rate of up to 13% during 1979 and 1980. Stable output growth means an avoidance of business cycles. We will look at some of the causes of inflation in later lectures. These fluctuations of the economy. its price will rise relative to other goods. that is of concern to macroeconomists. Some of the questions that concern macroeconomists include the following: How can government achieve these goals? How can policymakers know when to implement measures to achieve these goals and judge whether they are successful? In this and following lectures. Thus far. but for now we should recognize that the effects of inflation can seriously undermine an economy. the growth of output of the economy. The United States has been blessed with low rates of inflation. visit the Internet resource site Franklin D. low unemployment. You'll see recent statistics on inflation. Output growth In addition to price stability. Peruse this site for interesting information about the different measures of inflation. when the demand for a particular good increases. We will look at some of these theories and new ways in later lectures. we will address these questions. When prices rise more rapidly than wages. President Reagan's efforts to "break the back of inflation" resulted in a severe economic downturn during the early 1980s. 43 . historical information. Macroeconomic Concerns We will now take an introductory look at three of the main concerns of macroeconomics: inflation. interest rates. Changes in relative prices are fine¾they are the price system performing its allocation and distribution functions. you'll get charts. at the Consumer Price Indexes page. For example. and the nation's money supply. For a look at inflation. For example. Declines in economic output can send economies into recession or even depression. consisting of cycles of recession and expansion. policy makers undertook to change taxes. an increase in the overall price level. The persistence of "stagflation" dealt a severe blow to the notion of fine tuning the economy. when unemployment and inflation rose sharply and unexpectedly. and more on this common inflation measure. economists believed that the economy could be fine-tuned to achieve the desired rates of economic growth. Governments are often called upon to promote economic growth. and inflation. Roosevelt Library and Museum. another goal of macroeconomic policy is stable output growth. It is inflation. which can increase dramatically and impede the use of credit in an economy. Among the other problems caused by inflation are the effects on interest rates. and unemployment. Inflation One goal of macroeconomic policy is price stability. in addition to government spending programs.
the more long-term question of what contributes to steady economic growth over time is also a major concern. can be used to cool off an economy that is undergoing inflation. We have mentioned this type of policy earlier in this lecture when discussing the innovations of John Maynard Keynes. This means that less that 4. "Are you better off than you were four years ago?" The answer would always be a resounding. the focus 44 . The amount of goods and services per person would decline. Why is the growth of an economy over time important? To address this question. With increases in population. It may also go up when there are large numbers of people entering the labor force who do not have jobs immediately. efforts to stimulate economic growth should concentrate on the supply side.5% of the labor force is not employed. the unemployment rate goes up because some workers become unemployed due to the overall economic slowdown. raising taxes and/or cutting government spending. It is expected. There are three types of policies the government employs to influence the economy. Such measures will put more money into the hands of people in the economy and this money will get spent and re-spent on goods and services. Governmental policy-makers can change the nation's money supply and interest rates in order to influence the economy. Remember the campaign question. Full employment is not when everyone in the economy is working. The amount of unemployment in the economy is measured by the unemployment rate. the economy would be dividing a given amount of goods and services among more and more people. for example. Monetary policy is another available policy tool the government can use to influence the economy. Supply-side policies are also used by the government to influence the economy.Determining the causes of business cycles and what can be done to minimize them are among the primary concern of macroeconomics and policy-makers. "No!" Unemployment Yet another goal of macroeconomic policy is full employment. think of what would happen if there is no growth of the economy over time. the unemployment rate in the United States remained at just under 4. contractionary fiscal policy. the total amount of goods and services would remain constant over time. there will always be some unemployment.5%. In the United States these conditions represent full employment. the percentage of the labor force that is unemployed. Keynes advocated stimulating overall demand during a recession by "expansionary fiscal policy. In addition. investment. the unemployment rate typically goes up in June slightly due to large numbers of new college graduates who may require a few weeks to find work. During recessions. rather than focusing on the demand side of the economy. that some people are between jobs and are looking for new and better work. During the first part of 1998. Fiscal policy involves changes in the government's spending or tax policies in order to affect the economy. steady economic growth. Changes in the unemployment rate can occur because of changes in either the number of unemployed workers or the number of people in the labor force. For this and other reasons. but is looking for work. More recently. Government in the Macroeconomy How can the goals of price stability. amounting to a decline in the standard of living for the people in the economy. Early proponents of these policies during the Reagan Administration emphasized the use of tax cuts and tax incentives to stimulate savings. Advocates of this policy tool claim that. For example. This is the lowest unemployment rate in nearly 30 years and represents a very good job market for workers. and labor supply. This will increase economy-wide demand and begin to bring the economy out of the doldrums. In such a situation. and full employment be achieved? That is the key question of macroeconomics! We will be looking in-depth at some of the ways the government may be able to influence the economy so as to achieve those goals." which means increasing government spending and/or cutting taxes. Conversely.
and financial assets. ownership of companies. We have discussed the interaction of two of these components. dividends. profits. notes. households and firms. they receive interest and dividend payments. When households or foreigners purchase real estate. 45 . it shows that households purchase goods and services from foreigners. we introduced the circular flow between the input and output markets. and other nations. the government. financial assets flow between firms. firms. and land used by firms. receiving wages in return for supplying labor.has shifted toward promoting long-run economic growth by stimulating research and development. This figure above shows that households work for firms and the government. such as Treasury bonds. both foreign and domestic. and other transfer programs. welfare. In essence. produce goods and services that are consumed by households and government in return for revenue. let us add the other components of the economy to the circular flow diagram. the circular flow diagram tracks the flows of these three components of the economy. Now. When households or foreigners purchase government bonds. they receive interest payments. It also illustrates that households. and foreigners purchase goods and services from firms. This complex interaction occurs within three basic types of markets: goods and services. and other measures designed to increase productivity. There. the government. households. Households supply labor to firms and the government in return for wages. and rent from firms on their investments in stocks and bonds. Households also receive interest and transfer payments from the government for purchases of government bonds as well as for Social Security. Firms. Finally. households receive interest payments. The Components of the Macroeconomy The circular flow diagram Any market economy comprises the interactions of households. When households or foreigners purchase corporate bonds and shares of stock. Finally. Economic activity in a market economy consists of the flow of money for products. and foreigners. In addition. The diagram also shows that firms and households pay taxes to the government. and the financial market. and bills. the labor market. in an earlier lecture. they receive rents. labor. technological innovations.
firms. Instead of the price of an individual product on the vertical axis. purchases of new factories and equipment by firms (this type of spending is called investment). it adds up to the economy's aggregate demand. there is the total aggregate output for the economy on the horizontal axis here. The aggregate demand curve slopes downward to the right to show that consumers are willing to buy more goods and services in total at low prices levels than at high price levels. they are vastly different. If all of the goods and services produced by all of the firms in the economy at different price levels is summed. All of these different components of the economy. purchases of goods and services by government. Although they resemble the market supply and demand curves that we introduced in an earlier lecture.S. we get aggregate supply. When we discussed individual markets in earlier lectures. These comprise aggregate demand. These comprise aggregate supply. The aggregate supply and aggregate demand for an economy can be represented graphically. demand the goods and services produced in the economy. Now consider all of the goods and services being produced in the economy. aggregate supply increases with the overall price level. as a result.The Methodology of Macroeconomics Aggregate demand and aggregate supply Consider all the goods and services being demanded in the economy.). Producers prefer high output prices to low output prices.S. producing output is more profitable and. Now we have something analogous with the 46 . If all of this demand is accumulated across the whole economy. the point where the market demand and supply curves cross indicates the equilibrium price and quantity of a particular good. and net exports (the difference between goods and services produced in the U. producers will be willing to produce more output at high prices than low prices. the total amount of goods and services supplied by the economy will vary with the price level. Aggregate demand consists of the following categories of spending: consumption spending by consumers. The aggregate supply curves slopes upward to the right to show that producers will be willing to supply more output at higher price levels than at low price levels. At high prices. consumers. government and foreigners. As with aggregate demand. there is the overall price level on the vertical axis here. Let's look at the following figure: The aggregate supply and demand diagram shows the overall price level and aggregate output on the axes. Thus. and exported to other countries and those made in other countries and imported into the U. Instead of the output of one good on the horizontal axis.
When the economy reaches its highest level. it is the overall price level of all goods and services that is indicated. The reason is that. This leads producers to reduce output and causes an overall decline in economic activity and aggregate output. A typical business cycle is illustrated in the following figure: 47 . That's just what we claimed earlier in this chapter in the discussion on fiscal policy! Recall that we said Keynes claimed increases in government spending on goods and services can jump-start the economy and begin to bring it out of a recession. Expansion and contraction: The business cycle These short-term changes in aggregate demand or supply cause fluctuations in aggregate output.S.S. For example. While the U. Similarly. Recessions. Economy in the Twentieth Century: Trends and Cycles We will use the aggregate demand and supply framework to illustrate a wide range of economic activity. When the economy begins to improve and aggregate output increases. if the government increases its purchases of goods and services. can be caused by decreases in aggregate demand. will increase the demand side of the economy. for example. it is in what is known as the trough of the recession. These fluctuations define the business cycle. in turn. monetary. and supply-side policies. more will be demanded at any given price level. the economy is said to be in expansion. Recessions are defined as declines in aggregate output over a period of time. there are short-term fluctuations around the long-run trend. This increase in aggregate demand causes the aggregate demand curve to shift to the right which. businesses.aggregate supply and demand curves except that instead of the quantity of a particular good. for example. we'll utilize the aggregate demand and supply diagram to examine changes in the economy and the effects of fiscal. and the resulting recession is shown by the decrease in the equilibrium level of aggregate output. leads to an increase in the equilibrium level of aggregate output. When the economy has declined to its lowest level. The decline in aggregate demand is represented by a leftward shift in the aggregate demand curve. Later on. or foreigners declines. rather than the equilibrium price of a particular good. economy tends to grow over time. the intersection indicates the overall quantity of all goods and services produced in the economy. Keynes noted that recessions could begin when spending by consumers. changes in aggregate demand or aggregate supply can cause fluctuations in aggregate output. it is said to be at its peak. It is this improvement in the economy. The U. such as increasing government purchases. expansionary fiscal policy. following the implementation of fiscal policy. that is shown by the increase in equilibrium aggregate output on the aggregate demand and supply diagram. For example.
However.S. the economy has experienced three recessions of varying duration since 1970. and marked by widespread contractions in many sectors of the economy. "a recession is a recurring period of decline in total output. Both aggregate output and the number of people working has increased significantly overall. income." Expansions can range in duration from several months to several years. aggregate output (noted as Gross Domestic Product in the figure) declines over time. Economy in the Twentieth Century: Trends and Cycles (cont. These recessions are shown in the following figures: 48 . and trade. usually lasting from six months to a year. that is not really the case. employment. The U. we will look briefly at the pattern of expansions and contractions of the United States economy since 1970. aggregate output has fallen and unemployment has risen.Note that when the economy is in recession. After you complete the exercise. According to the National Bureau of Economic Research (NBER). Although the figure above shows recessions and expansions as being roughly symmetric. economy has grown steadily. You will have a chance to go to the NBER Web site to find out more about business cycles in the United States for the following in-line exercise.S.S.) The U. During those recessions. economy since 1970 Since 1970. the U.
The three recessions show up as declines in aggregate output (labeled "real GDP" here) and as increases in unemployment over the same period. The recession of the early 1980s was the most severe recession of the post World War II period in terms of duration and the severity of unemployment, which reached 11 percent.
CHAPTER 6 Measuring National Output and National Income
Gross Domestic Product
Recall one of the goals of the government's economic policies: stable economic growth. What is desirable is economic stability and avoiding business cycles. Recall also that one aspect of business cycles is the fluctuations of aggregate output, but how is this aggregate output measured? There are different ways of measuring it. By looking at these ways, we will get a better idea of not only what aggregate output is, but also how the economy works. Gross domestic product (GDP) is the most common way of measuring the total output of the economy¾what we have been calling aggregate output up until now. The two principle methods of measuring it are the expenditure approach and the income approach. In the expenditure approach, the spending on goods and services by households, government, firms, and foreigners are added-up. The income approach involves adding-up the income received by various components of the economy. Broadly speaking, GDP is the dollar value of all final goods and services produced within the domestic economy during a specified time period. In the news, you may hear about GDP for a given quarter or for a year, as these are the two most common time periods used. You can find the GDP figures for the most recent years, as well as the most recent quarterly data, at the U.S. Commerce Department's Bureau of Economic Analysis (BEA) Web site. As shown there, the U.S. GDP for 1998 was $8,511 billion. Let us look at what is and is not counted in measuring GDP. Final goods and services Only final goods and services are counted in GDP. This means goods that are sold to their final consumer. Intermediate goods are not counted in calculating GDP. Intermediate goods are those used in the production of other goods. Let us assume that you get a large pepperoni pizza for $13.95 for dinner. You and your friends are the final consumers of the pizza, so the $13.95 gets counted toward GDP. But what about the pepperoni, cheese, and other ingredients used to make the pizza? Let us say that the pizzeria used $1.15 worth of pepperoni on your pizza. Should that be counted? The answer is; it already is! When the pizzeria sells you the pizza, the value of all the ingredients is already included in the final selling price. Counting those ingredients separately and then counting the value of the pizza would, in effect, count those ingredients twice. Another way to calculate the value of final goods is to include the value added by the intermediate goods or services, rather than counting the total value of each intermediate good. The following table from the text illustrates this nicely:
Here, four intermediate steps are involved in bringing a gallon of gasoline to the final consumer. The oil is drilled, refined, shipped, and then sold to the retailer. Rather than adding the value of the product exchanged at each step, only the added value of each step is added. Either way it is done, counting the value of the final product or the value added along the way to a product's final sale, the result is the same.
Exclusion of used goods and paper transactions Let us say you come into some money and decide to buy a few things. You need a car, so you get a great deal on a used car (maybe the '57 Chevy, mentioned in the Lecture Objectives). You need a place to live, so you buy the house where your aunt used to live. You need to furnish it, so you get a used refrigerator for the kitchen. You have spent thousands of dollars and must have added a lot to this year's GDP, right? You may be surprised to learn that none of the purchases mentioned are counted in GDP because they are all used goods. The value of the used car was counted when the car was produced. Counting it now would mean that it was counted twice. It is only a single car and should be counted only once! Similarly, the sale of an existing home, used refrigerator, and other preowned items are not counted toward GDP. Now let us say that, after buying all the items mentioned above, you put some of your money in the stock market. Assume that you buy 1,000 shares of Microsoft stock at the beginning of the year and sell several months later for a tidy profit. Surely, that has to count in GDP? Although these types of paper transactions amount to billions of dollars every day, they are not counted in GDP. Even though the sales of stocks and bonds are not counted, any commissions that are paid are counted toward GDP because the broker involved is performing a service. Exclusion of output produced abroad by domestically owned factors of production Let us say that you take some of the profits from your sale of stock and buy a new, sporty foreign car (perhaps the Porsche Boxster mentioned in the Lecture Objectives). Does this sale, involving tens of thousands of dollars, count in GDP? Although you bought the car from an automobile dealer in the United States, the car was made abroad. As a result, it does not count in GDP. In this case, the car was not produced in the United States and the company is German. What about a Chevrolet made in Mexico and sold in the United States? To be counted in the GDP of the United States, the product must be produced in the United States. Products made in other countries, even if domestic companies make them, are not counted. This brings us to the distinction between gross domestic product and gross national product (GNP). In GNP, goods that are produced by domestic companies are counted, regardless of whether they were made in plants in the United States or abroad. Similarly, goods made by foreign-owned companies, even if they were produced in a factory located in the United States, are not counted in GNP. Thus, a Toyota Camry made in a factory in Tennessee would not be counted in GNP, but would be counted in GDP.
As we mentioned earlier, GDP can be calculated by either adding up all of the expenditures on goods and services produced in the economy or by adding up all of the income received by labor and other inputs in the economy. These are the expenditure and income approaches to calculating GDP. We will focus on the expenditure approach in this lecture, but we will also introduce the income approach. The expenditure approach The expenditure approach involves counting expenditures on goods and services by different groups in the economy. The four main components are consumption expenditures by households (C), gross private investment spending principally by firms (I), government purchases of goods and services (G), and net exports (exports minus imports EX - IM). Here is an equation that sums it up: GDP = C + I + G + (EX - IM)
goods produced in the United States and purchased in other countries. and apartment buildings. These purchases include spending on schools. unemployment compensation. The value of imports. is subtracted from the value of exports. Households also purchase services. This category does not include income transfers. and similar expenditures. to haircuts and tax preparation services. or welfare payments. Business inventories are goods that firms produce in one time period with the intent to sell later. The largest is personal consumption spending by households on final goods and services. clothing. Examples of services range from medical care. which are goods not intended for long-term use. such as Social Security payments to retired persons. condominiums. In addition. as listed in the table. which are actions rather than physical items. office buildings. roads. The expenditure approach includes the value of exports. such as motor vehicles and furniture. expenditures can be broken down into the four components given in the equation above. Similarly. the wages of government employees are included because such employees are performing services in exchange for those wages.Let us look at the following table: As you can see. government expenditures on goods and services provide income for the firms supplying products and the workers supplying services. The smallest component of GDP is net exports. The components used in the income approach are illustrated in the following table: 52 . In addition. and gasoline. the purchases by United States citizens of foreign-produced goods. The second largest component of GDP consists of purchases by federal. and local governments on final goods and services. car repairs and other transportation expenses. the flip side of the expenditure approach is to add together the income for different components of the economy. and military hardware. those that last for some period of time. tools. households can purchase non-durable goods. Residential investment consists of expenditures by households on new houses. The income approach The expenditures on goods and services by consumers provide income for firms. such as food. Thus. Investment spending comprises the third largest component of GDP. The first is nonresidential investment spending by firms on machines. factories. Households can buy durable goods. state. The table shows that there are also three main types of investment spending.
If the car is sold in the United States. These additions and subtractions are termed the net factor payments to the rest of the world in the table above. This yields all the relevant income flowing to each segment of the economy. Conceptually. and rental income (the income received by property owners). Finally. net interest (the interest paid by businesses). the value of these cars would not be included in GDP. for example. National income includes income made by United States citizens who are abroad. It would not be counted in GNP. buildings) in the economy that has undergone wear and tear over time is not included in national income. In addition. Thus. From GDP to Disposable Personal Income An important distinction is the difference between gross national product (GNP) and GDP. Therefore. depreciation is added because the replacement of physical capital (machinery. a Honda automobile assembled in Tennessee. the value of subsidies paid by the government (for example. Many people (such as your parents or grandparents) grew up with GNP as the primary measure of the output of the economy. GDP is more commonly used. and income earned by United States citizens working abroad. a few adjustments need to be made. Because it is owned by a United States corporation. payments made to farmers for not planting crops) are also deducted because no services are received in exchange for those payments. fees) are included in the price of goods and services in the expenditure approach. would it not be nice to be able to answer them? Let us take a brief look at the difference. 53 . factories. while GDP measures the output of factors of production located within the domestic economy. but GDP does not. First. payments for indirect taxes are added to national income. Now. however. it will be counted in GDP because the factory is located within the United States. If your parents or grandparents ask about the differences between these two concepts. however. national income needs to be adjusted because of differences in how national income and GDP treat income earned by foreigners working in the United States. corporate profits (the income of corporations). proprietors' income (the income of proprietorships and partnerships). Once national income is determined. A couple of other minor adjustments still need to be made. consider a Chevrolet factory located in Mexico. because indirect taxes (sales taxes. How do these differences translate into the real world? Consider. GNP measures the output of all domestically owned factors of production. payments made to United States citizens working abroad must be deducted from national income and the payments made to foreign citizens working in the United States must be added. First. GDP includes income earned by foreigners working in the United States. the general approach to income accounting is to begin with national income. they should also be included in the income approach. Conversely. Since the cars are not produced within the United States. but national income does not. because the factory is owned by a foreign company.As shown in the table above. the value of the cars produced there would be counted in GNP. This consists of the compensation of employees (wages and salaries paid to households).
If the rate of inflation exceeds the rate of contraction of the economy. but in fact. think of a country like Saudi Arabia. As you will notice. An increase in GDP. this table measures output in "billions of chained (1992) dollars. With inflation. as it did during the "stagflation" of the late 1970s. discussed above. this measure of GDP is known as nominal GDP. Consider a situation where the economy simultaneously experiences both recession and high inflation. but not GDP. such as personal income and disposable personal income. Which is larger. it may simply be due to an increase in inflation. Therefore. The output of these foreign workers is part of Saudi GDP. real estate. and to the measures of per-capita income. if a news report cites an increase in GDP. 54 . Saudi Arabians own businesses. because the production takes place abroad. prices increase across the economy. What if you read that GDP has increased over the last year? Does that mean the economy has produced more goods and services during the year? This is not necessarily true. GNP or GDP? On the one hand. The path from GDP to the other measures of economic output is shown by the following table: Nominal Versus Real GDP There are some limitations to the use of GDP as a measure of our economic well being.To get a firmer grasp of the idea. We will look at one of these now and discuss other limitations later in this lecture. Saudi Arabia's GNP is significantly larger than its GDP. GDP could increase even though aggregate output declines! Let us look at another measure of GDP as given on the BEA National Accounts Data Web page. Recall that GDP is the value of final goods and services. can stem from an increase in aggregate output and/or an increase in prices. How is this value measured? GDP is measured in current year dollars. and other assets in other countries. therefore. it gives rise to a limitation. but not GNP. The concept of GNP leads directly to the economic measure of national income. either answer could be correct. Current dollars are also known as nominal dollars and. meaning the year in which the goods and services are produced. Because nominal GDP uses current dollars to measure value. thus. This means the prices used to measure GDP go up." Why measure today's output in 1992 dollars? The main reason is to control for the effects of inflation. We will now look at how and why this is done. there are many foreign workers employed in Saudi Arabia. The income derived from these assets is included in Saudi GNP. Saudi earnings from foreign assets are so large that they dominate the foreign worker effect. In theory. On the other hand.
Until 1995. column (8) gives the nominal GDP for year 2. Calculating the GDP price index Both real and nominal GDP are measures of the overall quantity of goods and services produced by an economy. the quantities of each good produced in year 2 are multiplied by the prices for each good in the base year (year 1 in this case). 55 . This means that a rolling. 1997 is known as the base year. Column (6) illustrates the traditional method for calculating real GDP. if 1998 output is measured in the prices for goods and services that prevailed in 1997. in essence. we will look at other measures of inflation that use the prices for only a small number of goods and services. For example. the BEA measures real GDP in billions of chained dollars. To know this. we need another measure of aggregate output. nominal GDP can increase solely due to inflation. In other words. Such a measure is termed real GDP. Since 1995. One way to do this is to use the same dollars when determining the value of goods and services. meaning that 1987 was the base year used for the early 1990s. one that corrects for the effects of inflation. We are interested in whether the economy is really growing or declining. The difference between them is that real GDP corrects for inflation. Column (5) gives the nominal GDP for year 1. This new method uses what is known as "chaintype annual weights" which. This estimate is the GDP price index.Calculating real GDP As we just discussed. In this example. Let us take another quick look at the BEA's table for real GDP. Then. then the output for one year can be compared to another. the value of the goods is calculated by aggregating the resulting dollar values. Here. The method for correcting for inflation. In order to be counted. In the next lecture. geometric average is used to calculate the prices used for calculating real GDP. where 1997 prices are used to calculate the GDP of another year. This excludes much activity for many economies. GDP could be measured in constant year prices. One advantage of this measure of inflation is that economy-wide prices are used to calculate inflation. For each good. Look at the example of an economy with three goods for two years as given in the following table: The prices and quantities of each good in each year are given. real GDP was calculated using 1987 prices. goods and services must be sold in a market. the BEA has used a new method to calculate real GDP. uses an average of base years. As you will see. meaning the dollars of the same year. can be used to estimate inflation. the quantity is multiplied by the price. Limitations of the GDP Concept There are a number of aspects of economic activity that are not included in the measures of nominal and real GDP. Similarly. by using a rolling average of prices from year to year.
the exclusion of illegal economic activities results in a downward bias to estimate their GDP. the price you pay will be counted. for example. can be biased downward in comparison to those of GDPs of more industrialized countries. if you hire a cleaning service to do the job. We should also note that goods and services have to be sold legally in order to be counted in the GDP. such as Columbia and Mexico. For example. and other ingredients bought in the store will be counted. One result of this is that the GDPs of less developed countries. To measure the economic output on a per-person basis. To arrive at this measure of economic well being. have a lower standard of living as time goes by. Does that mean the standard of living for the participants of the economy has improved? In addition to the limitations of GDP just discussed. Per capita GDP/GNP An increase in real GDP means an economy has grown from one period to the next. In this instance. However. but it is excluded from GDP. if a hurricane rips through an area and billions of dollars are spent rebuilding homes. GDP or GNP is divided by the population. economists use per capita GDP or GNP. The participants of such an economy will therefore experience a decline in living standards. an economy with an increase in real GDP of 2% and an increase in population of 10% per year for several years. 56 . In addition. yeast. This excludes the underground economy. this measure gives a good indication of the average economic standard of living for a society. Although not perfect. The table to the right shows per capita GNP for 1997 in several countries. and other structures. although the value of electricity sold is counted. businesses. for example. those expenditures will add to GDP. It shows that some countries have a much lower level of economic well being than others. if you spend the day cleaning your house or apartment. Although the total output of the economy has gone up. Some destructive events can actually add to GDP. Other aspects that affect the standard of living for the participants in an economy are not included in GDP. only the cleaning products you used will be counted in GDP. some destructive aspects of economic activity are not subtracted from GDP. on average. in which household production plays an important role. For example. Consider. the value of a similar loaf baked at home is not. For example. marijuana is one of the major cash crops grown in some states. is not counted. Although the value of a loaf of bread that is bought in a store is counted. each person in the economy will. the negative effects of the air pollution that is created during the generation process are not deducted.Household production. Similarly. For some countries. only the value of the flour. changes in the population should also be considered.
the worst recession of recent years occurred in the early 1980s. The Great Depression was the worst economic calamity experienced in the United States during this century. Recessions. At such times. In terms of severity and duration. Let us look more closely at these fluctuations and their associated problems. and Unemployment Depressions are severe and prolonged economic downturns during which millions of people can be out of work for several years. They have seen strong economic growth. Inflation. There are times when the economy declines and times when it expands too fast. the difference between recessions and depressions is somewhat murky. Defining and measuring unemployment The most common measure of unemployment is the unemployment rate. As we mentioned in a previous lecture. 57 . and low unemployment. you will recall. with stable prices and increasing output and employment. things are not always rosy. low inflation. Let us look at the problem of unemployment in a bit more detail. In other words. Recessions. Although the overall trend of the economy is overwhelmingly positive. are less severe and do not last as long. The following table compares the downturns of the 1930s and 1980s: You will notice that the number of unemployed persons and the unemployment rate rose during recessions and depressions. the economy experiences problems with the twin evils of inflation and unemployment. and Growth People fortunate enough to grow up during the 1990s have experienced extraordinary economic times.CHAPTER7 Macroeconomic Concerns: Unemployment. Depressions. The unemployment rate is the ratio that compares the number of unemployed people to the number of people in the labor force.
Frictional unemployment will exist in any economy where people are free to choose their own jobs. a person must be over 15 years old. while other types are. geographic displacement.It is important to keep in mind that the labor force is not the same as the population. Another type of unemployment that arises naturally in a dynamic economy is structural unemployment. Such changes are inevitable in an ever-changing economy. This type of unemployment is due to changes in economic institutions. are now employed in other industries. when the number of people out of work is the highest. begin to feel more optimistic about their job prospects and begin to look for work. 58 . To be in the labor force. and either be employed or unemployed. People without a job and who are not looking for work are not considered to be in the labor force. There will always be people who are out of work while looking for jobs for which they are well qualified or which are more desirable. and perhaps even desirable. some types of unemployment are not considered to be a problem. and similar factors. Although this person could easily get a relatively low-skilled job. Let us look first at the different types of unemployment. First. During the trough of a recession. not all people who are without work are considered to be unemployed. he or she wants to put that education to work. We should note a couple of things here. part of a dynamic economy. be available to work. This influx into the labor force will increase the unemployment rate because these workers are counted as unemployed until they find work The costs of unemployment As surprising as it may seem. the unemployment rate can actually go down! This phenomenon. known as the discouraged-worker effect. and is looking for a job in a large investment firm. Such a person is an example of frictional unemployment. For example. The distinction between those considered to be unemployed and those not in the labor force is important and tends to bias the unemployment rate. but the unemployment rate often goes up! This happens because discouraged workers. technological change. occurs because discouraged workers drop out of the labor force. In other words. discouraged workers who have given up looking for a job are not counted as being unemployed! This bias gives rise to two counter-intuitive features about recessions and recoveries. one result of the technological revolution is that personal computers have become more common than typewriters in the homes and workplaces of the United States. on the other hand. a person can work for as little as one hour per week and be considered employed! Second. Consider a recent college graduate with a degree in business administration. For example. who were formerly making typewriters. To realize why. who have not been included in the labor force or in the unemployment rate. such as taking orders at a fast food restaurant. Unemployed people are out of work members of the labor force who have made specific efforts to find work during the previous four weeks. As a result. The dramatic decline in the number of typewriters sold in the United States means many workers. there will always be some unemployment due to job search activities. we should recognize the different reasons for being unemployed and why some unemployment is a necessary. During the beginning of recoveries. the number of people with jobs generally increases.
Cyclical unemployment arises when the economy takes a turn for the worse. on the other hand. necessary. The combination of these two types of unemployment is called the natural rate of unemployment. 59 . The increase in unemployment over the natural rate is considered to be cyclical unemployment. there will always be some structural unemployment. Because the economy continually undergoes structural changes over time. Recall that business cycles are fluctuations in the economy that cause changes in output and unemployment. This occurs as a natural part of a normal economy. and even healthy part of an economic system. The presence of frictional and structural unemployment is considered a natural.) Cyclical unemployment and lost output Consider the following table from the Bureau of Labor Statistics (BLS): This chart shows how employment in several sectors of the economy is expected to change over the next 10 years. is indicative of an economy that is not normal and healthy.The costs of unemployment (cont. One type of unemployment.
Unemployment results in additional costs to the economy. This gives rise to an increasing number of welfare recipients and expenditures for unemployment and welfare programs. Cyclical unemployment consists of this increase in unemployment during recessions and depressions. their income. the unemployment rate climbs. When the unemployment rate goes above the natural rate. and economic costs that are borne by the economy and the people within it. Many people are thrown into poverty during recessions and depressions. but in an increase in the share of the population on welfare. The following figure shows the relationship between unemployment and welfare recipients over a 20-year period. social. The personal costs stem from the fact that many people lose their jobs. there are fewer workers producing goods and services and is therefore a commensurate decrease in 60 . and perhaps their homes and families. the number of people in poverty rose by 10 million. the recessions of the early 1980s and 1990s not only resulted in higher unemployment. With a decrease in the number of people who are working. This gives rise to many of the social costs associated with unemployment. there are personal. As you can see.You can see from this figure that during recessions. An increase in unemployment means the number of poor people also increases. during the recession of the early 1980s. For example.
the CPI uses the prices of a few goods that represent those consumed by typical households. an index of these prices is calculated. For more on how the CPI is constructed and what it is used for.output.000 prices for the items included in its typical market basket of goods and services. Regardless of which index is used. To further better understand the problems with the CPI. by itself. meaning each dollar buys less than it did before. The estimates of lost output for the U. Inflation Inflation is an increase in the overall level of money prices in an economy. This is lost output that cannot be recouped. Inflation. government policy during the early part of President Reagan's administration deliberately incurred the recession of the early 1980s in order to break the back of the high inflation of the late 1970s. The benefits of recessions After the discussion of the severe costs of recessions. other indexes of prices are constructed. Rather than use prices for all the goods and services in the economy. Please take a look at the list of the CPI and corresponding inflation rates at this Web site from the Bureau of Labor Statistics (BLS) . it may seem strange to think there can be benefits associated with recessions. rather than the prices that consumers pay. Once the prices are collected. the basic way of using these price indexes to measure the rate of inflation is the same. In short. is the overall increase in prices measured? There are a number of price indexes used to measure inflation. Another common index is the producer price index (PPI) which uses the prices that producers receive for products. The following table shows that inflation declined during the recessions of the mid1970s and early 1980s. look up the Internet resource article "Why Inflation Figures Are Inflated. As mentioned in the lecture for chapter 21." In addition to the CPI. employees of the Bureau of Labor Statistics (BLS) go to retail stores. Inflation is measured by calculating the rate of change in a given price index from one time period to the 61 .5 trillion. and its overstatement of the inflation rate. economy due to recessions since 1974 range up to $1. Keep in mind that an increase in the price of a particular good does not. and a host of other locations to collect about 90. an increase in the demand for organic cotton leads to an increase in its price relative to other goods. doctors' offices. Each month. We have seen one of these already: the GDP price index discussed in the previous lecture.S. the economy is not producing as much as it could be producing. An increase in the price level causes a decrease in the purchasing power of each dollar. occurs when there is an overall increase in the price of goods in an economy. constitute inflation. then. check out the Internet resource site "The Consumer Price Index: Why the Published Averages Don't Always Match An Individual's Inflation Experience. For example. some prices may increase more rapidly than other prices. How." The indexes of these consumer prices can be compared to determine the rate at which prices are rising. Price indexes During inflation. on the other hand. The measure of inflation most often cited in news reports is the consumer price index (CPI). its importance.
The reduction in investment tends to reduce the long-term rate of growth in an economy. people have twice as much income to buy them with. Using 1996 as year 1 and 1997 as year 2. Lenders who may be hurt by the negative effects of unexpected inflation will react by charging higher interest rates over time. Welfare recipients. annual rates of inflation using the PPI are calculated by calculating the rate of change of PPI from one year to the next. The general rule of thumb is that inflation redistributes wealth away from those who underestimate it. The basic formula is: Note: the fraction in the formula has been multiplied by 100 in order to convert it to a percentage. Real interest rate on a loan = interest rate charged . Although things cost twice as much.9 for 1996 and 160. they often miss an important point: it is the price of goods and services relative to income that matters. When people take out loans. if inflation is higher than is expected. they get money in one period and repay with money in a later period. Because people with low income tend to have a higher percentage of their income not indexed for inflation.inflation rate However. With inflation. have incomes that are fixed over periods of time because welfare benefits are typically not indexed for inflation. let us get back to the real world where incomes do not necessarily keep up with inflation and other factors come into play. Let us look at two effects of inflation in this regard. inflation hurts people whose incomes increase less rapidly than prices. lenders are getting paid back with money that is worth less than at the time the loan was originally issued. First. the unexpected decrease in the value of money hurts lenders and benefits borrowers by decreasing the real interest rate.5 for 1997 (note.next. Let us use some of the data for 1996 and 1997 from the BLS table mentioned above to calculate the rate of inflation using the CPI. For example. The costs of inflation Although people often complain about the high prices these days. The difference between the interest rate charged on a loan and the inflation rate is the real rate of interest. 62 . You can think of it this way: Suppose the prices of all products doubled and incomes doubled during the same time period. inflation can change the distribution of income in society. for example. This increases the cost of borrowing and discourages firms from investing in physical capital. In other words. Nothing has really changed! But. Second. From the table. we can see that the CPI averaged 156. these numbers may be revised somewhat by the time you read this). An increase in overall prices hurts them because they can afford to buy fewer goods and services than before. the rate of inflation from 1996 is calculated as This is the figure given in the BLS table for the inflation rate using the average CPI for these years. unexpected increases in inflation tend to hurt people that lend money and help people that borrow money. Lenders take this into account by charging borrowers interest rates that include expected inflation.
workers become more skilled and productive.S.2%. What are some of the causes of this long-term growth? In essence. economy for 1998. Through investments in the education and training of the labor force. factories) and more labor. With more capital (machines.Global Unemployment and Inflation Unemployment and inflation are global problems. with an inflation rate of about 1. More efficient workers and use of capital will enable an economy to produce more output from a given stock of capital and labor. Compare these numbers for 1998 with the performance of the U. 63 . whatever increases the efficiency and productivity in an economy contributes to its economic growth. These investments in both physical capital and human capital are vital to the long-term growth of any economy. investments in physical capital and in research and development can foster economic growth by increasing the efficiency and productivity of the available capital. The following table shows rates of inflation and unemployment in different countries.S.6% and an unemployment rate of about 4. Output Growth Our focus on the fluctuations in unemployment and inflation should not obscure the fact that the overall trend of the U. Thus. an economy will be able to produce more. economy is overwhelmingly positive.
collectibles. money has several other important roles in economic systems. monetary systems arise naturally. Now our focus shifts to the money market. and the other things you want. feathers. if you are a programmer who wants to get bread. This greatly facilitates our trading labor and getting goods and services. Think for a moment about how you would go about your day-to-day business. Another function of money is as a store of value. With money. "If it waddles. The baker takes the money in exchange for bread because that money can be easily exchanged for anything he or she might want. In order for something to be money. Money is a convenient way to save for the future. trade some programming for some real estate. when looking for people to trade with. from tribes living in rainforests to the most industrialized nations. can be virtually anything. is much more convenient. He or she can exchange programming services for money. What is money? To answer the question why money arises spontaneously in all societies. you would trade your programming skills for milk. One of the most important functions of money is as a medium of exchange. Thus far. it must perform the functions of money. This means that. for 64 . it is probably money. It is possible to store one's wealth without money. The use of money spontaneously arises early in the development of virtually all societies. if it performs the functions of money. it is probably a duck. This means that people accept money in exchange for goods and services. This means that money is readily accepted as a means of payment. stones. and a host of other things have been used as money. however. In other words.CHAPTPER 8 The Money Supply and the Federal Reserve System We now begin our look at the monetary system. Think back to the earlier example of a computer programmer wanting to buy bread. Cigarettes. firms. One reason is because of the liquidity property of money. however. An Overview of Money It is interesting to note that money exists in all cultures. So." In this case. Let s say that you are a computer programmer and you went shopping. Because barter is so inefficient. With the barter system. It is primarily because the barter system is so inefficient that monetary systems naturally arise. Without money. If you store your wealth by buying land. What if the grocery does not need any programming done? You are out of luck. the programmer does not need to find a baker who needs programming. As we will see. You have to find a baker who needs some programming done. which is when people exchange one good for another. you can not just go to any bakery. but it is nowhere near as easy. for example. You may have heard the expression. plant leaves. Money. and quacks. The computer programmer could. then take that money to any baker and get bread. however. We tend to think of money as coins and little slips of gray-green paper. One major problem with the barter system is the double coincidence of wants. you must want what they have and they must want what you have. The question that naturally arises is why money? Let us look at what money does and see why it is so fundamental to every kind of society. we have been concentrating on the goods market. has feathers. one of the functions of money is to facilitate the exchange of goods and services. we have been concerned primarily with the flow of goods and services between households. bread. In addition. how would we get the things that we want? How would we sell the things that we make? The most often-used alternative to money is barter. or durable goods and hope that they hold their value over time. Money performs three major functions. Money. and the government. think of the alternatives.
however. called M1 or transactions money. Prices became established. The reason for this is that there are several kinds of money in the United States.00. For example. fiat money has no intrinsic value. Measuring the supply of money in the United States There are several measures of the money supply in the United States. cigarettes became the medium of exchange in the camps. However. if an apple sells for 50 cents and an orange sells for $1. for example. stones. Some forms of money are accepted in exchange more readily than are others. Cigarettes are a form of money called commodity money. which was then collected and rolled into new cigarettes. Prisoners in these camps used cigarettes as money in many camps. checkable deposits (called demand deposits). includes M2 plus institutional money funds. Commodity money is also subject to debasement. prisoners could save up cigarettes in order to buy something big in the future. Thus. It is much easier to carry around than stone wheels or cartons of cigarettes. Let us start with a measure of the most liquid forms of money. The value of fiat money is not that it is "backed" by some commodity such as gold. In addition to its value as money. Other forms of commodity money include jewels. The principal advantage of fiat money is its convenience. Cigarettes were also the store of value in the camps. for example. gold. M3. cigarettes were "shaved" of some tobacco. This means that they have some intrinsic value. For a very nice overview of the history of money. and time deposits. Thus. This means that money is used as a gauge of relative value. and cattle. A famous example is the monetary system that arose in prisoner of war camps during World War II. repurchase agreements. The list of measures of the money supply continues with each measure comprising a broader definition of money and less liquid forms of money. how can you compare apples with oranges? Is an apple worth two oranges? It might be hard to tell. the value of each unit of currency diminishes. and more. and other checkable accounts. but that it is readily accepted in exchange for goods and services. money market funds. 65 . As the saying goes. Parcels would arrive from aid agencies containing cigarettes and other provisions. The third major function of money is as a unit of account. People can compare the value of goods and services in terms of money. cigarettes. beads. In the POW camps. Commodity and fiat monies A lot of different items are used for money: feathers. This is the most narrow definition of money and includes currency. and Eurodollars. large time deposits. then we can easily compare them in terms of their dollar value.example. such as canned ham and jars of jam. for example. each of these items also has a value in and of itself. go to the Federal Reserve Bank of Minneapolis homepage. the value of fiat money disappears rapidly. In addition. Cigarettes were widely accepted in trades. a canned ham might trade for 20 cigarettes while a jar of jam might only be worth 10 cigarettes. The cigarettes were money for those societies because the cigarettes performed the three functions of money in the camps. When this acceptance is diminished. M2. Non-smokers began trading cigarettes with smokers. traveler's checks. includes the items in M1 plus household savings deposits. An example of fiat money is the little green strips of paper called dollar bills. Thus. Even non-smokers would accept cigarettes in exchange for other goods because they knew they could easily trade them for what they wanted. When governments print money too rapidly. In contrast. the different measures of money correspond to the different degrees of liquidity of the various forms of money. it may be more difficult at some future time to find people who will take land in exchange for the goods that you want. For this reason. the principal danger of a monetary system using fiat money is that of currency debasement. They really have no value except as money. cigarettes became the unit of account in the camps. or broad money. Recall that the primary function of money is as a medium of exchange.
This amount is called the bank's reserves. though. In essence. The following table shows the balance sheet (T account) for a typical bank. the nation's central bank. we will give a brief overview of the modern banking system. the bank only keeps some of it on hand. First.The Federal Reserve maintains an updated list of the amounts in each of these categories. The modern banking system As indicated above. How Banks Create Money In this section. The remainder gets loaned out to other individuals or businesses. M2 is much larger than M1. most of the money supply in the United States comprises deposits in checking and other bank accounts.6. For example. on the other hand. banks keep a fraction of the amount that savers deposit. have you ever been in a situation where M1 money (currency. Banks and similar institutions are called financial intermediaries because they act as intermediaries between savers and lenders. coin. reflecting the fact that forms of money are included in M2 that are omitted from M1. Its liabilities consist primarily of its deposits. means the bank must pay that person that amount upon demand. we will learn how banks and other financial intermediaries create money by taking in deposits and making loans. As you can see. Interestingly. This type of banking system. is called a fractional banking system. and checks) fails to be accepted as a means of payment? Have you ever been in a situation where something other than M1 must be presented to make payment? The private banking system Although we tend to think of money as the currency in our wallets and purses. called the H. You'll see that the broader the monetary measure. It is the excess reserves that are loaned out by the bank. The amount of deposits over and above the amount in reserves is called excess reserves. Banks keep these reserves either as cash on hand or as deposits with the Federal Reserve System (the Fed). A bank's assets consist of its reserves and the amount it has loaned out. The amount in an individual's savings account. 66 . Banks are required by the Fed to keep a given fraction of deposits on reserve. it is not that simple. the bank's assets and liabilities must balance. It is tempting to say that whatever the government declares is money must perform as money. For example. It is the percentage of total deposits that banks must keep as reserves. in which banks are required to only have a fraction of their deposits on reserves. This fraction is called the required reserve ratio. Remember. that the amount of money a bank has loaned to someone means that individual must pay the bank that amount plus interest. the larger the amount of money included in the measure. a substantial part of banks' profits come from the difference between the interest paid on deposits and the higher rates of interest banks charge on loans. Many people think it is strange that the deposits in a bank are a liability for the bank and the loans it has made are assets. When you deposit your paycheck into your checking account at your bank.
) There are a few things to keep in mind here. Recall that those showed the eventual increase in real GDP with a given spending increase or tax cut. the bigger the multiplier. that $100 has left the system and is no longer available to be redeposited and reloaned. the money multiplier is different from the spending and tax multipliers that we learned about in the previous two lectures. for example. It assumes that no cash leaves the banking system.000 in your checking account and she has $900 in her checking account. What is M1 now? You have $1. the money multiplier shows the maximum increase in the money supply from a cash deposit. borrows the $900 from your bank to buy a computer and the computer dealer deposits all of the money into a bank. With a required reserve ratio of 0. however. no cash has left the system.10. Suppose your bank loans the $900 to a friend of yours. First. How do we know that it will eventually add up to $10. Second.As surprising as it may seem. the money supply increases by 90 percent of the previous deposit because that is the maximum amount that can be loaned out and then redeposited. This shows how the money supply increases due to a cash deposit into a bank. If. the actual increase in the money supply will be smaller. M1 will have grown by another $810. With cash leakage from the system. M1 is now $1. the money multiplier is 5. the bank must put $100 in its reserves and can loan out the remaining $900.000 in cash into your checking account. Thus far. individual banks create money when they loan out deposits. The situation soon changes! With a required reserve ratio of 10 percent.900! Your friend's bank must keep 10 percent of her $900 deposit in its reserves and can loan out the remaining $810. 67 . The modern banking system (cont. If your friend. who deposits the money into her checking account. the money multiplier is 10.000. for example. that you deposit $1.000? We know this because of something called the money multiplier. If someone else borrows that money and deposits it into his checking account. Suppose. spends $800 on a computer and keeps $100 in a cookie jar for a rainy day. The money multiplier shows by how much the money supply will eventually increase as a result of an initial deposit. With a required reserve ratio of 0. M1 has not changed because you have just exchanged the cash for a demand deposit of $1. there is no cash leakage from the system.20. your friend borrows $900 from your bank. This process of making loans and deposits continues as follows: Notice that at each step. The money multiplier formula is: Note that the smaller the required reserve ratio. In other words.
If you withdrew $1. go to the BOG's biography page.000 from your checking account and put it into your cookie jar. and other factors. If they did hold some deposits in excess of their required reserves. which is set by the Fed. Finally. The Fed is governed by the "Board of Governors" (BOG). For a description of the Board of Governors. to 14-year terms. please go to the Federal Reserve Board's Web page about the Federal Reserve System. the money supply would shrink by more than the $1. there would be less loaned out at each step of the process and the money multiplier would be smaller. The amount of money that is created from initial cash deposits depends on the required reserve ratio. we will examine some of the main functions of the Fed.Third. The exact amount depends on the required reserve ratio. The following figure gives an overview of the structure of the Federal Reserve System.000. The Fed also controls additional aspects of the banking system. For a short summary of the Federal Reserve System. We have seen how money is created by a fractional banking system. 68 . the formula above assumes that banks do not hold any of their excess reserves. In the next section. The Federal Reserve System The Federal Reserve System is a system of 12 regional banks that act as the central bank of the United States. Each governor of the BOG is nominated by the president of the United States. we should note that the process works in reverse. and confirmed by the Senate. the amount of excess reserves held by banks. the amount of the cash leakage.
it can lower the discount rate. If the Fed lowers the required reserve ratio. The Fed uses the other tools of monetary policy. you can go to your bank. when the Fed wants to increase the money supply. some people are worried about what might happen. The required reserve ratio The simplest tool to understand is the Fed's use of the required reserve ratio. the Fed can change the money supply. The Fed clears interbank payments and performs a host of regulatory functions.Functions of the Fed The Fed acts as the banker's bank. as well as write and enforce consumer protection regulations.S. it can go to the Fed." Let us look at each of these in more detail. including the domestic and international operations of U. The Fed can alter the reserve requirement. There is a lot of discussion now about the upcoming Y2K problem. and should solve it in time. the money multiplier becomes larger and each deposit results in a larger increase in the money supply. Although the Fed can set the reserve requirement anywhere from 8 to 14 percent on transaction deposits. What do you think could happen if a lot of people do become worried as we approach the year 2000? Would it matter if the depositors' fears were unfounded? How the Fed Controls the Money Supply There are three main tools the Fed can use to control the nation's money supply. In addition. operations of foreign banking organizations. and by changing it. as well as the U. If your bank needs a loan. the bank may tell you that you have no funds in your account because the bank s computer thinks you deposited it. As a result. the reserve requirement in the U. it can increase the required reserve ratio. much more frequently. if the Fed wishes to reduce the money supply. has remained at 10 percent for several years. thereby increase the money supply. the more they can loan out and the higher the money supply becomes." In turn. not in 1999. The discount rate Banks may borrow from the Fed. there are time lags between changes in the reserve requirement and changes in the money supply. The Fed can change the so-called discount rate. This ratio is determined by the Fed. increase the amount of money borrowed from the Fed. One of the most important reasons for this lack of change is that this tool is a blunt instrument. The Fed rarely makes changes in the required reserve ratio. Conversely. Y2K stands for the Year 2000. if you try to withdraw money in the year 2000. They might confuse the year 2000 with the year 1900 or with some other date! This could be a problem in a bank. Finally. Conversely.S. Nevertheless. The problem concerns computers that will have a hard time making the transition to the next century because of the way early computer systems identified dates. the Fed can raise the discount rate in order to lower the money supply. Recall the money multiplier formula. banking organizations. For example. For example. They regulate bank acquisitions and mergers. the Fed can conduct what are called "open market operations.S. the Fed supervises and regulates the banking system in the United States. The more money they borrow. the Fed frees up some of the banks' reserves to be loaned out and. When the Fed lowers the discount rate. banks loan out money at higher interest rates. but in 2099! That means your account doesn't yet have the funds! Fortunately. banks are working on this problem. In essence. by lowering the required reserve ratio. The interest rate charged by the Fed is termed the "discount rate. Small changes in the reserve requirement can yield large changes in the money supply. the discount rate and open market operations. If you need a loan. 69 . banks find it less costly to borrow from the Fed and as a result. because of reporting delays.
It allows a more precise and rapid control of the money supply than any of the other monetary policy tools. it is not without any problems. Why do you think being insured might change behavior in an undesirable way? Think in terms of the insurance that households buy: fire insurance. the Fed. the money multiplier. In essence. when the Fed purchases government securities from the open market. Conversely. If we graph change in the money supply with a change in interest rate. Banking system. an open market purchase of government securities by the Fed results in an increase in banks' reserves. This is a type of insurance. This increases the amount of loans made by banks. An open market sale of government securities will decrease the money supply A global guide to central banking systems all over the world is available through the Internet resource "Mark Bernkopf's Central Banking Resource Center. without limit.One of the Fed's most important responsibilities is to be the lender of last resort. the Fed gives the banks government securities in exchange for cash. in turn. banking system to various foreign banking systems. this tool involves the sale and purchase of U.S.S. and personal liability insurance. Suppose that the insurance covered all losses. and the role of monetary policy in the U. no matter how large the demands. When the Fed buys government securities in the open market. the money supply goes up. increases the money supply. medical insurance. economy is available through the Internet resource site "U. The Fed holds large amounts of government securities and can purchase more. Financial Data. as well as various financial information. which leads to an increase in M1. the money supply is a fixed amount. Though this type of insurance helps to guarantee the stability of the banking system.S. This is important because it gives the Fed the ability to stem any run on the banking system. This is shown by the following figure: 70 . Consider the case of the Fed purchasing a government security from a bank.S. The supply curve for money At any point in time." It is excellent for a comparison of the U.S. the bank gives the Fed a bond certificate and gets money in exchange. In essence. the line of the money supply curve is vertical. This decreases the bank's required reserves and. government securities in the open market. This is a guarantee to depositors that the Fed will be there to meet their withdrawal demands. money supply.S." This site contains up-to-date information on the U. This. as a result. A good overview of the U. reserves. lowers the money supply. which enables the bank to make more loans. This money increases the bank's reserves. meaning it is a fixed amount in the short run. A problem with all insurance programs is that they tend to change the behavior of the organizations being insured. Thus. What about banks? Open market operations The primary tool the Fed uses to influence the money supply is the use of open market operations.
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