CFA Level 1 - Macroeconomics

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4.1 - Introduction
Macroeconomics
Macroeconomics is the branch of economics that studies the overall workings of an economy, such as total
income and output; aspects of the economy are viewed in aggregate. For instance, when referring to labor in
macroeconomics, the focus is on all workers within an economy, not the choices of an individual worker.

BASICS

Introduction
The information presented within Section A: Basics, is preliminary material and will not be tested directly on
your upcoming exam. However, we recommend reviewing this material as you will need to know it in order to
understand the more advanced topics discussed later.

Gross Domestic Product (GDP) and Gross National Product (GNP)

Gross Domestic Product (GDP) and Gross National Product (GNP) are the two most common measures of a
nation's economic output.

Gross domestic product is defined as the value of all goods and services produced within a nation during a
particular period of time (typically a year). Market prices are used to determine value and only "final" goods
and services (those consumed by the end user) are included.

Gross National Productmeasures the income of all of a nation's citizens, even if that income was earned
abroad. Amounts that foreigners earn within the nation's boundaries are not included.

4.2 - Gross Domestic Product (GDP)

Two different approaches are used to calculate GDP. In theory, the amount spent for goods and services should
be equal to the income paid to produce the goods and services, and other costs associated with those goods and
services. Calculating GDP by adding up expenditures is called the expenditure approach, and computing GDP
by examining income for resources (sometimes referred to as gross domestic income, or GDI, is known as the
resource cost/income approach.

Expenditure Approach
The expenditure approach utilizes four main components:

Consumption (C) – These are personal consumption expenditures. They are typically broken down into the
following categories: durable goods, non-durable goods, and services.

Investment (I) - This is gross private investment; it is generally broken down into fixed investment and
changes in business inventories.

Government (G) – This category includes government spending on items that are "consumed" in the current
period, such as office supplies and gasoline; and also capital goods, such as highways, missiles, and dams. Note
that transfer payments are not included in GDP, as they are not part of current production.

Net Exports - This is calculated by subtracting a nations imports (M)from exports (X). Imports are goods and
services produced outside the country and consumed within, and exports are goods and services produced
domestically and sold to foreigners. Note that this number may be negative, which has occurred in the U.S. for
the last several years. Net exports for the U.S. were minus $606 billion during calendar year 2004 (as per
Bureau of Economic Analysis, U.S. Department of Commerce June 29, 2005 press release).

Formula 4.1

GDP = C + I + G + (X – M)

Resource Cost/Income Approach

To calculate Gross Domestic Income (GDI), first consider how revenues received for products and services are
used:

1. Pay for the labor used (wages + income of self-employed proprietors)

2. Pay for the use of fixed resources, such as land and buildings (rent);

3. Pay a return to capital employed (interest);

4.Pay for the replenishment of raw material used.

Remaining revenues go to business owners as a residual cash flow, which is used to replenish capital
(depreciation), or it becomes a business profit. So with the resource cost/income approach, GDP (or GDI) is
calculated as wages, rent, interest and cash flow paid to business owners or organizers of production.

So GDP by resource cost/income approach = wages + self-employment income + Rent + Interest + profits +
indirect business taxes + depreciation + net income of foreigners.

Formula 4.2
GDI = wages + self-employment income + Rent + Interest + profits
+ indirect business taxes + depreciation + net income of foreigners

The above formula is probably hard to memorize, so at least try to remember this relationship
- GDI = wages + rent + interest + business cash flow

Total GDP figures should be the same by either method of calculation. But in real life, things don't always work
out this way. Official figures usually have a category called "statistical discrepancy", which is needed to balance
out the two approaches.

4.3 - Nominal vs. Real GDP, and the GDP Deflator

The main difference between nominal and real values is
that real values are adjusted for inflation, while nominal
values are not. As a result, nominal GDP will often
appear higher than real GDP.

Nominal values of GDP (or other income measures) from

different time periods can differ due to changes in
quantities of goods and services and/or changes in general
price levels. As a result, taking price levels (or inflation)
into account is necessary when determining if we are really better or worse off when making comparisons
between different time periods. Values for real GDP are adjusted for differences in prices levels, while figures
for nominal GDP are not.

The GDP Deflator

The GDP deflator is an economic metric that converts output measured at current prices into constant-dollar
GDP. This includes prices for business and government goods and services, as well as those purchased by
consumers. This calculation shows how much a change in the base year's GDP relies upon changes in the price
level.

If we wish to analyze the impact of price changes throughout an economy, then the GDP deflator is the
preferred price index. This is because it does not focus on a fixed basket of goods and services and
automatically reflects changes in consumption patterns and/or the introduction of new goods and services.

Real GDP for a given year, in relation to a "base" year, is computed by multiplying the nominal GDP for a
given year by the ratio of the GDP price deflator in the base year to the GDP price deflator for the given year.

Example:
Suppose we wish to calculate the real GDP for the year 2001 in terms of 1996 dollars. The value for (note that
these values are for illustration purposes only) 1996 price deflator is 100 and the 2001 price deflator is 115. The
2001 GDP in nominal terms is $10 trillion dollars.

Then: Real GDP year 2001 in 1996 dollars =$10 trillion × (100 / 115) = $8.6 trillion

4.4 - Limitations of GDP and Alternative Measures

There are many limitations to using GDP as a way to measure current income and production. Major ones
include:

·Changes in quality and the inclusion of new goods – higher quality and/or new products often replace older
products. Many products, such as cars and medical devices, are of higher quality and offer better features than
what was available previously. Many consumer electronics, such as cell phones and DVD players, did not exist
until recently.
·Leisure/human costs – GDP does not take into account
leisure time, nor is consideration given to how hard
people work to produce output. Also, jobs are now safer
and less physically strenuous than they were in the past.
Because GDP does not take these factors into account,
changes in real income could be understated.

·Underground economy - Barter and cash transactions

that take place outside of recorded marketplaces are
referred to as the underground economy and are not
included in GDP statistics. These activities are sometimes
legal ones that are undertaken so as to avoid taxes and
sometimes they are outright illegal acts, such as
trafficking in illegal drugs.

·Harmful Side Effects - Economic "bads", such as pollution, are not included in GDP statistics. While no
subtractions to GDP are made for their harmful effects, market transactions made in an effort to correct the bad
effects are added to GDP.

·Non-Market Production - Goods and services produced but not exchanged for money, known as "nonmarket
production", are not measured, even though they have value. For instance, if you grow your own food, the value
of that food will not be included in GDP. If you decide to watch TV instead of growing your own food and now
have to purchase it, then the value of your food will be included in GDP.

Alternative Measures of Domestic Income

Other than GDP and GNP, there are alternative measures of domestic income, such as national income, personal
income and disposable personal income.

National Income
National income is computed by subtracting indirect business taxes, the net income of foreigners, and
depreciation from GDP. It represents the income earned by a country's citizens. National income can also be
computed by summing interest, rents, employee compensation (wages and benefits), proprietors' income and
corporate profits.

·Personal income represents income available for personal use. It is computed by making various adjustments to
national income. Social insurance taxes and corporate profits are subtracted from national income, while net
interest, corporate dividends and transfer payments are added.

·Disposable personal income (or disposable income) is income available to people after taxes; i.e., it is personal
income less individual taxes.

4.5 - Components of Marginal Product and Marginal Revenue

I. Components of Marginal Product and Marginal Revenue

Marginal Product
The marginal product is the change in output that occurs when one more unit of input (such as a unit of labor) is
added.

Marginal Revenue
Marginal revenue is the increase in total revenue that occurs with the production of one more unit of output.

Value of Marginal Product

For a particular resource, the value of marginal product
(VMP) is the resource's marginal product multiplied by
the product price.

Marginal Revenue Product

The marginal revenue product of a resource is defined as
the increase in a firm's total revenue attributable to
employing one more unit of that resource. The increase in
output due to adding one more resource unit is called the
marginal product. The marginal revenue product is
calculated as the marginal product times the marginal
revenue.

The Relationship Between MRP and Demand

Due to the law of diminishing returns, we expect that both the marginal product and the marginal revenue
product for an input will decline as more of the input is deployed.

A firm seeking to maximize profit will increase employment of a variable input unit until the MRP of that input
is just equal to what it pays for the input. This rule will be followed by price takers and price searchers.
As the price of an input goes up, fewer units of that resource will generate the MRP needed to entice the firm to
employ that resource. The demand curve for a resource will be downward sloping, as shown in figure 4.1
below:

Figure 4.1: Results of Regulating Price and Output

Values for the demand curve will depend upon the price of the good being produced, the productivity of the
resource in question, and the amount of other resources used by the firm.

A profit-maximizing firm will continue to employ units of a resource as long as the MRP associated with the
unit exceeds the firm's cost. If we assume the units of each resource are perfectly divisible, then the following
conditions will apply to a firm with 3 production inputs (A, B, and C).

MRPa=Pa

MRPb =Pb

MRPc= Pc

Pa is equal to the price (or wage rate) of resource A, Pb is equal to the price (or wage rate) of resource B, and Pc
is equal to the price (or wage rate) of resource C.

Suppose resource A represents highly skilled labor and resource B represents labor with low skills. If a firm can
get 100 units of additional output by purchasing $500 worth of highly skilled labor and only 50 additional units
of output by hiring $500 worth of labor with low skills, then per unit costs will be reduced by hiring the highly-
skilled labor. Expenses can always be reduced by substituting resources with relatively high marginal product
per dollar spent for resources that have a relatively low marginal product per dollar. This substitution will
continue to occur if per unit costs are to be minimized until the following relationship is achieved:

MRPa = MRPb = MRPcinan

-------- -------- --------
Pa Pb Pc

Note that this relationship also implies that if skilled laborers are three times as productive as unskilled labor,
then firms will be willing to pay skilled laborers three times as much as unskilled labor.

4.6 - The Demand and Supply of Financial and Physical Capital

Physical vs. Financial Capital
The term physical capital applies to the stock of buildings, equipment, instruments, raw materials, semi-finished
and finished goods in inventory, and other physical objects used by a firm to produce its goods and/or services.

Financial capital includes the resources used to purchase those physical objects; those resources come from
savings. Interest represents the price of capital; the actual market interest rate will be the rate at which the
supply of capital is equal to the quantity of capital demanded.

Comparing the Future Marginal Revenue Product of Capital with Future Capital Prices
A firm needs to examine the future marginal revenue product of capital when making a decision to employ
more capital. The firm converts the value of those future income streams to a value in the present. Present value
is the current worth of a future income stream, discounted to reflect the fact that a dollar in the future is worth
less than a dollar today. The general form of the present value calculation is:

Formula 4.2

present value = future value / (1 + r)

Where: "r" represents the relevant interest rate

Note that if future value stays the same, and interest rates
decrease, future value increases. As interest rates decline,
more investments of capital become profitable to the firm,
and the quantity of capital demanded will increase.

Main Influences on the Demand & Supply of Capital

The main influences on the demand for capital are:

·the interest rate

·expectations concerning future business conditions – if
firms believe that future business conditions will be poor,
they will be less likely to make investments

The main influences on the supply of capital are:

·the interest rate

·income – as incomes increase, people generally save a larger proportion of their income
·expectations about future income – if people expect their income to decline, then they will tend to save more
now so as to even out their consumption. College students will tend not to be savers, as they usually expect their
future incomes to be significantly higher than the present.

The equilibrium interest rate will tend to fluctuate over time. Population changes, technological changes, and
expectations are some of the factors that will influence the demand and/or supply for capital.

Renewable and Non-renewable Resources

Renewable natural resources (a form of physical capital) are those resources that tend to be replenished by
nature. Examples include water or solar energy. Non-renewable natural resources are not available (for practical
purposes) once they are used. Examples include natural gas, oil, and coal.

The basic principle regarding the equilibrium for non-renewable natural resources is that the price of the
resource today should be equal to the present value of the next period's expected price for the same resource.
Essentially, the prices for a non-renewable resource are expected to increase at a rate equal to the interest rate.

Suppose an oil producer expects prices for oil to be lower in the future. A profit-maximizing oil producer would
try to sell as much oil in the present, and then invest the proceeds. If the price of oil is expected to increase at a
rate greater than the interest rate, then the oil producer should let as much oil as possible stay in the ground.

Keep in mind that prices for non-renewable resources do not exactly follow this pattern because the future is
always uncertain. Technological changes and political uncertainties are some of the many factors that make
forecasting price changes difficult.

4.7 - Economic Rent and Opportunity Cost

I. Economic Rent

Economic Differences of Small and Large Incomes

These differences are best explained by the concept of marginal revenue product, which we discussed earlier in
the chapter. Remember that marginal revenue product of a resource is defined as the increase in a firm's total
revenue attributable to employing one more unit of that resource. The increase in output due to adding one more
resource unit is called the marginal product. The relationship between additional resources and output implies
that skilled laborers are three times as productive as unskilled labor, and therefore, firms are willing to pay
skilled laborers three times as much as unskilled labor.

Keeping this in mind, workers with large incomes are

associated with a high marginal revenue product, while
those with small incomes are associated with a low
marginal revenue product. For example, a star baseball
pitcher (skilled labor) will have a high marginal revenue
product, while a dishwasher (unskilled labor) will have a
low marginal revenue product. Very few people are
qualified to pitch in Major League Baseball, while there
are many people qualified to wash dishes.

Economic Rent and Opportunity Costs

Economic rent is the difference between what an owner
of a factor of production (such as land, capital or labor) receives and the opportunity cost for that owner.

Let's suppose the factor of production is labor. In this example, the laborer receives $20/per hour for their job,
and the minimum salary they'd be willing to work for (opportunity cost) is $16/per hour. This $4/hour
difference is the laborer's economic rent. In the case of the superstar baseball pitcher, most of the salary earned
may be economic rent. Most of a wages of a dishwasher is opportunity cost, since these types of jobs pay
minimum wage.If the factor of production is a plot of land, the supply curve would be perfectly vertical, since
there is no way for the landowner to supply additional land. In this case, all money received is economic rent.

The size of economic rent received by a owner of a factor of production is determined by the elasticity of supply
for that particular good or service.

• If the elasticity of supply is neither elastic nor inelastic, the supply curve will slope upward and the
supplier's income would be split between economic rent and opportunity cost.
• If the elasticity of supply is inelastic, the supply curve would be perfectly vertical and the supplier's
entire income would be comprised of economic rent. For example, if the supply were a particular plot of
land, or a
• If the elasticity of supply is elastic, the supply curve would be perfectly horizontal, and the supplier's
entire income would be comprised of opportunity cost.
 Look Out!

Do not confuse "economic rent" with "rent". The rent paid

each month to live in an apartment, or to lease a car is not the
same. Remember that economic rent is simply a component of
the income received by a supplier of a good or service.

4.8 - Monitoring Cycles, Jobs, and Price Level

I. The Business Cycle

Phases of the Business Cycle

Economies usually have long-term secular trends, such as
a certain rate of expansion for the labor force and/or the
general population. One feature of market economies is
that economic activity sometimes rises above the long-
term trend line, while at other times it falls below.

Figure 4.2

A business peak, or boom, occurs when unemployment is low, incomes are high and businesses are operating at
full capacity. When aggregate economic conditions began to slow, the business cycle is said to be in a
contraction, or recessionary phase. Sales begin to fall, and unemployment starts to rise. The low point of the
contraction phase is called the recessionary trough. The business cycle begins the expansionary phase after the
low point is reached and business conditions began to improve. Business sales improve, and the
unemployment rate begins to decline. Another boom will follow, and the cycle will begin anew.

Conditions during the low point are referred to as a recession. Many economists define a recession as being a
decline in Gross Domestic Product over two or more quarters. Severe recessions (both in length of time and
severity of the contraction) are referred to as depressions.

4.9 - Key Labor Market Indicators

The civilian labor force is defined as those who have jobs or are seeking a job, are at least 16 years old and are
not serving in the military. A person who does not have a job, is available for work and is actively seeking work
is considered to be unemployed.
Key labor market indicators include:

• The Labor Force Participation Rate – This rate

is calculated by dividing the number of people
in the civilian labor force by the total civilian
population of those 16 years old or older.
• The Unemployment Rate - This is computed
by dividing the number of unemployed by the
number of people in the civilian labor
force. That number is multiplied by 100 and
expressed as a percentage. Part-time workers
are considered to be employed.
• The Employment/Population Ratio – This ratio
is calculated by dividing the number of job-
holding civilians who are at least 16 years old
by the total number of people in the civilian
population within the same age group. This
ratio will tend to go higher during economic
booms and lower during recessions.

There are several issues with calculating the

unemployment rate. The handling of discouraged
workers is one point of contention. This phrase
describes workers who are without a job but are not actively seeking a job because they have gotten discouraged
about their job search. Such people would not be officially counted as unemployed, although this is a point of
contention. Another area of dispute has to do with the inclusion of part-time workers as employed. Some
believe that they should not be counted as employed, especially those who would prefer to work full-time. Due
to definitional disputes with the unemployment rate, many economists prefer to use the employment/population
ratio, which uses numbers that are easily measured and are well defined.

Generally unemployment is higher during a recession. Employment usually does not pick up until after the
economy is coming out of a recession; it is usually regarded as a "lagging indicator" for the health of the
economy.

GDP, Real Wages and Aggregate Hours Worked

We cannot simply look at the number of people with jobs when examining the total quantity of labor in an
economy. Some workers only have part-time jobs, while others work more than the standard work-week.
Aggregate hours, which is the total number of hours worked by all employees, is a better measure of the
quantity of labor.

The number of aggregate hours worked should increase with GDP. Data pertaining to aggregate hours in the
United States is maintained by the U.S. Department of Labor Bureau of Labor Statistics.

Changes in real wage rates can be calculate by dividing nominal wages by the GDP deflator. Data for real
wages in the United States is also maintained by the Bureau of Labor Statistics.

4.10 - Types of Unemployment

The creation of "full employment" is a common economic policy goal. However, full employment does not
imply zero unemployment. A dynamic economy will always have some unemployment; this is not necessarily
harmful. Types of unemployment are often broken down as follows:
·Structural Unemployment – Changes occur in market economies such that demand increases for some jobs
skills while other job skills become outmoded and are no longer in demand. For example, the invention of the
automobile increased demand for automobile mechanics and decreased demand for farriers (people who shoe
horses).

·Frictional Unemployment - This type of unemployment

occurs because of workers who are voluntarily between
jobs. Some are looking for better jobs. Due to a lack of
perfect information, it takes times to search for the better
job. Others may be moving to a different geographical
location for personal reasons and time must be spent
searching for a new position.

·Cyclical Unemployment - This occurs due to downturns

in overall business activity.

As previously noted, full employment does not equate to

zero unemployment. Some unemployment is normal in a
market economy and is actually expected as part of an efficient labor market. Full employment is defined as the
level of employment that occurs when unemployment is normal, taking into account structural and frictional
factors.

The natural rate of unemployment is that amount of unemployment that occurs naturally due to imperfect
information and job shopping. It is the rate of unemployment that is expected when an economy is operating at
full capacity. At this time in the U.S., the natural rate of unemployment is considered to be about 5%.

Look Out!

The concepts of "full employment" and "natural rate of

unemployment" are used extensively in macroeconomics –
make sure you understand these concepts!

4.11 - The Consumer Price Index & Inflation

Inflation
Inflation is defined as an increase in the overall price level. Please note that inflation does not apply to the price
level of just one good, but rather to how prices are doing overall. A consumer facing inflation that occurs at the
rate of 10% per year will able to buy 10% less goods at the end of the year if his or her income stays the same.
Inflation can also be defined as a decline in the real purchasing power of the applicable currency.

Consumer Price Index (CPI)

The CPI represents prices paid by consumers (or
households). Prices for a basket of goods are compiled for a
certain base period. Price data for the same basket of goods is
then collected on a monthly basis. This data is used to compare
the prices for a particular month with the prices from a different time period.

Example:
The inflation rate is computed by subtracting the CPI of last year's prices from the CPI value for this year,
dividing that difference by last year's CPI value and then multiplying by 100.
So if the value of the price index for the current year is equal to 165, and last year's value was 150, the rate
would be calculated as:

Inflation rate = (165 – 150) X100= 10

150

CPI Sources of Bias

The CPI is not a perfect measure of inflation. Sources of bias include:

·Quality adjustments – quality of many goods (e.g., cars, computers, and televisions) goes up every
year. Although the Bureau of Labor Statistics is now making adjustments for quality improvements, some price
increases may reflect quality adjustments that are still counted entirely as inflation.

·New goods – new goods may be introduced that will be hard to compare to older substitutes.

·Substitution – if the price goes up for one good, consumers may substitute another good that provides similar
utility. A common example is beef vs. pork. If the price goes up, and the price of pork stays the same,
consumers might easily switch to pork. Although the CPI will go higher due to the price increase in beef, many
consumers may not be worse off. Also, when prices go up, consumers may effectively not pay the higher
prices by switching to discount stores. The CPI surveys do not check to see if consumers are substituting
discount or outlet stores.

4.12 - Aggregate Supply & Aggregate Demand

The Aggregate Supply Curve
The aggregate supply curve shows the relationship
between a nation's overall price level, and the quantity of
goods and services produces by that nation's suppliers.
The curve is upward sloping in the short run and vertical,
or close to vertical, in the long run.

Net investment, technology changes that yield

productivity improvements, and positive institutional
changes can increase both short-run and long-run
aggregate supply. Institutional changes, such as the
provision of public goods at low cost, increase economic
efficiency and cause aggregate supply curves to shift to
the right.

Some changes can alter short-run aggregate supply (SAS), while long-run aggregate supply (LAS) remains the
same. Examples include:

• Supply Shocks - Supply shocks are sudden surprise events that increase or decrease output on a
temporary basis. Examples include unusually bad or good weather or the impact from surprise military
actions.
• Resource Price Changes - These, too, can alter SAS. Unless the price changes reflect differences in
long-term supply, the LAS is not affected.
• Changes in Expectations for Inflation - If suppliers expect goods to sell at much higher prices in the
future, their willingness to sell in the current time period will be reduced and the SAS will shift to the
left.
The Aggregate Demand Curve
The aggregate demand curve shows, at various price levels, the quantity of goods and services produced
domestically that consumers, businesses, governments and foreigners (net exports) are willing to purchase
during the period of concern. The curve slopes downward to the right, indicating that as price levels decrease
(increase), more (less) goods and services are demanded.

Factors that can shift an aggregate demand curve include:

• Real Interest Rate Changes – Such changes will impact capital goods decisions made by individual
consumers and by businesses. Lower real interest rates will lower the costs of major products such as
cars, large appliances and houses; they will increase business capital project spending because long-term
costs of investment projects are reduced. The aggregate demand curve will shift down and to the
right. Higher real interest rates will make capital goods relatively more expensive and cause the
aggregate demand curve to shift up and to the left.
• Changes in Expectations – If businesses and households are more optimistic about the future of the
economy, they are more likely to buy large items and make new investments; this will increase
aggregate demand.
• The Wealth Effect – If real household wealth increases (decreases), then aggregate demand will
increase (decrease)
• Changes in Income of Foreigners – If the income of foreigners increases (decreases), then aggregate
demand for domestically-produced goods and services should increase (decrease).
• Changes in Currency Exchange Rates – From the viewpoint of the U.S., if the value of the U.S. dollar
falls (rises), foreign goods will become more (less) expensive, while goods produced in the U.S. will
become cheaper (more expensive) to foreigners. The net result will be an increase (decrease) in
aggregate demand.
• Inflation Expectation Changes – If consumers expect inflation to go up in the future, they will tend to
buy now causing aggregate demand to increase. If consumers' expectations shift so that they expect
prices to decline in the future, t aggregate demand will decline and the aggregate demand curve will shift
up and to the left.

4.13 - Short and Long-run Macroeconomic Equilibrium

In the short-run, an unanticipated decrease in aggregate demand will lead to an excess supply of resources,
which will lead to a decline in resource prices. Unemployment will increase, prices will go down and output
will be reduced. Over a longer period of time, lower resource costs will cause a shift to the right in aggregate
supply. The economy will move to producing a level of output consistent with full employment (as was the case
before the decrease in aggregate demand), but at a lower
price level.

An unanticipated increase in aggregate demand will, in

the short-run, lead to an output level that is greater than
what is consistent with full employment. This occurs
because price levels are different that what was
anticipated by resource providers. There will be less
unemployment than the "natural rate" of unemployment.
There will be upward pressure on resource prices and
interest rates, which will, over the long-run, result in a
decrease in aggregate demand. Resource providers will
make adjustments to the new price levels and output will
decline to what is consistent with full employment. A
new market equilibrium will occur at a higher price level.
So in the long-run, inflation (higher prices) will be the major effect of the increase in aggregate demand.

In the short-run, an unanticipated decrease in SAS will lower the availability of resources. This will lead to an
increase in resource prices, which will in turn cause the aggregate supply curve of goods and services to shift up
and to the left. A reduced level of output will be produced at higher prices. If the cause of the unanticipated
decrease in SAS is temporary, then there should be no changes in prices or output over the long-run. If the cause
is more important, then the long-run supply curve will shift to the left. The economy would produce a lower
level output at higher prices.

An unanticipated increase in aggregate supply will, in the short-run, lead to a shift to the right in SAS. Output
and income will expand beyond what is consistent with full employment at a lower price level. If what
produced the increase in aggregate supply is only temporary, the SAS curve will return to normal levels and
prices and output will be as before. If what produced the change is permanent, then both SAS and LAS will
shift to the right. There will be a greater amount of output, at lower prices.

Self-Correcting Mechanisms
Three aspects of a market economy that help to stabilize the economy and lessen the impact of economic shocks
include:

1.Changes in Resource Prices - If the economy is operating at less than full employment, there will be
downward pressure on prices for labor and other resources. That effect will stimulate short-run aggregate
supply. If the economy is operating above full employment, prices for labor and other resources will get bid up,
and short-run aggregate supply will be reduced.

2. Change in Real Interest Rates - During recessions, business demand for capital funding declines, causing a
lowering of real interest rates. The lower interest rates in turn stimulate consumers to buy large items and cost
of business investment projects are reduced, which stimulates business investment spending. Economic booms
lead to higher interest rates, thereby lowering demand for consumer durable goods and funding for business
investment projects. Therefore, interest rate movements work to stabilize aggregate demand.

3.Relative Stability of Consumption - The permanent income hypotheses states that household consumption is
mainly a function of expected long-range (permanent) income. Since long-run income has more of an impact on
spending than temporary changes in current income, consumption spending stays relatively the same across
business cycles. During economic boom times, consumers will increase their savings; during a recession,
temporary declines in income will induce households to draw on their savings so as to maintain a level of
consumption in line with their expected long-run incomes.

4.14 - Economic Theories

Classical vs. Keynesian Economics
Under classical economic theory, an economy will always
move towards equilibrium at full capacity and full
employment. Aggregate demand will adjust to full
potential GDP, assisted by flexible wages and
prices. Desired savings are kept equal to desired
investment by responses to interest rate changes.

British economist John Maynard Keynes took the

viewpoint that spending induces businesses to supply
goods and services. If consumers become pessimistic
about their futures and cut down on their spending, then
business will reduce their production. He rejected the
classical viewpoint that unemployment would be resolved
by flexible wage rates; instead, wages are viewed as being "sticky" when downward pressures exist. Business
will produce only the quantities of goods and services that government, consumers, investors and foreigners are
expected to buy. If the planned expenditures are less than what would be associated with production at full
employment, then output will be less than the economy's full potential.

The Four Components of the Keynesian Model

There are four components of planned aggregate expenditures in the Keynesian model: consumption,
investment, government spending and net exports. Some basic assumptions about the Keynesian model should
be noted. When the economy is operating at full employment capacity, then only the natural rate of
unemployment is extant. Wages and prices are not flexible until full employment occurs; at that point, increases
in demand will only cause prices to go higher.

• Consumption - Keynes believed that consumption expenditures are mainly influenced by the level of
income. As income increases, consumption will increase but not by as much as the increase in
income. The relation between consumption and income is known as the consumption function.
• Investment - This category includes spending on fixed assets such as machinery, and changes in
inventories of raw materials and final goods. Keynes believed that in the short run, investment spending
is not a function of income.
• Government - As with investment, planned government expenditures are not a function of income.
• Net Exports - Exports remain constant and imports increase as aggregate income rises, so net exports
(exports minus imports) will tend to go down as aggregate income goes up.

Formula 4.3

Aggregate Demand = C + I + G + (X – M)

In the Keynesian model, equilibrium is achieved when the value of current production equals planned aggregate
expenditures. At that point, there is no incentive for firms to alter their production plans. If expenditures exceed
the value of output, business inventories will be drawn down. Firms will need to expand production in order to
replenish inventories and meet the higher level of demand. If demand exceeds production, business inventories
will rise and production will be cut back until inventories are at normal levels.

Note that equilibrium can occur at levels of output which are below the level of output consistent with full
employment.

Figure 4.3: Aggregate Expenditures

In the graph above, AE0 represents aggregate expenditures that would occur at different price levels. The 45
degree line, AE=GDP, represents the points where equilibrium occurs. Equilibrium occurs at point (P0,Q0),
where output is less than can be achieved at QF, the output associated with full employment.

Ideally, planned aggregate expenditures will shift to a line such as AE1. At that point, full employment is
achieved.

From a Keynesian view, market economies are viewed as being inherently unstable: they are prone to booms
and busts. Changes in demand, magnified by multiplier effects, tend to cause wild swings in the
economy. Fluctuations in private business investment are the largest cause of the economy swinging to different
levels of output.

Monetarists believe that fluctuations in the money supply are the chief source of fluctuations in real economic
output and that the major cause of inflation is
excessive growth in the money supply.

According to the monetarist view, economies will

usually operate at full employment. Aggregate demand
is mainly influenced by changes in the money supply.
Fluctuations in aggregate demand will be diminished
if growth in the money supply is kept at a steady
rate.Monetarists concur with the Keynesian viewpoint
that wages are "sticky" when downward pressures
exist.

4.15 - Money, Banks, and the Federal Reserve

I. Basics

Money is a part of everyone's life, and we all want it,

but do you know how it gains value and how it is
created? Check out the following link for more:

The following page will prime you for the topics

discussed in this chapter:
What Is Money?

What Are the Functions of Money?

Money has three basic functions.

• It acts a medium of exchange. If money did not

exist, we would have much more complicated lives. If you wished buy bananas, you would need a barter
arrangement where another party valued something you had and could also provide you with
bananas. Anything can serve as money (ie. Coins, cigarettes, shells) as long as someone else will accept
it as a medium of exchange.

• Money is a way to store value. Although many things (land, gold, etc.) can serve as a store of value,
money has one large advantage in the sense that it can quickly be converted into other goods. One
problem with using money as a way to store value is that some forms of money do not pay
interest. Another problem is that inflation destroys the value of money over time.
 • Money is also used as a unit of account. The values and costs of goods, services, and assets can be
expressed as a unit of money. Prices expressed as money are used to help consumers make choices
among numerous goods and services.

What is the Money Supply?

The supply of money is the amount of money available in a country; it is measured in many ways. The two most
frequent ways to measure money are referred to as M1 and M2.

M1 is the narrowest definition of the money supply. It includes:

• cash (currency) in circulation

• checking accounts (demand deposits) – both non-interest earning and interest-earning
• travelers' checks

M2 includes:

• all components of M1
• money market mutual funds
• deposits in savings accounts
• time deposit of less than 100K at depository institutions (banks, credit unions, savings and loans)

Using Commodities as Money

Problems that arise when using commodities include requiring a double coincidence of wants (does the person
you want food from want your cigarettes?) and the difficulties in making price comparisons.

Look Out!

Within the context of our discussion, "Money" means

anything that can be used in exchange for goods or services. It
is not referring to currency (in the form of coins, dollar bills,
debit cards, etc.) that modern societies use every day to
purchase goods and services.

4.16 - The Banking System

Types of Institutions
There are three major types of depository institutions:

1.Commercial banks

2.Thrift institutions such as credit unions, savings and

loan associations (S&Ls), and savings banks. Credit
unions are cooperative organizations, usually restricted to
employees of a particular firm or government entity. The
savings banks and S&Ls have historically focused their
loan activities to the real estate mortgages.

3.Money market mutual funds offer bank-like

features. Shareholders of these funds are allowed to write
checks against these funds. However, these funds do have restrictions. The mutual funds specify minimum
check amounts such as $250.

Their main economic functions include providing liquidity, lowering the cost of borrowing money, and pooling
the risk associated with lending money.

All of these institutions make money by charging more for loans than what they pay for deposits, and they are
all subject to substantial regulation. Major areas of concern for regulation include reserve requirements, capital
requirements, lending rules, and deposit rules. For example, in the past, only commercial banks could offer
checking accounts, and savings banks could only offer saving accounts. Those restrictions were relaxed in the
1980s.

Money market mutual funds have been a major force in providing competitive interest rates to short-term
depositors. Technological innovation has been a major force in providing new services to customers. For
example, crediting interest on a daily basis was not feasible before the advent of modern computer technology.

The Fractional Reserve Banking System

A fractional reserve banking system exists when the amount of reserves banks must keep on hand is less than
the amount of their deposits. In the U.S., banks must keep a fraction of their assets as bank reserves – cash plus
deposits with the Federal Reserve, which is the nation's central bank. Banks issue loans with the funds that are
not held in reserve; in doing so, they expand the nation's money supply.

The Required Reserve Ratio

The required reserve ratio is the percentage of a particular liability category (to the bank), such as savings
accounts, that must be held as reserves. If someone deposits $10,000 at a bank and there is a 20% reserve
requirement, the bank must keep $2,000 as reserves and can loan out only $8,000. If the reserve requirement is
10%, the bank could loan out $9,000. The $9,000 that is loaned out can be deposited at the original bank or at
another bank; 90% of that $9,000, which is $8,100, can then be loaned out. This process continues until the
amount of money supply generated is equal to $10,000 × (1 / .1) = $100,000.

The Actual and Potential Deposit Expansion Multipliers

The potential deposit expansion multiplier is the reciprocal of the required reserve ratio. If the required reserve
ratio is 5% (.05), the potential deposit expansion multiplier is equal to 1 / .05 = 20.

The actual deposit expansion multiplier is less than the potential deposit expansion multiplier for two reasons:

·Banks may not loan out all available funds (i.e. they may have excess reserves, which are reserves that exceed
required reserves)

·Recipients of loans may not deposit the proceeds; they

may instead decide to hold them as currency

4.17 - Goals and Targets of the U.S. Federal Reserve

What is monetary policy?
Monetary policy is the control of the money supply (and
sometimes credit conditions) to achieve or satisfy
macroeconomic goals.

A country's central bank controls the nation's money

supply, enacts monetary policy and acts as a
clearinghouse between banks. The Federal Reserve is the
central bank in the U.S.; in Canada, the central bank is the
Bank of Canada.

The central bank has three tools to control the nation's money supply:

1. Setting of Reserve Requirements - In general, banks will use their reserves to make loans and turn a
profit. In doing so, they increase the nation's money supply. Increasing (decreasing) the reserve ratio
decreases (increases) the amount of funds available to loan, thereby decreasing (increasing) the nation's
money supply.
2. Open Market Operations - The Federal Reserve can purchase or sell U.S. government securities on the
open market. When they purchase (sell) government securities, it increases (decreases) the nation's
money supply. The monetary base is equal to bank reserves (vault cash plus reserves held at the Federal
Reserve), plus money in circulation. The nation's money supply is a multiple of the monetary base. The
Federal Reserve's open market operations directly impact the size of the monetary base.
3. The Discount Rate – The discount rate is the interest rate charged by the Federal Reserve to banks that
borrow money from them. Typically this is done in order to meet temporary shortages of reserves. Note
that banks do not automatically have the right to do so. An increase (decrease) in the discount rate will
discourage (encourage) banks from letting reserves go to very low levels, thereby tending to decrease
(increase) the money supply.

So if the central bank wishes to pursue an expansionary monetary policy, it will lower reserve requirements,
purchase government securities on the open market and/or decrease the discount rate.

A restrictive monetary policy implies that the central bank will increase the reserve requirements, sell
government securities and/or increase the discount rate.

Problems Associated with Measuring an Economy's Money Supply

·Changes in Checking Accounts - The introduction of interest-earning checking accounts and money market
mutual funds (some with check-writing privileges) have made M1 money supply figures for the 1980s and later
not comparable to figures for private years

·Debit Cards – Debit cards transfer funds from the cardholder's checking account when used for purchases and
may induce some people to hold less cash.

·Holding of the U.S. dollar Outside of the U.S. - The amount of currency held by people outside of the U.S.
has greatly increased. These holdings are difficult to measure. The impact is greater on M1 than M2 because
currency accounts for a relatively smaller portion of M2.

· Greater Availability of No-load Mutual (Stock and Bond) Funds - It is now easier for investors to purchase
mutual funds without paying an up-front commission (load). These holdings are not counted in M1 or
M2. Many mutual funds companies let investors cash out or move their stock and/or bond holdings to a money
market account over phone or on the internet.

4.18 - Money, Interest, Real GDP, and the Price Level

I. The Supply and Demand of Money
People hold money:

• To conduct transactions
• For precautionary reasons, such as to meet
emergencies, such as unexpected medical bills
• As a store of value

Holding money has an opportunity cost in the sense

that the money could be invested elsewhere and earn
interest. Even if the money is held in an interest-
earning checking account, a higher rate of interest
could be earned by purchasing financial instruments
such as bonds.

As the rate of interest goes higher, the opportunity cost

of money increases. So as interest rates go up (down),
people will be less (more) willing to hold money.

The supply of money is usually determined by the

Central Bank (Canada) or the Federal Reserve (U.S.)
and the targeted supply of money is not directly
related to the interest rate.

A graph for the supply and demand for money, as a

function of the interest rate, would appear similar to figure 4.4 on the following page.

Figure 4.4: The Supply and Demand for Money

Note that this demand curve assumes other relevant factors are held constant. If the quantity of goods produced
increases and/or the price level increases, the demand for money will increase. This causes the demand curve to
shift to the right. If economic activity declines and/or prices go down, then demand for money will decrease.

Changes in the availability of financial instruments are also changing the demand for money over time. The
widespread availability of credit cards has reduced the amount of money that households need to keep on hand.

Determining Interest Rates

Interest rates are determined by the interaction of the quantity supplied and the quantity demanded of money.
The quantity supplied of money is determined by the actions of the central bank and the banking system.
Suppose that the interest rate is too high in the sense that the quantity of money supplied is greater than the
quantity of money demanded. People will respond by purchasing bonds, in which case money will be reduced.
The greater demand for bonds will push interest rates down, towards equilibrium.

Short and Long-run Effects of Money on Real GDP

·Short-Run, Anticipated - If individuals correctly anticipate inflation, in the short-run an expansionary
(restrictive) monetary policy will increase (decrease) prices. Real output and employment will remain the
same. Nominal interest rates will increase while real interest rates will stay the same.

·Long-Run, Anticipated - Expansionary (restrictive) monetary policy will increase (decrease) the rate of
inflation and increase (decrease) nominal interest rates. Real interest rates, employment levels and real output
are not affected by monetary policy.

·Short-Run, Unanticipated - Unanticipated expansionary monetary policy, assuming the economy is not at full
employment, will somewhat increase prices, increase real output and reduce real interest rates. Unanticipated
restrictive monetary policy will increase real interest rates, decrease the inflation rate, reduce employment and
reduce output. This type of policy is appropriate when the economy is operating at greater than full
employment.

·Long-Run, Unanticipated - Expansionary monetary policy will lead to higher inflation and nominal interest
rates while real interest rates, real output and real employment will not be positively impacted. An important
point to remember is that, in the long run, inflation is the primary effect of expansionary monetary policy.

4.19 - The Equation of Exchange

The Quantity Theory of Money
The quantity theory of money proposes that the quantity of money and price levels increase at the same rate in
the long run. This concept is demonstrated by the equation of exchange.

The Equation of Exchange

The equation of exchange is comprised of the money stock, M, multiplied by the velocity of money, V. The
velocity of money is the number of times money turns over (spent as part of a final good or service) during the
year.

Therefore, we get the expression:

Formula 4.4

M × V= P × Q = Total Spending or GDP

P represents the price level, and Q represents the quantity

of goods and services produced. This equation is referred
to as the equation of exchange. It is the basic equation
used by monetarists – economists who believe that
fluctuations in the money supply are the chief source of
fluctuations in real economic output and that the major
cause of inflation is excessive growth in the money
supply.

If quantity and velocity are basically constants, increasing the money supply will just lead to an increase in
prices (inflation). The Quantity Theory of Money holds that in the long run, because quantity and velocity are
not changed by the money supply, a percentage increase in the money supply will lead to a corresponding
increase in the price level. However, if monetary policy can influence velocity or quantity, monetary policy can
be useful.
The equation of exchange can be converted into the demand for money function:

Formula 4.5

Md = (P × Q) / V = Y / V

Where Md is the demand for money and Y is nominal GDP. From the monetarist's viewpoint, the demand for
money is related to nominal GDP, not interest rates (the Keynesian viewpoint).

4.20 - Inflation
Determining Inflation

Inflation vs. Price-Level

The term price-level refers to the prices that must be paid in order to acquire a basket of good and services. The
phenomenon of inflation refers to a continual rise of the price-level. When inflation occurs, the purchasing
power of a unit of money (the dollar in the United States) is declining.

The inflation rate is calculated by comparing the price level in one time period to the price level of a previous
period. Suppose the price level is currently 110, and the price level of the previous year is 100. The annual rate
of inflation would then be 10%.

The inflation rate in general can be stated as:

Formula 4.6

Inflation Rate = ((P1 – P0) / P0) X 100

P1 is the price level of the later time period, and P0 is the

price level of the previous time period.

Causes of Inflation

Two main types of impulses for inflation in an economy

include:
·Demand-pull - aggregate demand rising more rapidly
than aggregate supply

·Cost-push – there is a decrease in aggregate supply

Factors creating a demand-pull inflation include an:

·Increase in government spending

·Increase in the supply of money

·Increase in the price level in the rest of the world – if prices increase in other countries, residents of those
countries will want to buy goods from domestic producers; i.e., exports will increase

The main factors which induce a cost-pull inflation include an:

·Increase in wage rates

·Increase in raw material costs

Demand-pull inflation represents an increase in aggregate demand, which will shift the aggregate demand curve
to the right. Cost-push inflation will involve the aggregate supply curve shifting to the left.Both result in higher
price levels.

Unanticipated Inflation
Unanticipated inflation in the labor market will cause workers to work for less wages then what they would
knowingly work for. Employers may get higher profits due to the higher prices. The result will be a transfer of
income from workers to employers. There is also a possibility that employment will be higher than "full
employment".

Unanticipated inflation in the financial capital market also begets a transfer of income. In this case, borrowers
gain at the expense of lenders. The amount of borrowing and lending will not be optimal, as lenders will
unwittingly loan out too much funds.

Anticipated vs. Unanticipated Inflation

Inflation that comes as a surprise to most people is called unanticipated inflation. If changes in price levels are
widely anticipated, then that inflation is referred to as anticipated inflation. In general, steady rates of inflation
can be anticipated successfully by economic decision makers.

There are many harmful consequences to inflation. Some of the consequences include:

• Individuals Apply their Efforts to Protecting Themselves from Inflation Instead of to Production -
People will spend a great deal of time and money acquiring information about how to protect themselves
(and/or profit) from inflation. Capital flows towards speculative assets such as gold and art objects,
instead of productive investments such as buildings and machinery and the incentive to speculate instead
of work increases.

• Inflation Increases the Risk of Investments - Wild fluctuations in price levels make forecasting future
earnings more difficult; this tend to discourage investment.

• The Information Delivered by Prices is Distorted by Inflation - Some price changes are restrained by
long-term contracts, while others respond quickly to changes in the general price level.

• Unanticipated inflation can change relative prices. These distorted prices may provide poor signals to
producers and resource suppliers.

4.21 - Phillips Curve

Tradeoffs Between Unemployment and Inflation (the Phillips Curve)
The Phillips curve depicts an inverse relationship between inflation and the rate of unemployment. In other
words, higher rates of inflation imply lower rates of unemployment. The relationship is named after the British
economist A.W. Phillips, who wrote an influential article about it.

That inverse relationship held true during the 1960s. During the
1970s, however, the U.S. economy experienced "stagflation" –
high unemployment and high inflation.

Unexpected rises in the inflation rate decrease the "real" wages of workers operating under long-term
employment contracts. This stimulates employment as real-wage costs to employers are
reduced. Underestimates of inflation induce job seekers to take job offers they may not otherwise take. The job
offer given may seem very good (if inflation is not taken into account) and it will be quickly taken. A worker
who understands that inflation is eroding his or her real wages would not be so quick to take the job offer.

Once works begins to anticipate inflation, there is no long-term reduction in the unemployment rate. In the
short-term, if inflation is higher than expected, there will temporarily be a reduction in unemployment. If
inflation is lower than expected, unemployment will be higher than normal.

Figure 4.5: Modern Phillips Curve with Expectations

In the graph above, Un is the natural rate of unemployment.

When integrating expectations and the Phillips curve, we find that:

• Expansionary fiscal and monetary policy leads to inflation, without a permanent reduction in
unemployment below the natural rate.
• If inflation is greater (less) than anticipated, unemployment will be below (above) the natural
unemployment rate
• If the inflation rate remains the same (does not increase or decrease), then the actual rate of
unemployment will move towards the natural rate of unemployment.

The following lessons were learned from the work with Phillips curves:

• Expansionary macro policy does not reduce the rate of unemployment, at least in the long run.
• Stable prices help keep unemployment low – stable prices are low unemployment are not conflicting
goals.

Impacts of Inflation on the Nominal Interest Rate

The nominal interest rate of a bond or loan is simply the stated or named interest rate. The real interest rate is
the nominal interest less current or expected inflation.

If economic participants expect higher inflation, they will alter their economic behavior. Lenders will be less
willing to make loans or will demand higher nominal rates of interest in order to compensate for the perceived
risk of inflation. Borrowers will seek more loanable funds in anticipation of higher prices. The net result will be
higher nominal interest rates.
Increases in the money supply will lead to higher price levels, unless there is a corresponding increase in real
output. Lenders will demand higher nominal interest rates so as to compensate for the expected inflation.

4.22 - Fiscal Policy Basics

Basics

What is fiscal policy?

Fiscal policy is the use of government taxation, spending and borrowing to satisfy macroeconomic goals.

Potential GDP
The GDP that results from an economy operating at full employment with full utilization of capital is called
potential GDP.

A reduction in after-tax wages will occur with the enactment of an income tax. The supply curve of labor will
therefore shift up and to the left. The new equilibrium quantity of labor hired will be less than what would have
occurred with potential GDP. There will be a "wedge" between before-tax and after-tax wage rates. Taxes on
expenditure increase the size of the "wedge" and further reduce employment.

Keynesians argue that if output is less than what would occur at full employment, fiscal policy should be used
to stimulate aggregate demand.

There are three major ways in which fiscal policy affects aggregate demand:
1.Business Tax Policy - Business taxes can change the profitability of businesses and the amount of business
investment. Lowering business taxes will increase aggregate
demand and business investment spending.

2.Government Spending - Government can directly increase

aggregate demand by increasing its spending.

3.Tax Policy for Individuals - Lowering taxes will increase disposable personal income and increase
consumption spending.

From the Keynesian viewpoint, fiscal policy should be used to increase aggregate demand when an economy is
operating at below full-employment levels. Ideally, the economy will be guided to output at the level of full
employment.

If aggregate demand exceeds aggregate supply and output is at full-employment levels, fiscal policy should be
used to reduce aggregate demand. This will push the economy to a point of noninflationary equilibrium.

The Supply Side Model is an economic theory holding that bolstering an economy's ability to supply more
goods is the most effective way to stimulate economic growth. Supply-side theorists advocate income tax
reduction because it increases private investment in corporations, facilities, and equipment.

The Laffer curve shows the relationship between tax rates and tax revenue.

Figure 4.6: The Laffer Curve

This graph shows that as the tax rate increases from zero, the amount of tax revenue collected will increase. At
point T*, however, increases in the tax rate lead to decreases in the tax revenue collected. High tax rates also
produce a loss to society in the sense that productive economic activity is being discouraged.

Governments would like to be at point T*, because it is the point at which the government collects maximum
amount of tax revenue while people continue to work hard. This would theoretically be the point at which
potential GDP is maximized.

Supply-side economists believe that high marginal tax rates, such as those experienced in the U.S. in the 1970s,
diminished aggregate production without raising substantial amounts of additional tax revenue. Tax cuts during
the 1980s (the Reagan presidency) are believed to have induced strong increases in supply, particularly with
regards to high-income earners. Supporters of the 2001 U.S. tax cuts, which reduced the top marginal tax rates,
believe that the cuts have increased economic growth through better supply-side incentives.

Tax policy also has consequences at a global level. Ireland has significantly reduced its personal and corporate
tax rates; during the 1990s its growth rate was much higher than the rest of Europe. There is an association with
high European tax rates and slow rates of economic growth.

4.23 - Effects of Fiscal Policy

Investment sources include:
·Private saving
·Government saving
·Borrowing from foreigners

Capital markets are influenced by fiscal policy in two

ways:

·Government spending and tax policy will generate either

a budget surplus or a deficit, which will in turn mean that
the government sector will either contribute towards
financing investment or "crowd out" private investment.
·Tax policy will affect the amount saved. Taxes on
interest earned will decrease the incentive to save and
create a wedge between the after-tax interest earned by
savers and the interest rate paid by firms.

Generational Effects of Fiscal Policy

Current fiscal policy impacts the amount of taxes that
future citizens will pay. If the government runs up long-
term budget deficits, then future generations will need to
pay higher taxes in order to pay the interest. Similarly,
future generations will pay lower taxes if the government
creates budget surpluses. Economists have created systems which examine the lifetime taxes and benefits
associated with generations or age groups. Those systems are referred to as generational accounting.

A government that chronically runs deficits will, at

some point in time, have to address that
imbalance. This fiscal imbalance will need to be
addressed with higher tax revenues and/or reduced
government spending.An imbalance is also created
when the government benefits received by one
generation exceed the taxes paid by that
generation. For example, initial recipients of Social
Security in the United States received far more
benefits than they paid in taxes. Such imbalances are
referred to as generational imbalances.Future
generations will need to pay more taxes, or receive
less benefits, in order to address this imbalance. Fiscal
policy therefore transfers benefits according to age; it
also determines how much each generation will pay
the government.

4.24 - The Multiplier Effect

The marginal propensity to consume (MPC) is equal to
ΔC / ΔY, where ΔC is change in consumption, and ΔY
is change in income. If consumption increases by
eighty cents for each additional dollar of income, then
MPC is equal to 0.8 / 1 = 0.8.

The expenditure multiplier is the ratio of the change in

total output induced by an autonomous expenditure
change.

Look Out!

In the Keynesian model, government and private investment

spending are considered to be autonomous while consumption
is not because it is a function of income.

Some consumption is considered to be autonomous. Even with no income, some consumption will occur
(savings will need to be used). So the consumption function could be expressed as C = α + (β × Y), where
α represents consumption that occurs regardless of income, β is the marginal propensity to consume and Y is
income.

Why is there a multiplier effect?

Suppose a large corporation decides to build a factory in a small town and that spending on the factory for the
first year is $5 million. That $5 million will go to electricians, engineers and other various people building the
factory. If MPC is equal to 0.8, those people will spend $4 million on various goods and services. The various
business and individual receiving that $4 million will in turn spend $3.2 million and so on.

If the marginal propensity to consume is equal to 0.8 (4 / 5), then the multiplier can be calculated as:

Multiplier = 1 / (1 – MPC) = 1 / (1 – 0.8) = 1 / 0.2 = 5

As a result of the multiplier effect, small changes in investment or government spending can create much larger
changes in total output. A positive aspect of the multiplier effect is that macroeconomic policy can effect
substantial improvements with relatively small amounts of autonomous expenditures. A negative aspect is that a
small decline in business investment can trigger a larger decline in business activity and, thereby, create
instability.

The previously mentioned formula for calculating the multiplier is a simplified one. Leakages (money spent, but
not on domestic goods or domestic services) reduce the size of the multiplier. Examples of leakages include
taxes and imports.

Another important point is that the multiplier effect takes time to work; months must pass before even half of
the total multiplier effect is felt. Also, keep in mind that the multiplier effect can cause idle resources to be
moved into production. If unemployment is widespread, then there should be little impact on resource prices.

4.25 - Discretionary Fiscal Policy and Automatic Stabilizers

Discretionary Fiscal Policy
Discretionary fiscal policy is made more difficult due to lags in recognizing the need for changed fiscal policy
and the lags that occur with enacting the changed fiscal policy. Implementing the modified fiscal policy usually
requires legislative action, which takes a long time to implement. There is a concern that fiscal policy changes
may be ill-timed, however. For example, an expansionary fiscal policy may be enacted when the economy is
already recovering from a recession. Fiscal policy does have an advantage over monetary policy in the sense
that increased government spending leads to an immediate increase in aggregate demand. The effects of a tax
cut may be more moderate and have more of a time lag because individuals may not immediately spend their
increases in disposable income that resulted from the tax cut.

Ideally, fiscal policy will be used to increase aggregate demand during recessions and to restrain aggregate
demand during boom times. Poorly timed fiscal policy
could actually increase inflation and accelerate declines in
the economy when the economy has already started to
slow down.

One difficulty with proper timing is that forecasting

economic activity is not an exact science. There is usually
a lag between the time fiscal policy changes are needed
and the instance that the need to act is widely
recognized. There can also be a substantial amount of
time between the time of recognition and the time that
fiscal policy changes are actually enacted. Lastly, another
difficulty with achieving proper timing is that the impact
of a change in fiscal policy may not be felt until six to
twelve months after the change has occurred.

Automatic Stabilizers
Automatic stabilizers, without specific new legislation, increase (decrease) budget deficits during times of
recessions (booms). They enact countercyclical policy without the lags associated with legislative policy
changes. Examples include:

·Corporate Profits - Taxes on corporate profits go up substantially during boom times, and decline rapidly
during times of recession.

·Progressive Income Taxes – Progressive taxation push people into higher income tax brackets during boom
times, substantially increasing their tax bill and reducing government budget deficits (or increasing government
surpluses). During recessions, many individuals fall into lower tax brackets or have no income tax liability. This
increases the size of the government budget deficit (or reduces the surplus).

· The Unemployment Insurance (UI) Program – This program provides payments to greater numbers of
people as unemployment increases during times of recession. At the same time, the taxes that contribute to UI
will go down as employment decreases. These two effects will cause the government budget deficit to
increase. During boom times, the program will automatically produce surpluses (or reduce deficits) as fewer
benefits are paid due to lower unemployment and tax revenues increase due to greater employment.

4.26 - Monetary Policy and Price Level Stability

Stable Prices vs. Sustainable Growth in real GDP
Price level stability refers to the concept that price levels are stable enough so that people do not feel compelled
to take inflation into account when making economic decisions. Many economists believe that measured
inflation in the range of 0 up to 2 or 3 percent a year is actually zero inflation. There may be quality
improvements in goods that are not reflected in the official measurement of inflation; this reflects a price level
measurement bias.

Price level stability is only a means to a higher goal. That goal is a rising standard of living, which depends
upon sustainable growth in real GDP. Whether or not that growth is sustainable depends upon other factors such
as technological advances, availability of natural resources, the willingness of people to work, the willingness of
people to invest, and political stability. Monetary policy helps to create a stable environment which favors
investment and saving.

Achieving Price Level Stability

The Federal Reserve can quickly affect short-term interest rates,
such as three-month T-bills and rates on savings
deposits. However, the impact of monetary policy on longer-
term interest rates is more moderate and more difficult to predict. Longer-term interest rates are more
influenced by the supply and demand for investment funds, as opposed to monetary factors. Secondly, the
impact of inflation must be taken into account. For example, suppose an expansionary monetary policy is
perceived to be inflationary. The impact of that policy on longer-term interest rates, such as real estate
mortgages, will be to raise them.

Expansionary Monetary Policy

An expansionary monetary policy, if inflationary effects are not anticipated, should lower interest rates,
particularly short-term ones. It will also have the effect of reducing velocity, as the opportunity cost of holding
money is reduced. Eventually the lower interest rates will induce more personal and business spending to occur
so that aggregate demand will increase. This process could take several quarters. Eventually the increased
demand will cause nominal and real interest rates to go higher, which will increase the velocity of money. At
that point the impact of the expansionary monetary policy will be further amplified.

4.27 - Expectations of Monetary Policy

Expectations impact perceptions about inflation and the timing of those perceptions. The effectiveness of
expansionary monetary and fiscal policy with regards to increases in output and employment is reduced by
expectations. The reduction in output caused by restrictive monetary and fiscal policy will be moderated by
expectations, as economic participants will more quickly anticipate the lowering of overall price levels.
Demand curves for labor and capital slope downward to the right. With other factors held constant, employers
will only hire more workers if real wage rates have decreased and capital expenditures will increase only if real
interest rates have declined.

Expansionary monetary and fiscal policy often assumes that workers will accept lower real wages and that
investors will accept lower real rates of return. It is the willingness of workers to accept wages that are lower
than what they would normally demand, and the
willingness of investors to accept lower real interest
rates than normal that causes employment and real
production to increase. Nominal wages and interest
rates remain the same; inflation is doing the job of
cutting real wages and interest rates. Therefore, in
order for employment and production to increase,
inflation must increase so that real wages and interest
rates can go down. This relationship is described by
the original Phillips curve, which shows that inflation
accompanies lower rates of unemployment.

As long as the public does not understand that

inflation has increased, the economy can be moved
according to the Phillips curve relationship.

Why would it take time for the public to recognize

and adapt to the new rate of inflation?
One reason is that some workers may not be able to do
anything about it. They may be locked into multi-year
labor agreements that do not permit negotiation until
the expiration of the labor agreement. Investors and
employees might also be subject to money illusion –
their attention could be focused on their nominal
wages and nominal interest rates, and they may not
realize that real wages and interest rates are declining.
At some point in time, however, they will recognize
that their real buying power (from wages and interest
income) has gone down.

Also, they may not immediately see that inflation is occurring. Not all prices go up during times of inflation, so
it may hard to see the big picture.

Eventually, the public will understand and adapt to the new inflationary environment and they will seek raises
in wages and interest rates in order to bring them back to their old income levels. The economy will move to a
long-term equilibrium position in which output and employment return to points where they were before the
monetary and fiscal stimulus occurred. The major change will be that prices will be at a higher level.

This makes sense, as we should not expect major benefits to occur just from printing more paper money or
running larger government deficits!

Expectations essentially reduce the time that government policymakers can fool the public into accepting cuts in
real wage and real interest rates and, therefore, the positive effects of financial and monetary stimulus are
moderated.
New Monetarist vs New Keynesian Feedback Rules
There are two famous new feedback rules for monetary policy. Those rules are:

• The Taylor rule is a Keynesian feedback rule that focuses on short-term interest rates. The rule takes
into account the target inflation rate, the difference between actual inflation and the target inflation rate,
and the difference between real GDP and potential GDP.
• The McCallum rule is a monetarist rule that emphasizes the growth rate of money. It states that the
Federal Reserve should target a monetary base growth rate equal to the target inflation rate plus the ten-
year moving average of the real GDP growth rate minus the four-year moving average of the monetary
base velocity.

The major differences between the rules are:

·Targeting an interest rate versus monetary growth (as usual for Keynesians versus monetarists!).
·The Taylor rule provides for a response to fluctuations in real GDP, while the McCallum rule does not.