Economics - Macroeconomics

Study Session 4 Macroeconomics
Section A. Taking the Nation's Economic Pulse

a. Two ways of measuring GDP. GDP is a measure of both output and income. The revenues business firms derive from the sale of goods and services are paid directly to resource suppliers in the form of wages, self-employment income, rents, profits, and interest. There are two ways of measuring GDP. GDP derived by these two approaches will be equal. Expenditure Approach: totals the expenditures spent on all final goods and services produced during the year. Under this approach, GDP is a measure of aggregate output. There are four components of GDP under this approach: Personal consumption expenditures: durable goods, non-durable goods and services. This is the largest component under this approach. Gross private domestic investment: the flow of private sector expenditures on durable assets plus the addition to inventories during a period. It is the production or construction of capital goods that provide a flow of future service. Unlike consumer goods, they are not immediately "used". Gross investment includes expenditures for both (1) net investment, which is gross investment minus an allowance for depreciation and obsolescence of machinery and other physical assets during the year, and (2) inventory investment, which is the change in the stock of goods and raw materials held during a period (inventories need not be sold to contribute to GDP in the current period). Private investment indicates the economy's future productive capacity. Government consumption and gross investment: government purchases, not including transfer payments. It includes both (1) expenditures on such items as office supplies, law enforcement, and operation of veteran hospitals; and (2) the capital purchase of long-lasting capital goods such as missiles, highways and dams for flood control. Government expenditures (which include transfer payments like social security) and government consumption are not equal. Net exports to foreigners: exports minus imports. Exports are domestically produced goods and services sold to foreigners. Imports are foreign-made goods and services purchased by domestic consumers, investors and governments. When
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measuring GDP by the expenditure approach, we must add exports and subtract imports. Net exports may be either positive or negative. Resource Cost-Income Approach: Calculate GDP by summing the income payments to the resource suppliers and the other costs of producing those goods and services. Under this approach, GDP is a measure of aggregate income. It includes: Aggregate Income: compensation of employee (wages and salaries), income of self-employed proprietors, rents, profits and interest. The sum of these five items is known as national income. Employee compensation is the largest source of income generated by the production of goods and services. Non-Income Cost Items: o Indirect business taxes: they are taxes imposed on the sale of products. They boost the market price of goods when GDP is calculated by the expenditure approach. When looked at from the factor-cost viewpoint, taxes are an indirect cost of supplying the goods to the purchasers. o Depreciation: it pays for the replacement of the capital used up in the production process. It is not a direct cost (no direct payment to a resource owner) because it reflects what is lost to the producer when machines and facilities become less valuable. Net Income of Foreigners: Since GNP (Aggregate Income + Non-Income Cost Items) counts the income that American earn aboard, but it omits the income foreigners earn in the US, this amount must be added (or subtracted if it is negative).
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b. GNP versus GDP. GDP is the total market value of all domestically produced final goods and services for that year. The five key factors are: Market value, final goods and services, produced, within a country, during a specific time period. Only final goods and services count: GDP includes goods and services purchased by final users. Intermediate goods purchased for resale or for the production of another good or service are excluded to avoid double counting. Their value is embodied in the value of the goods purchased by the end-user. GDP is a "flow" variable: it measures the market value of production that flows through the economy. Financial transactions and income transfers (e.g. social security and welfare payments) are excluded because they represent exchanges, not productions, of goods and services. GDP counts transactions that add to current production. GDP counts only goods and services produced domestically, whether by citizens or foreigners. It includes only goods produced during the current period. Thus, sales of used goods are not counted by GDP. However, sales commissions count toward GDP because they involve services provided during the period.
GNP is the total market value of all final goods and services produced by the citizens of a country. It measures the output that is produced by the "nationals" of a country. This figure is the output generated by the labor and capital owned by the citizens of the country, regardless of whether that output is produced domestically or abroad. Consider the case of America. GNP is the income earned by Americans, regardless of whether the income is earned in the United States or abroad. It omits the income foreigners earn in the United States, but counts the income that Americans earn abroad. It is equal to GDP minus the net income of foreigners. GNP = GDP + Income received by citizens for factors of production supplied abroad - Income paid to foreigners for the contribution to domestic output In short, GNP measures the worldwide output of a nation's citizens, while GDP measures the domestic output of the nation. In general, the bulk of output is produced domestically using resources owned by nationals of the country. Thus, GDP often differs only slightly from GNP. These two differ substantially only when a country attracts a large number of
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foreign workers or investments (the country's GDP will exceed its GNP). If a relatively large number of a country's citizens work abroad, or its citizens have made substantial investments abroad, the country's GNP will exceed its GDP.
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c. Real and nominal GDP. An economic variable may have both real and nominal values. The nominal value is expressed at current prices. Therefore, changes of the nominal value over time reflect the impact of two factors: changes in the real size of the economic variable, and changes in the general price level (i.e. inflation). The real value is the value that has been adjusted for the impact of inflation. Therefore, the real value reflects only the real changes in the economic variable. It is more useful in comparing data at different points in time. When comparing GDP across time periods, we confront a problem: the nominal value of GDP may increase as the result of either expansion in the quantities of goods produced or higher prices. Since the former will improve our living standards, we have to adjust nominal values (or nominal GDP or money values) for the effects of inflation to get real values (real GDP). A price index is used to do the adjustment. It measures the cost of purchasing a market basket (or bundle) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference period (a base year).
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d. Two key price indexes: the consumer price index (CPI) and the GDP deflator. Consumer price index is an indicator of the general level of prices. It attempts to compare the cost of purchasing the market basket bought by a typical consumer during a specific period with the cost of purchasing the same market basket during an earlier period. The CPI is better at determining how rising prices affect the money income of consumers. The CPI is more widely used for price changes over time. GDP deflator is a price index that reveals the cost during the current period of purchasing the items included in GDP relative to the cost during a base year (currently, 1992). Because the base year is assigned a value of 100, as the GDP deflator takes on values greater than 100, it indicates the prices have risen. It is a broader price index than the CPI since it is better at giving an economy-wide measure of inflation. It is designed to measure the change in the average price of the market basket of goods included in GDP. In addition to consumer goods, the GDP deflator includes prices for capital goods and other goods and services purchased by business and governments. The GDP deflator also allows the basket of goods to change as the composition of GDP changes, while the CPI is computed using a fixed basket of goods. Even though they measures are based on different market baskets and procedures, the two measures of the annual rate of inflation are quite similar. However, the CPI and GDP deflator were designed for different purposes. Choosing between the two depends on what we are trying to measure. Note: The CPI and the GDP deflator suffer from substitution bias, which causes the indices to overstate the rate of inflation (the GDP deflator does this less than the CPI). Both indices fail to account for improvements in the quality of goods and the introduction of new products. As a result, the increase in consumer living standards is not fully incorporated into the index. Data on both money GDP and price changes are essential for meaningful output comparisons between two time periods. We can use the GDP deflator together with nominal GDP to measure the real GDP: GDP in dollars of constant purchasing power. Real GDPi = Nominal GDPi x (GDP Deflator for base year/ GDP Deflator for year i) Suppose the nominal GDP in 1992 and 1998 were $6244 and $8509 billions of dollars, respectively. It increased by 36.3%. The GDP deflator for 1992 and 1998 were 100 and 112.7, respectively. The real GDP in 1998, there, should be: Nominal GDP in 1998 x GDP deflator in 1992 / GDP deflator in 1998 = 8509 x 100 / 112.7 = $7550 billions of dollars.
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Measured in terms of 1992 dollars, the real GDP in 1998 was only 20.9% higher than that in 1992.
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e. Problems with GDP as a measuring rod. GDP is not a perfect device for measuring current production and income. Major limitations are: Non-market production: Household production is excluded from GDP since such production does not involve a market transaction. However, this production represents positive output but does not contribute to GDP calculation. Such activities may represent 10-15% or more of total GDP. A good example is household services. If you take care of your own baby, it is not counted as GDP; if you hire someone to do it, it is. The underground economy: It is unreported barter and cash transactions that take place outside recorded market channels. Both legal and illegal activities occur in this economy (some are otherwise legal activities (legal if reported) undertaken to evade taxes). Others involve illegal activities, such as trafficking in drugs and prostitution. Even though they are often productive, they are not included in GDP. Estimate of the size of the underground economy in the United States range from 10 percent to 15 percent of total output. Leisure and human costs: Leisure is valuable to each of us but GDP excludes it. Human costs (such as job safety, physical strenuousness) is also excluded. For example, two countries may have the same per capita GDP. In country 1, this was achieved by an average workweek of 30 hours, while in country 2, the workweek was 50 hours. Clearly, the two countries are not equally "well off," since the citizens of country 1 have more time for leisure activities. GDP does not reflect this difference. Quality variation and introduction of new goods: Since new and improved products are constantly replacing old ones, changes in the price level cannot be measured accurately. Some common goods today were just not available in the past, and vice versa. Under such circumstances, comparative GDP statistics lose some of their precision. Harmful side effects and economic "bads": There is no adjustment in GDP for harmful side effects that sometimes arise from production, consumption, and the events of nature. For example, air and water pollutions. On the other hand, expenditures on the cleanup of air and water pollution will add to GDP! Similarly, GDP makes no allowance for destructive acts of nature such as Hurricane Andrew after which millions of dollars were poured into reconstruction efforts to regain the same living standards as before. Since GDP ignored the destruction, but counted rebuilding activities, it tended to overstate the change in living standards during the period.
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Despite these limitations, GDP has made great contributions to measure the value of the goods and services produced in the market (or business) sector. It is a reasonably precise measure of the rate of output in the market sector and how that output rate is changing. This measure may be used to help direct policies, but should not be used as a measure of economic welfare. It is not a measure of economic welfare or happiness of the citizenry. It is not even primarily a measure of economic well-beings.
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f. Related income measures. GDP is the market value of all final goods and services produced within a country during a specific period. The five key factors are: Market value, final goods and services, produced, within a country, during a specific time period. GNP is the total market value of all final goods and services produced by the citizens of a country. It is the income earned by Americans, regardless of whether the income is earned in the United States or abroad. It omits the income foreigners earn in the United States, but counts the income that Americans earn abroad. It is equal to GDP minus the net income of foreigners. The difference is quite small for United States and most other countries. National Income: GDP - Net income of foreigners - depreciation - indirect business taxes. It is the total income payments to owners of human and physical capital during a period. It includes both the domestic and foreign income earned by the nationals. It is the sum of employee compensation, self-employment income, rents, interest, and corporate profits. Personal Income: The total income received by domestic households and non-corporate businesses. It is available for consumption, saving, and payment of personal taxes. Personal income differs from national income because some income is earned but not received and some income is received but not earned during the current period. Disposable Income: An individual's available income, after personal taxes are paid, that can be either consumed or saved.
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B. Working with Our Basic Aggregate Demand/Aggregate Supply Model

a. Factors that shift aggregate demand and aggregate supply. The aggregated demand / supply model is used to analyze the economy of a nation.
The aggregate demand curve (AD) isolates the impact of the price level on the quantity of goods and services (i.e. real GDP) through consumption (C), investment (I), and net exports (X). A reduction in the price level will: o Increase the wealth of people holding the fixed quantity of money. o Reduce the real rate of interest. o Make domestically produced goods cheaper than those produced abroad. All these factors will lead to an increase in the quantity of goods and services demanded at the lower price level. The aggregate supply curve (AS) represents the relationship between the quantity of goods and services supplied and the price level. It is important to distinguish between long-run aggregate supply and short-run aggregate supply. o The long-run aggregate supply curve is vertical. In the long run, people have sufficient time to alter their behavior to adjust fully to price changes. The substainable level of output is determined by a nation's resource base, technology and the efficiency of its institutional factors. The price level has no effect on a nation's long-run aggregate supply. In the long-run equilibrium, current output (Yfull) will equal the economy's potential GDP, the economy is operating at full employment, and the actual rate of unemployment will equal the natural rate of unemployment.
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o The short-run aggregate supply curve typically slopes upward to the right. In the short-run, some prices (e.g. rents, wages) are temporarily fixed as the result of prior commitments. Therefore, firms will expand outputs as the price level increases because higher prices will improve profit margin. Short-run equilibrium occurs when the aggregate quality of goods and services demanded is equal to the aggregate quantity supplied.
Factors that Shift Aggregate Demand:
At each price level, the AD curve shifts to the right due to changes in C, I, and X (and vice versa) caused by: An increase in real wealth (greater wealth increases the demand for all goods). A lower interest rate (when borrowing is cheaper, investment increases; consumption is cheaper with a lower interest rate). Increased optimism about the future (current investment increases). An increase in expected future inflation: people will buy now before prices go higher. An increase in income abroad (increases export demand). A decrease in the exchange rate (increases export demand). And vice versa. Factors that Shift Aggregate Supply:
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We need to differentiate the long-run and short-run effects. Long-run supply refers to the economy's long-run production possibilities (maximum rate of sustainable output). Increase in long-run aggregate supply (LRAS) is caused by: An increase in the supply of resources. This will expand the economy's sustainable rate of output. Note that an economy's resource base includes physical capital, natural resources and labor. An improvement in technology and productivity. This will increase the average output per unit of resources. Institutional changes that increase the efficiency of resource use. Examples: 1. Effective police and legal protection against unlawful use of resources without the permission of owners improves efficiency. 2. Price supports for agricultural products result in inefficient production methods and lower output. And vice versa. Increase in short-run aggregate supply (SRAS) (without affecting long-run aggregate supply) is caused by: A decrease in resource prices/production costs -- that is, production costs. Unless the lower prices of resources reflect a long-term increase in the supply of resources, they will not alter LRAS. A reduction in the expected rate of inflation. If high inflation is expected, suppliers would like to reduce supplies now to sell them at higher prices later, but consumers would like to spend more money now. Favorable supply shocks, such as good weather or a reduction in the world price of an important imported resource. Supply shock is an unexpected event that temporarily either increases or decrease aggregate supply. Normally it does not alter the economy's long-term production capacity. And vice versa.
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b. Unanticipated changes in aggregate demand and aggregate supply. The impact of changes in market conditions will be influenced by whether the changes are anticipated and unanticipated. If a change takes place slowly and predictably, decision makers will make choices based on the anticipation of the event. Anticipated changes are therefore expected by decision makers. Such changes do not generally disrupt equilibrium conditions in markets. Unanticipated changes are not expected by decision makers. They cannot instantaneously adjust to these changes and therefore unanticipated changes have a much greater impact on the economic outcomes than anticipated changes. Economics primarily concerns how people respond and markets adjust to unanticipated changes. Effects of Unanticipated Changes in Aggregate Demand When an economy is initially in long-run equilibrium, and there is an unanticipated increase in aggregate demand:
Initially, the economy is in long-run equilibrium at E1, with an output level of Yfull and a price level of P1. Suppose an unanticipated increase in aggregate demand occurs, shifting the AD curve from AD1 to AD2. In the short-run, unanticipated aggregate demand increases cause output to increase and unemployment to fall because of the time lag between the increased demand and an increase in resource prices (prices of many resources such as wages and rents remain fixed). This lag increases profits and leads businesses to expand output. Suppliers will expand output along the initial short-run aggregate supply curve (ASshort run 1) to point e, which is the short-run equilibrium. Note that output at e (Y2) exceeds the full-employment capacity (Yfull).
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In the long-run, resource prices eventually "catchup", shifting aggregate supply inward. A new equilibrium (E2) is established at a higher price level (P3), the natural rate of unemployment and the economy's long-run potential output (Y2 falls back to Yfull).
Conclusion: an unanticipated increase in aggregate demand temporarily expands output beyond the full-employment capacity. However, in the long-run it does not alter the economy's productive capacity and the primary effect is higher prices (inflation). On the other hand, if there is an unanticipated decrease in aggregate demand:
Initially, the economy is in long-run equilibrium at E1, with an output level of Yfull and a price level of P1. Suppose an unanticipated decrease in aggregate demand occurs, shifting the AD curve from AD1 to AD2. In the short-run, resource prices "lag" ahead of falling prices. The unanticipated decrease in aggregate demand will create excess supply at the initial price level (P1). Suppliers will cut back output along the short-run aggregate supply curve (ASshort run 1) to point e, which is the short-run equilibrium. Note that output contracts below long-run potential and unemployment rises above the natural rate, resulting in a recession. In the long-run, resource prices fall. As lower resource prices lead to lower production costs, output increases to its long-run potential, and unemployment returns to the natural rate.
Conclusion: An unanticipated decrease in aggregate demand temporarily reduces output below the full-employment capacity. In the long-run, its primary effect is lower
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prices. The above assumes that prices (including wages) are downward flexible. However, since resource prices are inflexible in a downward direction, the adjustment process may be both lengthy and painful. Effects of Unanticipated Changes in Aggregate Supply The effect of unanticipated change in aggregate supply depends on whether the factors that cause the changes are temporary or permanent. To summarize: If those factors are temporary, only short-run aggregate supply will be affected, while long-run aggregate supply will remain the same. An unanticipated increase in aggregate supply lowers the price level and increases current GDP. In the long-run, aggregate supply does not increase because the impetus to the supply rise is not expected to be repeated. Decision-makers save a large proportion of their temporarily higher real income, which expands the supply of loanable funds. The interest rate falls and expenditures on interest sensitive capital goods and consumer durables rise. Aggregate supply eventually returns to its long-run potential. If those factors are permanent, both short-run and long-run aggregate supply will be affected. If capital formulation and technological advancement are gradual and anticipated, a sustainable, higher level of real output and real income is the result. If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate and lower price level.
Detail illustrations:
Initially, the economy is in long-run equilibrium at E, with an output level of Yfull and a price level of P1.
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Assume that highly favorable weather conditions occur. Such conditions are temporary because they cannot be counted on in the future. In the short run, short-run aggregate supply will increase from ASshort run 1 to ASshort run 2. The economy will move along the aggregate demand curve AD to point e, which is the short-run equilibrium. Output and income will expand beyond the economy's full-employment capacity to Y2. This will result in a lower rate of unemployment. Price level will fall to P2 due to increased supply. Because households will not be able to maintain their temporarily higher incomes, they will save most of them for use in the future. This will reduce interest rate from r1 to r2, stimulating expenditures on business investments and consumer durables.
In the long run, weather conditions will return to normal levels, and the entire process described above will reverse. As a result, the long-run aggregate supply will remain unchanged. If there is an unanticipated decrease in short-run aggregate supply, the opposite will happen.
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Initially, the economy is in long-run equilibrium at E, with an output level of Yfull 1 and a price level of P1. Assume that a new technology significantly improves the productivity of the labor force. Because such a favorable supply condition is permanent rather than temporary, both short-run and long-run aggregate supply will increase. Output and income will expand to a higher full-employment capacity at Yfull 2.
Combined the unanticipated changes in demand and supply, we conclude: Recessions occur because unanticipated reductions in aggregate demand and unfavorable supply shocks. The result is lower goods and services price relative to costs of production (and resource prices). Economic booms occur because unanticipated increases in aggregate demand and favorable supply shocks. The result is higher goods and services price relative to costs of production (and resource prices).
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c. The economys self-corrective mechanism. 1. Consumption Demand Consumption is the largest component of aggregate demand. It is relatively stable over the business cycle, as consumption is determined by primarily by long-term expected income of households rather than by their current income. Temporary changes in household income generally do not have significant impact on consumption demand. i. During an economic expansion, households will save a substantial amount of the above-normal income. ii. During a recession, households will save less and/or draw on their prior savings. Therefore, consumption demand stabilizes the economy and aggregate demand by increasing less than income during an economic boom and decreasing less than income during an economic recession. 2. Real Interest Rates Changes in real interest rates will help to stabilize aggregate demand and redirect economic fluctuations. Consumer optimism provokes greater current spending and a decrease in the supply of loanable funds. This causes the interest rate to rise, investments to diminish and aggregate demand to shrink. Under business pessimism, the demand for investment funds decreases, depressing the real interest rate. As a result, current consumption rises and the opportunity cost of investment falls: these two outcomes stimulate aggregate demand and revive an economy in an economic contraction.
3. Real Resource Prices Changes in real resource prices will redirect economic fluctuations. If output is temporarily greater than the economy's full employment (FE) capacity (economic expansion), real resource prices will rise due to increased demand and low unemployment. This will place a downward pressure on aggregate output, and the economy is restored to FE at higher prices. If output is temporarily operating at less than capacity (economic recession), excess supply and high unemployment reduce resource prices so output rises to FE with lower prices.
Most economists agree on those self-correcting forces: the economy's self-correcting mechanisms are effective in moving the economy toward full employment but require time, thus many governments use discretionary monetary and fiscal policy to smooth
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the business cycle. So the key issue is: how rapidly do they work? Do we need discretionary monetary and fiscal policies to promote stability and prosperity? If they work slowly, market economies will experience prolonged recessions, with below-capacity output and abnormal high unemployment. In this case, discretionary monetary and fiscal policy may help restore economic stability and prosperity. In they work quickly, a constant growth rate of money supply and balanced budgets are preferred. In this case, discretionary monetary and fiscal policy may create economic instability.
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Section C. Keynesian Foundations of Modern Macroeconomics

a. Classical economics versus Keynesian economics. Classical economists from Adam Smith to the time of Keynes focused their analyses on economic efficiency and production. a key assumption: the prices of all resources are flexible. the driving force of the economy: supply. Say's Law: production creates it own demand. The purchasing power necessary to buy desired products (i.e demand) is generated by production (i.e. supply). The pricing system corrects any production imbalances so equilibrium exists. o Over-production relative to demand is impossible because the purchasing power (income) generated by production to resource suppliers will be sufficient to purchase the goods produced. o During periods of recession, high unemployment will force wage to fall, thereby reducing costs of production and bringing the economy back to full employment within a short period of time. However, this theory failed to explain prolonged recessions such as the Great Depression.
Keynesian view of spending and output: Keynesian economists rejected the classical assumption that wage and price reduction would eliminate unemployment since wages and prices were highly inflexible, particularly in a downward direction. Demand is the driving force of the economy. Spending induces business firms to supply goods and services, and less spending will thus lead to less output. Equilibrium takes place when the level of total spending is equal to current output, and changes in output rather than changes in prices direct the economy to equilibrium. When aggregate expenditures are deficient, there are no automatic forces capable of assuring full employment. Recessions and depressions result when total spending falls because businesses reduce production. Therefore, government intervention is required to keep the economy at full-employment capacity without inflation.
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b. Basic Keynesian model. The key to the basic Keynesian model is the concept of planned aggregate expenditures. As with aggregate demand, the four components of planned aggregate expenditure are: o Planned consumption expenditures (C) This is the most important component, and the disposable income is the major determinant of this component. The consumption function describes the positive correlation between disposable income and consumption. As disposable income increases, consumption expenditures increase, but by a smaller fraction than the increase in income. This is reflected in the slope of the consumption function, the MPC (marginal propensity to consume), which is less than one.
As a result, the consumption function (line C) is flatter than the 45-degree line. o At high levels of disposable income, it exceeds consumption expenditures, and therefore households save. o At low levels of disposable income, households either borrow or dip into their savings to purchase consumption goods. Therefore, consumption expenditures exceed disposable income and households dissave. o As a result, money simplifies and reduces the costs of transactions. o Planned investment expenditures (I) This component encompasses expenditures on fixed assets and changes in inventories. It is primarily determined by current sales relative to plant capacity, economic outlook, and the interest rate. In the short run these expenditures are autonomous expenditures
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which are independent of income and remain constant. o Planned government expenditures (G) Like investment, this component is also independent of income (or autonomous). It is a policy variable determined by political process. o Planned net exports (NX) Exports are dependent on spending choices and income levels abroad. These decisions are unaffected by changes in the nation's domestic income level. In contrast, the level of imports increases as income rises. Therefore, there is a negative relationship between income and net exports. The net exports will decline as income expands. Note that these are the components of GDP based on the expenditure approach: Planned Aggregate Expenditures = Cplanned + Iplanned + Gplanned + NXplanned We need to distinguish between planned and actual expenditures. o Planned expenditures reflect the choices of consumers, investors, governments and foreigners, given their expectations as to the choices of other decision makers. Firms base their production decisions on planned aggregate expenditures. o Planned expenditures need not equal actual expenditures. o If actual expenditures are less than planned expenditures, then businesses will accumulate inventories, resulting in larger inventory investments than what they planned. o and vice versa. Equilibrium is present in the Keynesian model when planned aggregate expenditures equal the value of current output: Total output (Real GDP) = Planned C + I + G + NX When this is the case, businesses are able to sell the total amount of goods and services that they produce. There are no unexpected changes in inventories. Thus, producers have no incentive to either expand or contract their output during the next period. Note that this equilibrium need not take place at full employment. As long as planned aggregate expenditures equal output, the economy is in equilibrium even if output is well below full-employment capacity.
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As long as the aggregate expenditure function remain unchanged, no other level of output can be sustained. The 45-degree line maps out all points where aggregate output equals output (GDP). The planned aggregate expenditure schedule is flatter than the 45-degree line, reflecting the fact that as income rises, consumption rises by a smaller amount. If aggregate expenditures are above equilibrium, total spending will be less than total output, resulting in unplanned increase in inventories. Firms will reduce production, forcing output to fall back to equilibrium. If aggregate expenditures are below equilibrium, total spending will be more than total output, resulting in unplanned decrease in inventories. Firms will increase production, pushing output to back to equilibrium. Shifts in aggregate expenditures and changes in equilibrium output
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Aggregate expenditures are the catalyst of the Keynesian model. Changes in expenditures make things happen. Until full employment is attained, supply is always accommodative. Graphically, a shift upward in AE implies a new equilibrium, i.e., a higher level of output. 8.5 represents the economy's out at full employment. Initially, the economy is in equilibrium at E1, with an output level of 8.2. There is no tendency for output to change because planned aggregate expenditures equal output. Because resource prices are fixed, the only way to push the economy back to full-employment capacity is to increase spending. If spending is increased, AE will be lifted upward. When the aggregate expenditures schedule reaches AE2, equilibrium output will expand to the full-employment capacity. Once the full-employment capacity is reached, further increase in aggregate expenditures can no longer increase real output but lead to higher prices. Nominal output will expand (the dotted segment of the AE = GDP schedule), but real output will not.
The Keynesian model within the AD/AS framework
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The basic Keynesian model assumes that resource prices such as wages are completely inflexible in a downward direction. It implies a 90-degree, angle shaped aggregate supply curve. ASshort run is horizontal until output reaches the full-employment capacity. This segment of the supply curve is known as the Keynesian range, which is the (flat) SRAS curve for output less than potential GDP. Since resource prices are completely inflexible in a downward direction, the general price level is fixed within the Keynesian range. Within that range output is determined entirely by the level of aggregate demand, and is independent of the price level. For example, when the aggregate demand is AD1, below-capacity output (Y1) and high unemployment occur while the price level remains unchanged at P1. Unless there is an increase in aggregate demand (e.g., from AD1 to AD2), the economy will remain in recession. When the aggregate demand is just sufficient (i.e. AD2), the economy can reach full-employment capacity without inflation. Once the full-employment capacity is reached, the short-run aggregate curve becomes vertical. Further increases in aggregate demand (e.g. AD3) will merely lead to higher prices while failing to expand real output. The long-run aggregate supply curve (LRAS) is vertical at the full employment capacity (Yfull).
It is changes in output and employment, not price changes, that restores equilibrium in the Keynesian model. The implications of this equilibrium are:
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When equilibrium output is less than the economy's capacity, only an increase in expenditures will lead to full employment. Increasing aggregate expenditures is an effective policy tool during periods of recession. Once full employment is reached, further increases in aggregate expenditures would lead to higher prices only. The regulation of aggregate expenditure is the crux of sound macroeconomic policy. If we could assure aggregate expenditures large enough to achieve capacity output, but not so large as to result in inflation, the Keynesian view implies that maximum output, full employment, and price stability could be attained.
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c. The multiplier. Keynesian model focuses on the impact of changes in autonomous expenditures: Since one individual's expenditure becomes the income of another, changes in autonomous expenditures generally lead to an expansion in income greater than the initial shift in expenditures. The expenditure multiplier is defined as the change in total income (equilibrium output) divided by the autonomous expenditure change that brought about the enlarged income. This relationship can be explained as: Change in income --> additional expenditures (less than income due to consumption function) --> change in another person's income -->..and so on..-->The total change in income is much higher than the original change, and the total change in expenditures is much higher that the original change too. The multiplier principle implies that one individual's expenditure becomes the income of another. Marginal propensity to consume (MPC) is defined as additional current consumption divided by additional current disposable income. MPC = Additional Consumption/Additional Income For example, if your income increases by $1000 and you therefore increase your current consumption expenditures by $800, your marginal propensity to consume is 0.8. There is a direct relationship between the expenditure multiplier and the marginal propensity to consume: Multiplier = 1 / (1 - MPC) This means a higher MPC will bring a larger multiplier. Continue with the above example, the multiplier would be 5. This indicates that an additional expenditure of $20 will eventually lead to a total of $100 expenditure. The multiplier magnifies the fluctuations in output and employment that emanate from autonomous changes in spending. It shows that even small changes in investment, consumption, or government spending can lead to a much larger changes in output. There are both positive and negative sides to the amplified effects. During economic recessions, a small reduction in investment expenditures can exert bigger impact on making things worse. The stability of a market economy is constantly susceptible to even modest disruptions. On the other hand, the multiplier principle illustrates the potential of
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macro-economic policy to stimulate output even if it is able to exert only a small impact on autonomous expenditures. That is, a small increase in expenditures such as government spending can cause a very large increase in output, pushing a recessionary economy back to normal. There are three factors that dampen the effects of the expenditure multiplier: Leakages: when computing the marginal propensity to consume, we assumed that all income were either saved or spent. However, in the real world, leakages in the form of taxes and spending on imports will reduce the size of the multiplier. Time lag: it takes time for the multiplier to work. Availability of idle resources: when there are idle resources, the multiplier implies that the additional spending will bring them into production, leading to additional real output rather than increased prices. However, when the full employment is present (absence of idle resources), the multiplier effect will be dampened by an increase in the price level, not higher output.
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d. The Keynesian view of the business cycle. Keynesian economists believe that a market economy, if left to its own devices, is unstable and likely to fluctuate between economic recession and inflationary boom, and to make things worse, to experience prolonged periods of recession. The Keynesian view emphasizes the destabilizing potential of autonomous changes in expenditures powered by the multiplier and changes in optimism. An increase in aggregate demand will lead to an expansion output that will have a tendency to feed on itself (magnified by the multiplier). The initial increase in demand will lead to a sharp increase in demand. Higher demand --> higher employment and incomes --> additional consumption and higher business sales --> lower level of inventories --> output expanded to replenish inventories...This creates the expansion phase of the business cycle. However, this expansionary phase will not last forever. When the full employment capacity is reached, the growth rate of the economy will slow down due to constraints of labor and resources. This will dampen the optimism of business decision makers and cause them to cut back on fixed investments. Again, the multiplier will magnify the impact of the change in demand and lead the economy into a recession. This creates the contraction phase of the business cycle.
Wide fluctuation in private investment is the villain of Keynesian business cycle theory. Keynesian economists believe that the recessionary phase is likely to be quite lengthy and they have little confidence that either lower interest rates or falling resource prices will be able to reverse the tide of the falling incomes.
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Section A. Economic Fluctuations, Unemployment, and Inflation

a. A hypothetical business cycle. Although the real GDP in industrial nations has been growing over time, periods of economic expansion have been followed by slowdown and contraction. Business cycle is the fluctuations in the general level of economic activity as measured by such variable as the rate of unemployment and changes in real GDP. Periods of growth in real output and other aggregate measures of economic activity followed by periods of decline are the distinguishing characteristics of business cycles. Refer to the graph below. A complete business cycle is represented by A to G:
Business peak: When most businesses are operating at capacity level and real GDP is growing rapidly, a business peak, or boom, is present. Contraction: Aggregate business conditions are slow, real GDP grows at a slower rate or even declines, and unemployment rate increases. This indicates that the economy begins the contraction, or recessionary, phase of a business cycle. Recession: The bottom of the contraction phase is referred to as the recessionary trough. Recession is a downturn in economic activity characterized by declining real GDP and rising unemployment. In an effort to be more precise, many economists define a recession as two consecutive quarters in which there is a decline in real GDP. When a recession is prolonged and characterized by a sharp decline in economic activity, it is called a depression. Expansion: After the downturn reaches bottom, and the economic conditions begin to improve, the economy enters the expansion phase of the cycle. Here business sales rise, GDP grows rapidly and the rate of unemployment declines. The expansion eventually blossoms into another business peak, and begins the cycle new.
In the real world, the observed fluctuations in real output are irregular and unpredictable.
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b. Labor market and unemployment. The non-institutional civilian adult (16 and over) is grouped into two broad categories: Persons not in the labor force, such as household workers, students, retirees, and disabled. Civilian labor force: the total number of people 16 years of age or older who are either employed or seeking employment. Labor force participation rate is the number of people in the civilian labor force over 16 years of age who are either employed or actively looking for employment, as a percentage of the total population 16 years and over. Labor Force Participation Rate = Civilian Labor Force / Civilian Population 16 and Over Civilian labor force is then grouped into: Employed: including employees and self-employed workers. Unemployed: describes a member of the civilian labor force who is currently not working, but is either currently seeking employment or waiting to start or return to a job. Examples are new entrants, re-entrants, lost last job, quit last job and being laid off. Rate of unemployment is the percentage of persons in the labor force who are unemployed. This is a key barometer of conditions in the aggregate labor market. Rate of unemployment = [(Number of persons unemployed) / (Number in the labor force)] It is important to note that unemployment is different from not working: there are several reasons -- including household work, school attendance, retirement, and illness or disability -- why a person may not be working but is not unemployed. Remember that an individual is counted as unemployed if he/she is either actively seeking employment, or waiting to begin or return to a job.
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There are two points to be noted about unemployment: In a dynamic world where information, like most other things, is scare and people are free to choose among jobs, some unemployment is inevitable. There is a positive side to job search and unemployment: it generally permits individuals to better match their skills and preferences with the requirements of a job. Such job moves enhance both employee productivity and earnings. The problems in measuring unemployment are: People are excluded from unemployment figure even though they would prefer to be working (or working more): examples include discouraged workers (they believe that continuing the job search is fruitless and thus give up looking for a job. They wish to work but because they are not actively searching for work they are excluded from the labor force and are not counted in the unemployment rate.) and part-time workers (they may wish to work full time but cannot find full time work. Such a worker is considered employed (but actually underemployed), thus understate the unemployment rate). People are included in unemployment figure but they are not seriously seeking employment. Many government income-assistance programs are required to register for employment, but many recipients of those programs may not be seriously searching for work. One example is seasonal workers such as construction workers, farm workers (they may be technically unemployed and receiving unemployment benefits but may not be looking for a job during the months that their work is made impossible by the weather. Such workers overstate
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the unemployment rate.) People working in underground economy are not counted.
Some economists argue to use employment/population ratio to measure unemployment. It is the number of persons 16 years of age and over employed as civilians divided by the total civilian population 16 years of age and over. Employment/Population Rate = Number of persons 16 and over who are employed / Civilian population 16 and over The components of the ratio are easily measured and well defined and do not require a subjective judgment as to whether a person is available for work or actively seeking employment. There are three types of unemployment. Frictional Unemployment: It is caused by constant changes in the labor market. It occurs due to incomplete information: Available workers are unaware of job openings and employers are not fully aware of qualified, available workers. Suppose a worker is looking for a job. In his or her search, there are costs and benefits. The benefits of extending a job search are that he or she is more likely to find a "better" job (more pay, better environment, etc.). The cost of an extended search is defined as an opportunity cost: each job the worker refuses in pursuit of a "better" job represents lost income and benefits that could have been earned, and thus the marginal cost of job search will rise with the length of one's job search time. The length of a job search involves comparing the marginal benefit to the marginal cost of further searching. As soon as the costs exceed the benefits, the worker stops searching and accepts a job offer. Changes that affect the costs and benefits of job search influence the level of unemployment. Examples are centralized job listing system, unemployment benefits, etc. It is important to note that, even though frictional unemployment is a side effect, the job search process typically leads to improved economic efficiency and a higher real income for employees. Thus job search performs an important labor market function. Structural Unemployment:
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This occurs due to changes in the basic structure of the economy that eliminate some jobs while generating new job openings for which unemployed workers are not well suited. Essentially, the skills of a structurally unemployed worker have been rendered obsolete by changing market conditions and technology, and the retraining of workers for new sector jobs takes time and resources. The crucial difference between frictional and structural unemployment is that, with the former case, workers possess the requisite skills to fill the job openings; with the latter case, they do not. There are many causes of structural unemployment. Technological change is the number 1 reason. Shifts in public sector priorities and institutional factors that reduce the ability of employees to obtain skills necessary to fill existing job openings also increase structural unemployment. Cyclical Unemployment: This occurs because the recessionary phase of business cycles creates inadequate aggregate demand for labor, leading to layoffs and cutbacks in production. Unexpected reductions in the general level of demand for goods and services are the major cause of cyclical unemployment. Fewer goods and produced, and fewer workers are required to produce them. Employers lay off workers and cut back employment. When there is a general decline in demand, many employers will be laying off workers and few will be hiring. Most workers' search efforts will be fruitless and the duration of their unemployment will be abnormally long. With time, unemployed workers will lower their expectations and many will be willing to accept employment at a lower wage. This adjustment process, however, will take time. Full employment is the level of employment stemming from the efficient use of the labor force after subtracting the natural rate of unemployment, which is the level of unemployment that exists permanently due to information costs, dynamic changes, and the structural conditions of the economy. Full employment implies the natural, not zero, rate of unemployment. For the United States, full employment is thought to exist when between 94 and 95 percent of the labor force is employed. Please note that full employment does not mean zero unemployment. Some unemployment is present and consistent with the efficient operation of a dynamic labor market. Full employment is a meaningful concept only it refers to productive employment that will generate goods and services desired by consumers at the lowest possible cost.
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Another closely related concept is the natural rate of unemployment. It is: o The long-run average unemployment rate due to frictional and structural conditions of labor markets. o Affected both by dynamic change in demographics such as number of young workers, and by public policy such as unemployment benefits and minimum wage. o Sustainable into the future. o Thought to be between 5 percent and 6 percent currently in the United States. The actual rate fluctuates around the natural rate, in response to cyclical economic condition. During the past four decades the actual rate of unemployment generally rises above the natural rate during a recession and falls below the natural rate when the economy is in the midst of an economic boom. Potential GDP is the output achieved and sustained into the future, considering the labor force size, the expected productivity by labor, and the natural rate of unemployment. Due to cyclical factors of the business cycle, the actual GDP usually differs from the potential GDP. In economics, we are interested in how to achieve the maximum potential output while minimizing instability associated with the business cycle.
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c. Effects of inflation. Inflation is a continuing rise in the general level of prices of goods and services. It can also be defined as a decline in the value (the purchasing power) of the monetary unit. There is too much money chasing too few goods. The annual inflation rate is simply the percentage change in the price index (PI) from one year to the next: i = (This year's PI - Last year's PI)/(Last year's PI) For example, the CPI is 115 for 2001 and 120 for 2002. The inflation rate during 2002 is: (120 - 115)/115 = 4.35%. Unanticipated inflation is an increase in the general level of prices that was not expected by most decision makers. For example, if most people anticipate an inflation rate of 3% but the actual inflation rate turns out to be 10%, it will catch people off-guard. High rates of inflation are almost always associated with substantial year-to-year swings in the inflation rate. That is, if the inflation rate is high and variable, it is almost impossible to anticipate future inflation rates accurately. Anticipated inflation is an increase in the general level of prices that was expected by most decision makers. In general, decision makers are able to anticipate slow steady inflation rates with a high degree of accuracy. High inflation will generate uncertainty and weaken the link between income and productive activity. Specifically: Unanticipated inflation changes the results of long-term projects since risk increases under inflation; a heightened level of uncertainty makes people less willing to make mutually advantageous long-term contracts. Market efficiency is reduced since potentially productive activities are not undertaken. Inflation makes it difficult to interpret the information contained in prices. Unreliable price signals lead producers and resource suppliers to make choices they later regret. Thus, the allocation of resources will be less efficient than would be the case if prices in general were more stable. People respond to high and variable inflation rates by trying to protect themselves from inflation, instead of spending time on production. Resources are not used efficiently.
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Section B. Fiscal Policy

a. Fiscal policy: definitions. Fiscal policy refers to the use of government expenditure, tax and borrowing activities to achieve economic goals. Two factors may cause changes in the size of the federal deficit or surplus: (1) the state of the economy, and (2) discretionary fiscal policy. Fiscal policy: Government spending and taxing practices designed to promote or inhibit various economic activities. Balanced budget: It implies that current government revenue is equal to current government expenditures. Government revenues are generated through taxes and user charges; expenditures include the purchase of goods and services and transfer payments. Budget deficit: It exists when total government spending exceeds government revenue. A budget deficit is financed through the issuance of Treasury securities; such issuance of securities adds to the national debt. Budget surplus: It occurs when revenues exceed spending. Under a budget surplus, excess revenue is applied to the total outstanding debt accumulated during prior periods, therefore reducing it by the amount of the surplus. Structural budget deficits: A planned budget deficit generated by increasing government spending or reducing taxes. Also known as active budget deficits. Cyclical budget deficits: A budget deficit resulting from a significant slowdown in economic activity, as, for example, would be the case during a recession when tax revenues decline and government outlays increase. Also known as passive budget deficits.
Keynesians argued that the federal budget (fiscal policy tool) should be used to promote a level of aggregate demand consistent with the full employment rate of output. Increased (decreased) spending increases (decreases) aggregate demand. Increased (decreased) taxation decreases (increases) aggregate demand. The potency of a change in tax policy is influenced by whether the change is expected to be temporary or permanent. A temporary one will not change anything. Unless tax cuts are targeting investment, aggregate supply is not affected by fiscal policy.
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b. Problems of proper timing. To reduce economic disturbances, fiscal policy must be put into effect at the proper time in the business cycle. Policy changes take time, when they take effect, the recession or inflationary overheating may have passed. For example, during an economic downturn, the government uses expansionary fiscal policy to stimulate aggregate demand. Suppose by the time the expansionary fiscal policy starts to exert its primary impact, the economy's self corrective mechanism has restored full employment capacity. Therefore, the stimulus injected by expansionary fiscal policy will result in excessive demand and inflation, causing more economic instability. Proper timing of fiscal policy is not an easy task due to three reasons: Recognition lag: there is usually a time lag between when a change in policy is needed and when its need is widely recognized by policymakers. Forecasting a forthcoming recession or boom is a highly imperfect science. Administrative lag: there is generally a lag between the time when the need for a fiscal policy change is recognized and the time when it is actually instituted. The time required to change tax laws and government expenditure programs is quite lengthy. Impact lag: even after a policy is adopted, it may be six to twelve months before its major impact is felt.
Changes in fiscal policy must be timed properly if they are going to exert a stabilizing influence on an economy. However, the use of fiscal policy to calm the business cycle is very difficult: it may accentuate the corrective action of the economy rather than correct the problem for which it was intended. In the real world, a discretionary change in fiscal policy is like a two-edged-sword --- it has the potential to do harm as well as good. If timed correctly, it will reduce economic instability. If timed incorrectly, however, the fiscal change will increase rather than reduce economic instability.
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c. The impact of expansionary and restrictive fiscal policies. Keynesian View of Fiscal Policy: Prior to the Keynesian revolution, it was widely accepted that a balanced federal budget is highly desirable. Rather than balancing the budget annually, Keynesian analysis indicates that fiscal policy should reflect business cycle conditions. Specifically, effective fiscal policy should move the economy in an opposite direction from the forces of the business cycle. An increase in government spending and/or a decrease in taxes (i.e., a budget deficit) will be magnified by the multiplier process and lead to an increase in aggregate demand. If the economy is operating below full capacity and timed properly, this policy will stimulate aggregate demand and guide the economy to full employment equilibrium. This is known as expansionary fiscal policy. Note that such a policy increase federal budget deficit.
Here we illustrate an economy operating in the short run at Y1, below its potential capacity of YF. There are two routes to a long-run full employment equilibrium. o Policymakers could wait for lower wages and resource prices to reduce costs, increase supply to SRAS3, and restore equilibrium at E3. Keynesians believe this market-adjustment method will be slow and uncertain. o Alternatively, expansionary fiscal policy could stimulate aggregate demand (shift to AD2 and guide the economy to E2. On the other hand, the Keynesian model suggests an opposite, restrictive fiscal policy to combat inflation. Note that such a policy reduces federal budget deficit.
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Strong demand such as AD1 will temporarily lead to an output rate beyond the economy's long-run potential YF. If maintained, the high level of demand will lead to long-run equilibrium (E3) at a higher price level. However, restrictive fiscal policy could restrain demand to AD2 (or better still, prevent demand from expanding to AD1 in the first place) and thereby guide the economy to a non-inflationary equilibrium (E2). In summary, wise use of fiscal policy can help stabilize and maintain demand at or near the full employment rate of output. Such a policy is called countercyclical policy.
However, as crowding-out and new classical models indicate, there are side effects of budget deficits or surplus that will substantially, if not entirely, offset their impact on aggregate demand. Fiscal policy is much less potent than the early Keynesian view implied. Crowding-Out Model: Crowding-out effect is the reducing in private spending as a result of higher interest rates generated by budget deficits that are financed by borrowing loanable funds market. It suggests that budget deficits will exert less impact on aggregate demand than the basic Keynesian model implies. Because financing the deficit pushes up interest rates, budget deficits will tend to retard private spending, particularly spending on investment. This reduction will at least partially offset additional spending emanating from the deficit.
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Another implication is that the budget deficit will change the composition of aggregate demand. As private investment is crowded out, the output of capital goods will decline, and the productivity and income of future workers will decline. In a global economy, crowding-out model suggests that the higher interest rate generated by budget deficits and government borrowing will attract an inflow of capital from abroad. The dollar will then appreciate, causing a decline in net exports (budget deficit and trade deficit tend to be linked). This secondary effect will largely, if not entirely, offset the stimulus effects of the deficits. The implications of crowding-out analysis are symmetrical: restrictive fiscal policy will "crowd-in" private spending, and it may not be very effective as a weapon against inflation. It will also cause an outflow of financial capital to abroad, causing an increase in net export. The New Classical Model: It stresses that substitution of debt for tax financing changes the timing, but not the level, of taxes. o When the government employees expansionary fiscal policy by cutting taxes, its budget deficits will increase. o The government typically finances the deficits by issuing more debt, and higher future taxes must be levied to meet the debt obligations. o Keynesians ignore the impact of the higher future taxes on consumption, and assume that households will spend the entire additional disposable income on current consumption. o New classical economists argue that budget deficits merely substitute higher future taxes for lower current taxes, and do not affect the wealth or permanent income of households. Therefore, current consumption will not change when current taxes are cut, and fiscal policy is completely ineffective.
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Initially the economy is at E2, below its potential capacity. The government employs an expansionary fiscal policy by cutting taxes. However, demand remains unchanged at AD1 when households fully anticipate the future increase in taxes.
Simultaneously, the additional saving to meet the higher future taxes will increase the supply of loanable funds to S2 and permit the government to borrow the funds to finance its deficit without pushing up the real interest rate. A decrease in taxes leads to unchanged aggregate demand and interest rates. In this
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model, fiscal policy exerts no effect. The real interest rate, consumption level, real GDP, and level of employment all remain unchanged. However, note that it is unrealistic to expect that households will anticipate all or most of the future taxes implied by additional government debt.
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d. Budget deficits and trade deficits are linked. Let's use expansionary fiscal policy to illustrate this concept. When the US employs a more expansionary fiscal policy, federal budget deficits will increase. As the government increases its borrowings to finance the enlarged budget deficits, the US real interest rates will rise. The higher interest rates have three effects: o They will dampen domestic private spending, causing a reduction in aggregate demand (i.e., the crowding-out effect). o They will attract funds from abroad, reducing the US real interest rates and therefore minimizing the crowding-out effect. o As foreign investors acquire dollars to make financial investments in the US, the demand for the US dollar in the foreign exchange market will increase, the dollar will appreciate. o The appreciation of the dollar will cause US exports to fall and imports to rise. As a result, net exports will decline, causing a reduction in aggregate demand. o Recall that trade deficits are the excess of imports relative to exports. As the appreciation of the dollar causes imports to rise relative to exports, the trade deficits of the US will increase.
Conclusions: o Expansionary fiscal policy tends to increase budget deficits and trade deficits simultaneously.
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o The inflow of capital from abroad changes the form of the crowding-out effect, not necessarily its magnitude. o The appreciation of domestic currency caused by the inflow of foreign capital crowds out net exports. In contrast, the higher real interest rates crowd out domestic private spending. o Conversely, restrictive fiscal policy tends to reduce budget deficits and trade deficits simultaneously.
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e. Automatic stabilizers. Automatic stabilizers apply stimulus during a recession and restraint during a boom even though no legislative action has been taken. The major advantage of them is that they institute counter-cyclical fiscal policy without the delays associated with policy changes that require legislative action. During a recession they trigger government spending without authorization of Congress (unemployment compensation and welfare programs). During inflationary overheating they take spending power out of the economy without the delays caused by legislative actions, thereby minimizing the problem of proper timing. Three major built-in stabilizers are: o Unemployment compensation: when the economy starts to fall into recession, unemployment increases. Government payments for unemployment compensation will increase, while government receipts from the employment tax that finances unemployment benefits will decline. As a result, the unemployment compensation program automatically promotes a budget deficit. Similarly, when the economy expands into an inflationary boom, the program promotes a budget surplus. o Corporate profit tax: when the economy starts to fall into a recession, corporate profits will decline, and so will corporate tax payments. This decline in tax revenues will promote a budget deficit. Similarly, when the economy expands into an inflationary boom, the resulting increase in tax revenue will promote a budget surplus. Because corporate profits are highly sensitive to the business cycle, this is the most counter-cyclical of all the automatic stabilizers. o Progressive income tax: when the economy expands into an inflationary boom, personal income will grow sharply. As a result, more people will fall into the "tax due" category, and others will be pushed into higher tax brackets. Therefore, income tax revenues will rise more rapidly than income, reducing the momentum of consumption growth. In addition, higher tax revenues will promote a budget surplus. Automatic stabilizers help stabilize the economy by reducing the fluctuations of aggregate demand and directing the economy toward full employment.
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f. Supply-side effects of fiscal policy. Marginal tax rates determine the allocation of people's additional income between tax payments and disposable income. Supply side theory targets the marginal tax rate to stimulate the economy. By reducing marginal tax rates, the reward for additional work (investment, savings, and other activities) increases. The source of the supply-side effects accompanying a change in tax rates is fundamentally different from the source of the demand side effects. A change in tax policy affects aggregate demand through its impact on disposable income and the flow of expenditures. In contrast, changes in tax rates, particularly marginal tax rates, will affect aggregate supply through their impact on the relative attractiveness of productive activity in comparison to leisure and tax avoidance. For example, a reduction in marginal tax rates encourages individuals to work, save and invest, and reduces leisure time and tax avoidance activities. The increase in productive activities will enlarge the effective resource base and improve the efficiency of resource use, thereby increasing aggregate supply in the long run. Unlike the Keynesian model, the supply-side model is not a short-run countercyclical tool used to stabilize the economy at full employment. If the tax change (lower marginal tax rate) is perceived as long term, both long- and short-run aggregate supply will increase, and real output and income will expand. Since it takes time for the labor and capital markets to adjust fully to the new incentive structure, supply-side economics is a long-run, growth-oriented strategy. The supply-side effects of a reduction in marginal tax rates:
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o Initially, the economy is at long-run equilibrium E1. o A reduction in marginal tax rates will encourage people to earn additional income and use resources more efficiently. o Because these effects are long-run in nature, both long- and short-run aggregate supply will increase. Accordingly, real output and income will increase to Y'F. o The rise in real income will increase aggregate demand to AD2. o If aggregate demand increases by a larger amount than aggregate supply, the price level will rise. o If aggregate demand increases by a smaller amount than aggregate supply, the price level will fall. According to supply-side economics, marginal tax rates affect the aggregate supply of goods and services in three major ways: o High marginal tax rates discourage work effort and reduce the productive efficiency of labor. In response to the high marginal tax rate, people may decide to take longer vacations, forgo overtime work hours, or move to countries with lower taxes. o High marginal tax rates adversely affect the rate of capital formation and the efficiency of its use. High tax rates will retard foreign investment, and direct domestic capital to countries with lower tax rates. In addition, this process will divert resources away from projects with a higher rate of return but fewer tax avoidance benefits, thus wasting scarce capital and resources. Examples include collecting antiques and raising horses.
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o Higher marginal tax rates cause businesses to purchase tax-deductible items instead of more desired, non-deductible goods. Here the inefficiency stems from the fact that individuals do not bear the full cost of tax deductible purchases. Such tax-deductible expenditures include business entertainment, luxury company cars, etc. Summary: A decrease in marginal tax rates leads to increase in investment and savings, an increase in work and productivity, a decrease in leisure, and a decrease in tax sheltering, leading to an increase in aggregate supply in the long run (LR), an increase in GDP, a decrease in unemployment and a decrease in prices. There is evidence that countries with high marginal tax rates do less well than those with lower rates. For high-income recipients, there are strong supply-side effects associated with the changes in marginal taxes. In observing its empirical effects please note that supply-side effects often take place over lengthy time periods.
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Section C. Money and the Banking System

a. The supply of money. Money is an asset that performs three basic functions: o It serves as a medium of exchange to buy and sell goods and services. Money simplifies and reduces the costs of transactions. Without money, exchange would be complicated, time-consuming and enormously costly. It permits us to realize the enormous gains from specialization, division of labor, and mass-production processes that underlie our modern standard living. o It provides a means of storing value to allow the movement of purchasing power from one period to another. Although it is not the only way of storing value, it is the most liquid of all assets due to its function as the medium of exchange. However, many methods of holding money do not yield an interest return and the purchase power of money will decline during a time of inflation. o It is used as an accounting unit to compare the value and cost of things.. As the unit of measurement, money is used by people to post prices and keep track of revenues and costs. In the past, most societies have used scarce resources (e.g., gold, silver) for money. The value of this sort of money is based on the value of the underlying commodity. In modern societies, money has neither intrinsic value nor is it backed by a commodity with intrinsic value. This kind of money is called fiat money. For example, dollar bills are just pieces of paper, and checking account deposits are just some numbers. Fiat money is valuable because: o Government designate fiat money as legal tender, meaning that it is acceptable for payment of debts; and o Accordingly, the public is willing to accept fiat money because they know it can be used to purchase goods and services. The main thing that makes money valuable is the same thing that generates value for other commodities: demand relative to supply. The value of a unit of money is inversely related to the level of prices. Money increases in value when demand for it rises (as with any other good, greater demand increases the "price" of the good) and/or its supply falls (with less money available in the market, the purchasing power of a monetary unit, like the dollar, increases). The supply of money must be controlled in order to keep the purchase power of money stable over time. Two most widely used measures of money supply are:
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The M1 Money Supply: cash, checking accounts and traveler's checks. This is the narrowest definition of the money supply. This definition focuses on the money's function as a medium of exchange. It comprises: o currency in circulation including coins; o checkable deposits maintained in depository institutions; o traveler's checks. During the 1970s, M1 was almost entirely composed of currency and demand deposits, neither of which earned interest. In essence, M1 was primarily medium-exchange money. Since the 1980s, interest-earning checkable deposits have grown to about one-third of M1. Therefore, today M1 has a much larger savings component. Changes in the nature of M1 reduced its comparability with earlier data. As a result, economists and analysts now pay more attention to M2 when comparing money supply data across time periods. The M2 Money Supply: M1 + savings + small time deposits + retail money funds. This definition focuses on the money's function as a medium of exchange and store of value. This broader definition includes all the items in M1 money supply, plus savings deposits, and o time deposits (accounts for less than $100,000) held in depository institutions o money market deposit accounts (MMDAs) held at all depository institutions o money market mutual funds shares. Although these three additional items are not generally used as a means of making payment, they can be easily and quickly converted to currency or checking deposits for such use. The M3 Money Supply: M2 + large time deposit accounts + institutional money funds + longer term repurchase agreements + Eurodollar accounts. Be noted that credit cards are not purchasing power but a convenient means of arranging a loan. Credit is a liability acquired when one borrows funds, while money is a financial asset that provides the holder with future purchasing power. However, the widespread use of credit cards will tend to reduce the average quantity of money people hold.
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b. Fractional reserve banking. In the US, the Federal Reserve System (also known as "the Fed") consists of 12 Federal Reserve District banks, which are spread throughout the U.S. and are controlled by the Fed's Board of Governors. The Fed acts as the nation's central bank and has the responsibility for carrying out monetary, banking, and regulatory policies. The banking system in the US consists of three types of depository institutions. Under legislation passed in 1980, all of these depository institutions can offer both checking and savings accounts and extend a wide range of loans to customers. o Commercial banks: financial institutions that are owned by shareholders and seek to operate at a profit. o Savings and loan associations: financial institutions that accept deposits in exchange for shares that pay dividends. o Credit unions: cooperative financial organizations of individuals with a common affiliation such as an employer. Funds of credit unions are primarily channeled into loans to members. Banking differs from most businesses in that a large portion of its liabilities are payable on demand. However, it is highly unlikely that all depositors will withdraw the money in their accounts on the same day. Thus, banks usually maintain a fraction of their assets in reserves to meet the withdrawal requirements of depositors. Under the fractional reserve banking system, a bank is obligated to hold a minimum amount of reserves (either in the form of vault cash or in a special account with the Fed) to back up its deposits. Reserves held for that purpose, and which are expressed as a percentage of a bank's demand deposits, are called required reserves. Therefore, the required reserve ratio is the percentage of a bank's deposits that are required to be held as reserves. Reserves held in excess of required reserves are called excess reserves.
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o Since reserves draw no interest, banks will try to load their excess reserves out as long as they can find credit-worthy borrowers. o The Fed sets the requirements on required reserves by determining the required reserve ration. o Banks need to maintain certain level of excess reserves partly because their deposits fluctuate and so do their required reserves. By issuing loans bankers expand the money supply. However, the amount of cash and other required reserves limits the ability of bankers to expand the money supply. In this system, the central bank acts as a lender of last resort. Required reserve ratio is a percentage of a specified liability category (for example, transaction accounts) that banking institutions are required to hold as reserves against that type of liability. Suppose the required reserve ration in the US is 20%, and then suppose that you deposit $1000 cash with Citibank. Citibank keeps $200 of the $1000 in reserves. The remaining $800 of excess reserves can be loaned out to, say, John. After the loan is made, the money supply increases by $800 (your $1000 + John's $800). After getting the loan John deposits the $800 in Bank of America (BOA). BOA keeps $160 of the $800 in reserves, and can now loan out $640 to another person. Thus, BOA creates $640 of money supply... The process goes on and on. With each deposit and loan, more money is created. However, the money creation process does not create an infinite amount of money. Potential deposit expansion multiplier is the maximum potential increase in the
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money supply as a ratio of the new reserves injected into the banking system. It is equal to the inverse of the required reserve ratio: Potential Deposit Expansion Multiplier = 1 / Required Reserve Ratio The maximum potential increase in the money supply as a result of new cash deposit is computed as below: Maximum Potential Increase in Money Supply = New Cash Deposits x Potential Deposit Expansion Multiplier = New Cash Deposits / Required Reserve Ratio For the above example, the potential deposit expansion multiplier is 5, and the maximum potential increase in money supply will be $5000. The lower the required reserve ratio, the greater the potential deposit expansion multiplier and the greater the increase in the money supply from a given deposit. Actual deposit expansion multiplier is generally less than the potential for two reasons: o Currency leakages: Some persons hold currency as cash rather than depositing it in a bank. The cash remains in circulation outside the banks, and will never contribute to the excess reserves necessary for money creation in a fractional reserve banking system. o Idle excess bank reserves: Banks fail to use all the new excess reserves to extend loans.
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c. How the Fed controls the money supply. Generally, the central bank of a country controls the money supply and conducts monetary policy. The Fed is the central bank of the US, and is responsible for conducting monetary policy to promote both full employment and price stability. Unlike commercial banks, the Fed is not a profit-making organization. It operates with substantial independence from both Congress and the executive branch of government. The independence of the Fed helps to reduce the influence of political pressures that will adversely affect the Fed's ability to follow a stable, non-inflationary monetary policy. Structure of the Federal Reserve: There are three major decision-making centers within the Fed: o The Board of Governors, which is the ruling body of the Federal Reserve System consisting of seven (7) Governors. It sets the rules and regulations applicable to all depositary institutions, such as reserve requirements, composition of asset holdings. o The District Federal Reserve Banks, of which there are 12 district banks and 25 regional branches. They provide banking services for commercial depositary institutions and the federal government. o The Federal Open Market Operations Committee (FOMC), which is the monetary policymaking arm of the Fed consisting of 12 voting members (the 7 Governors plus 5 presidents of district Federal Reserve Banks). It establishes Fed policy on the purchase and sale of government securities, the most frequently used method of controlling the money supplu in the US. When following an expansionary monetary policy, the Fed increases the growth rate of the money supply. Conversely, when following a restrictive monetary policy, the Fed reduces the growth rate of the money supply. The Fed has three major means of controlling the money stock. o Reserve Requirements: The reserves of banking institutions are composed of (1) currency held by the bank (vault cash) and (2) deposits of the bank with the Federal Reserve System. The Fed sets the rules. Since banking institutions will want to hold interest-earning assets rather than excess reserves, an increase in the reserve requirements will reduce the supply of money, and vice versa. However, the Fed has seldom used its regulatory power over reserve requirements to alter the supply of money due to its disruptive impact on banking operations - small changes in
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reserve requirements can sometime lead to large changes in the money supply. o Open Market Operations: Since it can be undertaken easily and quietly, this is the most common tool used by Fed to alter the money supply. To increase the money supply, the Fed buys Treasury securities (either on a temporary or permanent basis) from securities dealers. Dealer firms that sold the securities to the Fed now hold a check that they deposit with commercial banks. This increases the money supply. The Fed's purchase and sale of US securities influence the size of monetary base, which is the sum of currency in circulation plus bank reserves (vault cash and reserves with the Fed). It reflects the stock of US securities held by the Fed, and provides the foundation for the money supply of the United States.
o Discount Rate - The cost of borrowing money from the Fed. Borrowing money from the Fed is a privilege, not a right. The Fed charges interest (discount rate) on the loan. An increase in the discount rate is restrictive in money supply: it tends to discourage banks from shaving their excess reserves to a low level. On the other hand, a lower level of short-term interest rates (discount/federal funds rates) increases the ability of banks to extend loans and thus create additional money. Borrowing from the Fed amounts to less than one-tenth of 1 percent of the available loanable funds of commercial banks. A bank can go to federal funds market to borrow to meet its reserve requirements. The market is where banks with excess reserves extend short-term loans to those banks seeking additional reserves. The interest rate in this market is called the federal funds rate. The federal funds rate and the discount rate tend to move together (typically, the discount rate is below, or equal to, the federal funds rate). In reality, the Fed does not rely on an active use of the discount rate for purposes of carrying out monetary policy. As mentioned previously, the Fed uses open-market operations to achieve its objective of manipulating the level of reserves in the banking system and, consequently, the federal funds rate. The latter is the Fed's sole objective in regards to changes in monetary policy. The discount rate is essentially adjusted after a change in monetary policy has already been reflected in the Fed's open-market operations and a new federal funds target has been established (so that the federal funds rate and the discount rate do not diverge much). The Fed vs U.S. Treasury: The US Treasury:
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o is a budgetary agency, and is concerned with the finances of the federal government (fiscal policy). o issues bonds to the general public to finance the budget deficits of the federal government. o does not determine short-term interest rates or money and bank reserve growth. The Fed: o is a monetary agency. It is concerned with monetary policy and has the responsibility to control inflation. o does not issue bonds. o determines the level of the federal funds rate (and influences overall short-term rates and reserve/money growth) primarily through the purchase and sale of U.S. Treasury securities.
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d. Ambiguities in the meaning and measurement of the money supply. Many structural changes and financial innovations are altering the nature of money, and therefore the usefulness of money growth figures (both M1 and M2) as an indicator of monetary policy. o Widespread use of the US dollar outside of the United States. People in many countries, especially those with hyperinflation and/or political instability, prefer to hold the US dollar in order to store the value of future purchase power. As a result, as much as two thirds of US currency is held overseas. This substantially reduces the reliability of the M1 money supply. It impact much more on M1 than M2 figure because the currency component is a much smaller proportion of M2 than M1. o The increasing availability of low-fee stock and bond mutual funds. Since stock and bond mutual fund investments are not counted in any of the monetary aggregates, movements of funds from various M2 components will distort M2 money supply figures. o Debit card and electronic money. As debit cards and electronic money are widely used, less money will be held in the form of currency and more as bank deposits. As a result, the money supply will grow rapidly making M1 figures less reliable.
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Section D. Modern Macroeconomics: Monetary Policy

a. Demand and supply of money. At any given interest rate, the amount of wealth that households and businesses desire to hold in the form of money balances (either as cash or any other highly liquid form of value such as checking accounts) is called the demand for money. Transactions and asset demand determine demand for money. People hold (demand) money: o to conduct transactions o to deal with emergencies (precautionary motive) o to store purchasing power The opportunity cost of holding money as cash is the nominal interest rate. Interest rate determines the quantity of money demanded. It reflects the price, or to be accurate, the opportunity cost of holding money. There is an inverse relationship between the quantity of money demanded and the interest rate.
Determinants of the demand for money: o As nominal GDP increases as the result of either higher prices or the growth of real output, the demand for money balances will also increase - that is, the entire demand for money schedule will shift to right. o Changes in institutional factors (such as the widespread use of credit cards, readily availability of short-term loans) will also influence the demand schedule
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for money. The money supply schedule is vertical since domestic supply of money is determined by central bank and reserve requirements. The supply of money is not affected by changes in the interest rate. The Fed determines the money supply through its reserve requirements, open market operations, and discount-rate policy. For example, if the Fed follows an expansionary monetary policy, the supply for money will increase, shifting the supply curve for money to the right. Once the supply of money is set, the nominal interest rate will move toward a level that equates the quantity of money demanded with the money supply.
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b. Unanticipated monetary policy. The effects of monetary policy are much different when the impact of monetary policy is anticipated. When the policy is anticipated, decision makers factor in what normally would occur if monetary policy were unanticipated. The prime consideration is the impact that monetary policy has on prices. Expansionary monetary policy leads to higher prices, i.e. inflation. When decision makers anticipate the inflation that occurs when the money supply increases, their actions will offset the usual impact of expansionary monetary policy. o The expectation of inflation causes lenders to reduce their willingness to supply funds to the loanable-funds market. The reduction in the supply of loanable-funds pushes interest rates up and offsets the falling interest rates caused by expansionary monetary policy. o Moreover, the higher nominal interest rates tend to lessen the increase in aggregate demand that results from expansionary monetary policy. Simultaneously, the anticipation of inflation leads sellers to reduce their willingness to supply goods and services, and aggregate supply falls. The fall in aggregate supply offsets the rising output and rising employment caused by the increase in aggregate demand when there are unanticipated increases in the money supply. The anticipation of higher prices leads to a lower impact of expansionary monetary policy. The process works similarly for restrictive monetary policy. The lower prices caused by restrictive monetary policy can be anticipated and included in the decision-making of individuals. Anticipation of the effects of restrictive monetary policy makes the policy less effective than would otherwise be the case. The anticipation of lower prices leads to an increase in aggregate supply that will lead to rising employment and output. This offsets the falling output and rising unemployment that would accompany the decrease in aggregate demand brought about by restrictive monetary policy. Additionally, the lower prices to lower nominal interest rates, and the lower interest rates induce an offsetting increase in aggregate demand. Together, these two reactions make monetary policy less effective when the effects of the policy are anticipated.
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c. The quantity theory of money. Equation of exchange: Money Supply (M) x Velocity of Money (V) = Price (P) x Real Output (Y) o The velocity of money is the average number of times a dollar is used to purchase final goods and services during a year). It is computed as V = GDP/Money Supply = PY/M. In essence, it is the turnover rate of money. For example, if the nominal GDP is $200 billion and the money supply is $40 billion: V = 200/40 = 5. o The equation of exchange reflects two ways of viewing GDP: the left side reflects the monetary flow of expenditures on final products, and the right side reflects the sum of the price (P) times the output (Y) of each final product purchased during the period. Classical economists believed that the real output and the velocity were almost constant. o The real output Y was determined by factors other than the amount of money in circulation, but by such factors as technology, the size of the economy's resource base, and the skill of the labor force. o The velocity of money was thought to be determined by institutional factors such as the frequency of income payments, the organization of banking and credit, etc. These factors were thought to be insensitive to changes in the money supply. Thus, if both Y and V are constant, then the equation indicates that an increase in money supply will lead to a proportional increase in price level. This equation of exchange leads to the "quantity theory of money", which hypothesizes that a change in the money supply will cause a proportional change in the price level because velocity and real output are unaffected by the quantity of money. When considering the behavior of prices, output, money and velocity over time, we can write the quantity theory equation in terms of growth rates: Rate of inflation + Growth rate of real output = Growth rate of the money supply + Growth rate of velocity.
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d. Short-run and long-run effects of monetary policy. Discretionary monetary policy is monetary policy that is instituted at the discretion of policy makers, and is not predetermined by rules or formulas. Short-Run Effects of Unexpected Expansionary Monetary Policy on Interest Rates, Price Level and Real Output
In the short run as aggregate demand increases, the output will expand and the unemployment rate will fall. o Both the Fed's bond purchases and the banks' use of the additional reserves to extend new loans will increase the supply of loanable funds, and place downward pressure on the real rate of interest. o Inflation rate will increase by a small amount if excess capacity is present, but will increase by large amount if the economy is at full employment stage. o When the Fed shifts to a more expansionary monetary policy, it will increase money supply primarily by buying bonds in the open market. The money supply will shift to the right from Qs to Qb, causing the nominal interest rate to fall from i1 to i2 (depending on offsetting inflation rate and real interest rate). o As the real interest rate falls from r1 to r2, aggregate demand increases. Because the monetary expansion is unexpected, the increase in aggregate demand will lead
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to higher output (from Y1 to Y2) and higher prices (from P1 to P2) in the short run. o Real output will increase if excess capacity is present, but will remain unchanged (or increase by a small amount) if the economy is at full employment stage. There are three factors that contribute to the increase in aggregate demand in the above example: o The lower real interest rate will make current investment and consumption cheaper relative to future spending. o The lower real interest rate will lead to an outflow of capital, which will cause the dollar to depreciate and thereby stimulate the net export component of aggregate demand. o The lower interest rates will tend to increase asset prices (the prices of stocks, houses and other structures) which will also stimulate current demand. Effects of Unexpected Expansionary Monetary Policy on Output and Price
o If output is initially below full employment, the economy will expand along the short-run aggregate supply curve until the real output reaches full employment capacity (YF). The increase in output in long-term in nature. In essence, the expansionary monetary policy provides an alternative to the economy's self-corrective mechanism. The side effect is inflation, since the price level will rise from P1 to P2. o However, if the demand stimulus effects are imposed on an economy already at full employment, they will lead to excess demand and higher product prices without increasing the real output. o In the short run, the economy will temporarily expand along the aggregate supply curve SRAS1 to Y2, beyond the economy's full employment capacity (YF). At this point the unemployment will fall below
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the natural rate of unemployment, the general price level will increase from P1 to P2. Remember that in the short run, the prices of many resources (e.g. fixed-rate loans, wages) are fixed. o However, the short-run equilibrium (E2) is unstable. In the long run, resource prices will rise, shifting the short-run aggregate supply curve to the left from SRAS1 to SRAS2. Accordingly, the economy will move along AD2 until output move back to the full employment capacity (YF). As full employment is restored, the economy reaches a new long-run equilibrium (E3 with an even higher price level (P3). Conclusion: the real and long-term effects of an unexpected expansionary monetary policy depend on if the economy is already operating at full capacity. Long-Run Effect of Unexpected Expansionary Monetary Policy on Interest Rates
o Initially, the expected inflation rate is 0%, and the real interest rate is 4%. o Suppose the more rapid money expansion leads to a long-term inflation rate of 5%. o Overtime, lenders and borrowers will build the higher inflation rate into their decisions. Lenders will require a 9% interest rate on loans, while buyers will be willing to pay 9% interest on loans. o As a result, both, both the supply and demand of loanable funds will shift upward by the 5% inflation rate. o Consequently, the nominal interest rate will rise to 9%, while the real interest rate remains tat 4%. The difference between the two is the expected inflation rate. Conclusion: in the short-run, both nominal and real interest rates decline. In the long run, nominal interest rate increases while real interest rate remains unchanged.
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Effects of Unexpected Restrictive Monetary Policy on Interest Rates, Price Level and Real Output An unanticipated restrictive monetary policy will just do the opposite. Restrictive monetary policy will reduce aggregate demand. In the short run, nominal interest rate will increase due to the reduction in money supply, real output will decline, the price level will decline, and real interest rate will increase. The appropriateness of such a policy depends on the initial state of the economy. o If the output is initially below full employment capacity, such a policy will throw the economy into a recession. Real GDP will decline, output will fall, and unemployment will rise above the natural rate of unemployment. o If an economy is experiencing upward pressure on prices as the result of strong demand, such a policy is an effective weapon against inflation. If the proper dosage is timed correctly, restrictive policy will direct the economy to a non-inflationary, long-run equilibrium. In summary, the major consequence of rapid money growth is inflation. It will neither reduce unemployment nor stimulate real output in the long run. Money growth and inflation are closely linked in the long run. Monetary policy (as with fiscal policy) must be properly timed if it is to help stabilize an economy. However, proper timing is not easy since there may be a substantial time lag before the change in policy will exert a significant impact on aggregate demand. o Recognition lag: There is a time lag of several months between the change in economic conditions and when the Fed recognizes that change. o Impact lag: There is an additional time lag between the institution of a policy and when it begins to exert a significant impact on the economy. For example, the primary impact of a change in monetary policy on the price level and inflation may be as many as 36 months after the change is instituted. o Such lengthy time lags undermine the effectiveness of monetary policy as a stabilization tool. These lags lead most economists to believe that monetary policy-makers should respond only to major economic disturbances, rather than attempting to smooth out every ripple.
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Section E. Stabilization Policy, Output, and Employment

a. Index of leading economic indicators. Stabilization policy is effective only if it injects stimulus and applies restraint at the proper phase of the business cycle. Since it takes time for macroeconomic policy to work, policy makers really need to know about the future -- where the economy is going to be 6 to 12 months from now. The Index of Leading Indicators has been devised to accomplish this. It is published by the Conference Board in Business Cycle Indicators. The index generally turns down prior to a recession and turn up before the beginning of a business expansion. It consists of: 1. Length of the average workweek in hours 2. Initial weekly claims for unemployment compensation 3. New orders placed with manufacturers 4. Percentage of companies receiving slower deliveries from suppliers 5. Contracts and orders for new plants and equipment 6. Permits for new housing starts 7. Interest rate spread, 10-year Treasury bonds less fed funds rate 8. Index of consumer expectations 9. Change in the index of stock prices (500 common stocks) 10. Change in the money supply (M2) No single indicator is able to forecast accurately the future direction of the economy. These variables have tendency to lead (predict) turns in the business cycle and they are frequently and promptly. However, there are two problems with the index and therefore policymakers must respond to the changes in the index carefully. o There has been significant variability in the lead time of the index. For example, a downturn in the index is not always an accurate indicator of the future. o The index has often given false alarms. For example, a recession forecasted by a decline in the index does not materialize. Market Signals as Indicators of Economic Expectations Certain markets (i.e. commodity market, foreign exchange market) can provide information on economic expectations, which can be used to predict future economic activities. Therefore, commodity prices, exchange rates and other market signals can provide policymakers with an early warning of the need to institute a policy change. However, market signals should be used as a supplement to, not as a substitute for, the index of leading indicators and economic forecasting models.
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b. Lags and the problem of proper timing. Activists believe that policy makers must correctly forecast the future direction of the economy and act before there is a contraction in real GDP or an observable increase in the rate of inflation. Discretionary changes in both monetary and fiscal policy must be timed appropriately if they are going to exert a stabilizing influence on the economy. There are three time lags that make proper timing difficult: o recognition lag: the time period between a change in economic conditions and recognition of the change by policy makers. It takes a few months to gather, tabulate and analyze reliable information of recent economy to determine if a policy change is necessary. o administrative lag: the time period between the recognition of policy change and before the policy change is instituted. This lag is short for monetary policy implementation because the Federal Open Market Committee can institute a policy change very quickly, but long for fiscal policy implementation because legislative procedures are required to approve a fiscal policy change. o impact lag: the time period between the implementation of a macro policy change and when the change exerts its primary impact on the economy. This lag in the case of monetary policy is likely to be even longer than that of fiscal policy. For example, it takes significant amount of time between a shift in monetary policy and a change in the level of spending, while the impact lag of a fiscal policy to change tax rates is very short. Studies show that the combined duration of these time lags is about 12 to 18 months for monetary policy, and even longer for fiscal policy. Due to the lengthy and variable time lags and our limited ability to forecast turns in the economy, it is highly unlikely that the primary impact of a policy change would come at the proper time. Therefore, non-activists argue that proper timing of discretionary policy changes is unrealistic, and such a discretionary policy is likely to be destabilizing in nature.
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c. Economic expectations and their role in determining the effectiveness of fiscal and monetary policy. An economic policy change may exert a very different impact, depending on whether, and how quickly, it is widely expected or catches people by surprise. If decision-makers do not anticipate the strong demand and inflation that eventually accompanies expansionary policies, the demand stimulus of these policies will temporarily increase output and reduce unemployment.
If the policy change is anticipated but decision makers adjust to a policy change slowly, both output and employment will increase in the short run, and so will the price level. Eventually, buyers and sellers in the resource market will adapt to the higher general price level. Wages and prices of other resources will be increased. Hence, the short-run aggregate supply will fall to AS short run 2. Output will return back to full-employment capacity, unemployment will fall to its natural rate, and price level will rise further to P3. This is the case of adaptive expectations.
If decision-makers anticipate expansionary policies, the demand stimulus of expansionary policies is recognized as inflationary. Agreements for future wages and resource prices are specified through escalator clauses to account for rising prices in
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the future. As a result, resource prices will rise quickly, reducing short-run aggregate supply to AS short run 2. The primary impact of an anticipated demand stimulus is inflation and no change in real output, both in the short run and long run. This is the case of rational expectations.
In other words, anticipated changes reduce the effectiveness of fiscal and monetary policy. This is known as the policy-ineffectiveness theorem.
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d. Adaptive and rational expectations. Adaptive-Expectations Hypothesis: people always react to changes, they do not anticipate changes. Individuals are relatively uninformed so they use the most accessible information (their own experience). They cannot possess the large amount of information necessary to analyze the complex issue of prices. Therefore, decision makers believe that the best indicator of the future is what has happened in the recent past. The next period is expected to be pretty much (not exactly like) the recent past. For example, if the inflation rate in the current year is 3%, decision makers will expect the inflation in the next year to be 3%. If the actual inflation rate in the 2nd year is 4%, decision makers will expect the inflation in the 3rd year to be 4%. o Due to the time lag between a policy and its effects and people to incorporate the effects in their decision making process, the adjusting process may be slow. o People may make systematic forecasting errors under this hypothesis, and an error may be made over and over again in a regular manner. For example, people will always underestimate inflation rates when inflation is rising continuously. Rational-Expectations Hypothesis: all evidence is considered by decision makers when formulating expectations concerning future economic events, such as the probable future inflation rate. Decision makers are not naive and will not consider only past prices in forming their expectations about future prices. Information is widely available to the public. Thus decision makers form their expectations about the future based on all available information, including knowledge about policy changes and how they affect economy. For example, the inflation rate during each of the past three years was 5%. Suppose that the central bank announces a higher growth rate of money supply. Adaptive decision makers would continue to expect the future inflation rate to be 5% for the next year, but rational decision makers will analyze the effects of the monetary acceleration, and expect a higher inflation rate (say, 6%) next year. o Since people will make decision once they observe a policy change, the adjusting process is much quicker. o Forecast is not always correct, but the errors tend to be random and unsystematic. That is, rational decision makers will make forecast errors, but they will learn from past experience and avoid making the same error over and over again. These two hypotheses differ in two major respects: o How quickly people adjust to a change. o The likelihood of systematic forecasting errors.
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The short-run effects of policy changes are different under these two hypotheses: o Adaptive expectations hypothesis states there is a time lag before people anticipate the eventual effects of a policy change. Therefore, policies that stimulate demand and place upward pressure on the general level of prices will temporarily increase output and employment. o Rational expectations hypothesis states the impact of a shift in fiscal and /or monetary policy on output is unpredictable. Systematic errors will not occur. People will be as likely to overestimate the inflationary side effects as to underestimate them when there is a shift to a more expansionary macro policy. Despite this difference on short run effects of policy changes, their long-run implications are identical. People will eventually anticipate the long-run effects of more expansionary policy, and inflation, not real output, will be the end result.
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e. Non-activist monetary policy. All economists agree that the market economy performs the best when all of the follow goals are met: o Minimal economic fluctuations. o Stable prices. o Unemployment at the natural rate. What they disagree is how to achieve these goals. The consensus views of both activists and nonactivists are: o Monetary policy should focus on price stability - the attainment of persistently low rates of inflation. o Demand stimulus policies cannot reduce the rate of unemployment below the natural level - at least not for long. o Wide swings in both monetary and fiscal policy should be avoided as they are destructive to economic development. o Use of discretionary fiscal policy as an effective stabilization tool is impractical due to the almost impossible proper timing. Activists believe that: o The economy's self-corrective mechanism works slowly. o The index of leading indicators, economic forecasting models, and sensitive market signals can provide an early warning system. o Discretionary monetary and fiscal policy can be used to inject demand stimulus during a recession and apply restraint during an inflationary boom, thereby speeding the adjustment process. Non-activists believe that: o The economy's self-corrective mechanism works quite well. o Discretionary policy destabilizes, rather than stabilizes, the economy. o The same monetary and fiscal policy should be maintained during all phases of the business cycle, and the public should be informed of this choice. In short, nonactivists prefer stable, predictable policies. For a non-activist: o Monetary policy: o Money supply growth rate: the money supply should grow continuously at an annual rate that approximates the long-run real growth rate of the economy. o Price level: the monetary policy should directly target a broad price index to maintain a constant price level. Examples of the price index include the CPI and the GDP deflator. Advocates argue that in the long-run, monetary policy cannot determine real output, employment, interest rates, or other
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real variables. What it can and does determine is the level of prices. o Fiscal policy: o Fiscal policy following the rule of annual balanced budget would lead to fluctuating tax rates and/or expenditures over the business cycle, and result in greater instability. o Under the rule of balanced budget over the business cycle, the same tax rates and expenditure policies would remain in effect during both booms and recessions. As a result, the government will run deficits during recessions, and surpluses during expansions. This allows countercyclical policies to be used in the short run. Over the business cycle, the federal budget is balanced. This minimizes the long-run destabilizing forces of fiscal policy. o However, it is difficult to assess if the current tax and expenditure policy will balance the budget over the cycle. Developing a workable program for implementation is difficult, if not impossible.
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F. The Phillips Curve: Is There a Trade-off between Inflation and Unemployment?

a. The Phillips curve. The Phillips Curve is a curve that illustrates the relationship between the rate of change in prices (or money wages) and the rate of unemployment. It provides another way of looking at the relationship between prices and unemployment. If the increase in inflation rate is unanticipated, the unemployment rate will fall due to: o Real wage rate of employees' and employers' wage will drop (long-term contract effect). o The underestimate of inflation rate will tend to reduce the search time of job seekers since they will quickly accept job offers on the basis of a mistaken belief that the offers are pretty good ones in relation to the market for their labor services. Both of these factors will expand employment and reduce the unemployment rate below its natural rate.
Beginning in early 1960s several economists argued that there was a trade-off between inflation and unemployment - a lower rate of unemployment could be achieved if we were willing to tolerate a little more inflation. However, they failed to integrate expectations into their analysis. The Phillips Curve in the Context of Adaptive Expectations
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When stable prices are observed and anticipated, both full-employment output and the natural rate of unemployment will be present (A in both panels). o Suppose that the government shifts to a more expansionary policy. This will increase prices, expand output beyond its full-employment potential, and reduce the unemployment rate below its natural level (move from A to B in both panels). o Eventually, decision makers will fully anticipate the higher inflation rate. When this happens, the short-run aggregate supply will shift to the left, output will fall back to its full employment capacity, and unemployment will return to the natural rate (move from B to C in both panels). o As the inflation policy continues and decision makers anticipate it, both the AD and SRAS curves will continually shift upward (dotted AD and SRAS curves in the left panel) without leading to an increase in output and employment. o Inflation fails to expand output and reduce unemployment rate when it is anticipated. Thus, the long-run Phillips curve is vertical at the natural rate of unemployment. Conclusions: o There is a short-run trade-off between inflation and unemployment. Decision makers tend to underestimate the future inflation rate when expansionary policy is applied, and overestimate it when restrictive policy is applied. As a result, expansionary policy will temporarily reduce the unemployment rate, and restrictive policy will temporarily increase the unemployment rate. o There is no long-run trade-off between inflation and unemployment. As decision makers fully anticipate the inflation rate, unemployment will return to its natural rate.
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The Phillips Curve in the Context of Rational Expectations
When stable prices are observed and anticipated, both full-employment output and the natural rate of unemployment will be present (A in both panels). o Suppose that the government shifts to a more expansionary policy. This will soon lead to a higher rate of inflation. o As soon as the policy change is announced, decision makers in the resource market will fully anticipate and quickly adjust to the higher prices. This will result in an immediately reduction in aggregate supply. Therefore, by the time the demand stimulus arrives, it will have already been offset by higher money wages, costs and product prices. o In the left panel, the output moves directly from A to C, the real GDP remains at the full-employment capacity, unemployment remains at its natural rate, and the price level steadily increases, reflecting the higher inflation rate. o In the right panel, the short-run Phillips Curve will immediately shift to the right. Even though inflation increases, unemployment remains at its natural rate. o However, the rational expectations hypothesis does not assume that forecasts will always be correct. If decision makers underestimate (overestimate) the future inflation rate, the short-run Phillips curve will shift to the right by a lesser (larger) amount, and unemployment will fall below (rise above) its natural rate. Conclusions: o With rational expectations, the trade-off between unemployment and inflation is unpredictable. If decision makers accurately forecast the inflation effect of expansionary policy, there is no trade-off in the short run or long run. If they underestimate (overestimate) the future inflation rate, unemployment will
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temporarily decline (increase). Therefore, it is difficult to use expansionary policy to reduce the unemployment rate. o The best policies are pre-announced, stable ones that are directed toward long-run objectives. To be effective, an anti-inflation policy must be credible. Three major points follow from the integration of expectations into the Phillips curve analysis: o Demand stimulus will lead to inflation without permanently reducing unemployment below the natural rate. There is no long-run trade-off between inflation and unemployment. o When inflation is greater than anticipated, unemployment falls below the natural rate. Conversely, when inflation is less than anticipated, unemployment will rise above the natural rate. In contrast, the early views about the Phillips curve believe that it is the size of the inflation rate that influences the unemployment rate. o When the inflation rate is steady (neither rising nor falling), the actual rate of unemployment will equal the economy's natural rate of unemployment. Empirical evidence supports the modern view of the Phillips curve, not the early view.
ANALYSTNOTES.COM
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Study Session 4 Macroeconomics

Study Session 4 Macroeconomics

Section A. Taking the Nation's Economic Pulse

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B. Working with Our Basic Aggregate Demand/Aggregate Supply Model

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Factors that Shift Aggregate Demand:

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Section C. Keynesian Foundations of Modern Macroeconomics

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The Keynesian model within the AD/AS framework

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Section A. Economic Fluctuations, Unemployment, and Inflation

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Section B. Fiscal Policy

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Section C. Money and the Banking System

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