ECO561 LECTURE NOTES

CHAPTER 1 Demand, Supply, and Market Equilibrium

Firms and Households: The Basic Decision-Making Units

The fundamental decision-making units in a market economy are firms and households. A firm is an entity that produces goods or services. Using labor, capital and other inputs, firms take resources and transform them into products that people or other firms wish to purchase. Firms include obvious examples, such as automobile producers that take labor, tires, sheet metal, machinery, and other inputs and transform them into cars and trucks. Firms also include less obvious examples, such as video rental stores. These take videotapes purchased from other firms and combine them with a store, cash registers, shelves, advertising, and personnel to bring those videos to you. Firms are the primary producing units in a market economy. Each firm started out as the dream of one or a few individuals. People who are responsible for taking new ideas or new products and turning those ideas into successful businesses are known as entrepreneurs. Entrepreneurs are also often responsible for organizing, managing, and assuming the risks of a firm. To get an idea of some of the responsibilities that entrepreneurs assume, look over the various aspects of starting and running a business provided in "Starting Your Business." Another good site information and discussion on entrepreneurs is the "Young Entrepreneurs' Organization" site. It provides a good starting point for those who are interested in going beyond our discussion of entrepreneurs. In addition to firms, households form the other fundamental component of market economies. Households can range from individuals living alone and single parent families to college friends sharing a house as well as extended families living together. Households are described in the text as the primary consuming units in an economy. While such a description does not capture the richness of what households can be, it does describe one of their primary roles in the economy.

Input Markets and Output Markets: The Circular Flow

So far, we have described firms primarily as producing units and households as consuming units in the economy. Let us look a bit closer at these basic ideas. Firms sell the goods and services they produce in product or output markets. The resources they purchase in order to make their outputs are bought in input or factor markets. Where do firms get these inputs? From households! Think about when you or some other member of your household goes off to work. Where are you (or they) going? You (or they) are probably going to a firm! Household members supply the labor that enables firms to produce their outputs. In addition, households supply the funds that firms use to purchase land, factories, office buildings, and equipment. How do they do this? When members of a household save for the future by putting money in a bank, or buy stocks or corporate bonds, they are supplying firms with funds to finance such expenditures. y An input market is where the resources used to produce goods and services are exchanged. y A labor market is the input market in which households supply work for wages to firms that demand labor.

y A capital market is the input market in which households supply their savings to enable firms to buy capital goods. y A land market is the input market in which households supply land or other real property to firms. Households are not just the consuming units of the economy. As seen by the descriptions of the different types of input markets, we can see that households are the ultimate suppliers of inputs to firms. Firms are producing units, but are also consumers of labor, land, and other inputs produced by households. Each fundamental unit of the economy acts both as producer and consumer. This relationship is shown by the circular flow diagram. This diagram illustrates the interaction of firms and households in markets for outputs and inputs.

To understand how markets work, we will first build a theory of demand that describes a relationship between the demand of the quantity of a product and different market prices. We will then build a theory of supply that describes a relationship between the quantity of a product supplied and the different market prices. Then we will put them together in order to show how the production and consuming sides of the economy interact and how prices are determined.

Demand in Output in Product/Output Markets

A household s decision about how much of a product to buy, or whether to buy any of a given product, depends on a number of factors. We will call these factors the "determinants of demand." The primary determinants include the price of a product, the household's income, the household's accumulated wealth, the prices of related products, the household members' tastes and preferences, and their expectations about the future. Let us relate this to the real world for a moment. Perhaps a member of your household is thinking about getting a new pair of skis. People are more likely to buy new skis if they are on sale than if they are not (price is a factor).

The amount of take-home pay will also play a role. People are more likely to buy when they have just gotten a high-paying job than if they have been laid-off (income is a factor). Similarly, it is more likely that someone will buy if they have just inherited a large chunk of change from Aunt Zelda (wealth is a factor). Because new bindings, poles, and boots are also necessary to go along with new skis, one is less likely to buy skis if these related products are very expensive than if there is a great deal on them (the prices of related goods are factors). Finally, people will buy new skis if they love skiing and are expecting a great season (tastes, preferences, and expectations are factors). The circular flow diagram shows that every act of buying and selling is linked to other acts of buying and selling in the economy. What you do depends on the actions of others. Your income is determined by other people's demand for what you produce, and their income is partly determined by your demand for the products they produce. Suppose you buy a new pair of jeans. Trace the effect of this purchase on other markets and other people's buying and selling. Price and quantity demanded: The law of demand The amount of a product that households would buy in a given period of time at the current market price is called the quantity demanded of the product. The law of demand says that when the other determinants of demand remain constant, there is a negative (or inverse) relationship between the quantity of a good demanded and its price. What does this mean? Basically, it is just a fancy way of stating what we already know: that people are more likely to purchase an item at lower prices than at higher prices. As managers of even the smallest stores know, people will buy more of a good when it goes on sale! If the price goes up, people will tend to buy less of a product. Demand curves slope downward The relationship between the price of a product and its quantity demanded is known as the demand for the product. According to the law of demand, price and quantity demanded move in opposite directions; as price goes up, quantity demanded goes down, and vice versa. If we list a series of prices and the corresponding quantities demanded, we get a demand schedule. A demand schedule for a representative consumer named Anna is listed as follows:

As we can see, as the price per call increases, Anna makes fewer calls per month and her quantity demanded declines. A demand schedule, like the one shown here, will let us know how much of a product households are willing to buy at different prices. It is a representation of the demand for a good. We can represent the demand for a product in another way. Note that we have two variables here: price and quantity demanded. If one variable goes on the vertical axis and the other goes on the horizontal axis, we can represent the relationship between them graphically. Doing so, we get the demand curve for the product. The demand curve for Anna's phone calls is given below. Note that price is on the vertical axis and quantity demanded is on the horizontal axis. This is the way we draw demand curves.

Note that the curve labeled "Demand," slopes downward to the right. In other words, as the price gets lower the corresponding number of phone calls per month increases. This graph shows a negative relationship between the price and quantity demanded of phone calls. Recall that is just what the law of demand claims! As the price of the good goes down, we just move along the demand curve to determine the quantity demanded at the new price. Notice also that the demand curve intersects both the vertical and horizontal axes. The intersection at the vertical axis means that there is a price above at which Anna will not make any phone calls. The price at which consumers will no longer purchase a product is called the reservation price of the good. With limited income, people simply cannot afford to buy certain goods if the price gets too high. If making long distance phone calls became prohibitively expensive, people might write letters or send an e-mail rather than make a phone call. The intersection at the horizontal axis means that, even if the good is free, people will only consume so much of it. Think about this in terms of making phone calls. Even if they were free, you would not spend all your time on the phone! Other determinants of household demand Remember when we discussed the various factors that influence how much of a good people want to buy? We discussed how income and other factors are, in addition to price, important determinants of quantity demanded. For example, in buying new skis, people are more likely to buy when their incomes are high rather than low. How can we represent this on a demand curve? Let us do so using the example of Anna's phone calls. If Anna's income goes up, she will respond by making more telephone calls. In other words, at each price per call, she will make more calls per month than when her income is low. We can show this by shifting the demand curve up and to the right. At a price of $7 per call, she used to make 3 calls per month. Now that her income is higher, she can afford to make 12 calls per month at that price. At each price, her quantity demanded is higher. Such a shift in demand is called an increase in demand for the product. This shifting of the demand curve is called a change in the demand for the good. Note what is going on here! A change in the price causes a movement along a demand curve and results in a change in the quantity demanded. A change in some other determinant of demand besides price, such as income, causes a shift of a demand curve. This

is called a change in demand for a good. The difference between a change in quantity demanded and a change in demand is an important distinction and one that ought not to be overlooked. Changes in income, wealth, the prices of related products, tastes and preferences, and expectations can each cause a change in demand. For some goods, if income increases, the demand for the good will increase. Such was the case for our ski example and for Anna's demand for phone calls. Such goods are called normal goods. For other goods, however, an increase in income will result in a decrease in demand. This is represented by the demand curve shifting to the left. Such a shift shows that quantity demanded will be less at each price. Goods for which an increase in income results in a decrease in demand are referred to as inferior goods. An example of inferior goods would be used cars, frozen macaroni and cheese casseroles, or hamburger. As incomes increase, demand for these products goes down as people buy new cars, restaurant meals, and steak instead. The following figure shows how demand changes as well as how the demand curve shifts for normal and inferior goods as a result of an increase in income.

Now let us consider how the price of related goods can change the demand for a good. Recall that we mentioned how a change in the price of ski bindings, boots, and poles could affect the demand for skis. Similarly, the price of buns, catsup, or other related goods can change the demand for hamburger. If an increase in the price of a related good causes a decrease in the demand for a good, those goods are called complementary goods. Complementary goods are often goods that go together when people consume them. For example, when ski bindings are expensive, the price of an overall ski package increases and fewer skis will be bought. On the other hand, an

increase in the price of snowboards will make it more likely that people will buy skis rather than snowboards. Such goods, for which an increase in the price of one good causes an increase in the demand for another good, are called substitute goods. Substitutes can often be used in place of each other. For example, people can substitute chicken for hamburgers. If the price of hamburger increases, we can expect people to substitute chicken for hamburger, resulting in an increase in the demand for chicken. The effects of an increase in hamburger prices on a substitute and a complement are shown in the figure below:

From household demand to market demand In economics, we are usually concerned with the overall demand for products rather than the demand on the part of individual households. To get the market demand for a good, we just need to add up the quantities demanded at each price for all the households that are consuming the good. Consider the following illustration:

We simplify things by assuming that only three households consume coffee and we show their demand curves. Now, let us determine how much coffee will be purchased per month at a couple of different prices. At $1.50 per pound, Household A will buy 8 pounds per month, Household B will buy only 3 pounds, and Household C will buy 9 pounds. So, at $1.50 per pound, the quantity demanded for this market will be 20 (8 + 3 + 9). Similarly, we can figure that at a price of $3.50 per pound, a total of only 8 pounds per month will be purchased in this market (4 + 0 + 4).

Supply in Product/Output Markets

Now that we have covered demand in some detail, we can breeze through the concept of supply rather quickly. While consumers are less willing to purchase goods at high prices compared to low prices, firms, on the other hand, prefer higher prices and are willing to supply more of a given product at a higher price than at a lower one. After all, most firms are in a business to make profits and profits are generally higher when prices are high.

Price and quantity supplied: The law of supply The supply of a product is the relationship between its price and the quantity supplied. If it is a positive relationship (a price increase), the quantity supplied increases. This relationship is known as the law of supply. If we list different combinations of prices and quantity supplied for a product, we get the supply schedule for the good. This is shown in the following schedule:

In plotting price and quantity supplied on a graph, the same way we did with demand, we get a line that slopes upward to the right. This shows there is a positive relationship between these two variables, as stated by the law of supply. The supply curve for a product is shown below:

Just as certain factors can change the demand for a product and result in a shift in the demand curve, so too can certain factors change the supply for a good. A change in the costs of production will change supply. For example, an increase in wages in an industry can make a product less profitable to produce, therefore some producers will cut back production or shift resources into producing other goods for which labor costs have not risen. Technology can also affect a producer s willingness to supply certain products. For example, the development of computers has enabled books to be published in a much less labor-intensive manner, resulting in substantial cost savings. Because of these savings, profits are higher and, as a result, publishers are willing to produce more books at any given price than before. Prices of related products can also affect supply. For example, if the price of shorts goes up dramatically, manufacturers of pants may devote more resources to making shorts and fewer resources to making pants. As a result, the supply of pants will decrease.

Changes in production costs, technology, prices of related goods, and other factors can cause a change in supply, which, in turn, causes the supply curve to shift. In general, decreases in production costs or improvements in technology will cause supply to increase. This is shown by a shift of the supply curve to the right. A decrease in supply will cause the supply curve to shift to the left. The same distinction applies here as with the concept of demand. A change in the price of a good will result in a change in quantity supplied and is represented by a movement along the supply curve. A change in other factors, such as production costs or technology, causes a change in supply which is represented by a shift of the supply curve. An increase in supply due to technological progress is shown below:

Economists like to know the supply and demand curves for particular products. Why do you think it is difficult to use actual observations of buying and selling to draw a supply or demand curve? (Think in terms of the ceteris paribus assumption.) From individual firm to market supply The supply of a good or service can be defined for an individual firm, or it can be defined for a group of firms that make up a market or an industry. The market supply of a product is the sum of all the quantities of a good or service supplied per period by all the firms selling that good or service. As with market demand, market supply is the summation of the individual firms supply curves at each price, as shown by the following figure:

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Market Equilibrium
The operation of the market depends on the interaction between suppliers and demanders. Market equilibrium exists when quantity supplied is equal to quantity demanded. Note that there is just one price where this is true! The equilibrium price is the price that will generally prevail in a perfectly competitive market that is not subject to governmental intervention. As you might remember from your chemistry classes, a system is in equilibrium when there is no tendency for it to change under existing conditions. When a market is in equilibrium, there is no tendency for the market price to change. In other words, the equilibrium price is stable under the existing market conditions. Consider, for example, the soybean market depicted in the following figure:

Under the existing conditions of supply and demand (the existing incomes for consumers, prices of related goods, state of technology, input prices, and other conditions), the market price of soybeans will be $2.50 per bushel. When farmers hear the farm report on the radio in the morning, the price of soybeans will be quoted as being $2.50 per bushel. Agricultural products such as apples, bread, or other items, are generally about the equilibrium prices. If the equilibrium price is the price that is stable under existing conditions, that must mean other prices will tend to be unstable. That is exactly the case. Consider what happens when the market price is below the equilibrium price. At low prices, producers supply less and consumers want to buy more than at the equilibrium price. This creates an excess demand, and causes a shortage of the product. Imagine the situation at your local market if the minute supplies of the product came in, frantic consumers immediately would scoop them up! What is the manager of the store likely to do in such a situation? The manager would most likely raise prices. When the market price is below the equilibrium price, consumers compete with each other in order to grab the good deals. This puts upward pressure on the market price. Such pressure will cease when the market price reaches the equilibrium price. The shortage resulting from the price being below the equilibrium level is shown in the following figure at the price of $1.75. The amount of the shortage is the difference between quantity demanded and quantity supplied at that price. In this case, there is a shortage of 25,000 bushels (50,000 - 25,000). Now consider what happens when the market price is above the equilibrium level. In this case there is an excess supply, or surplus, of the product. At high prices, producers are willing to produce more of the product, but consumers are willing to buy less than at the equilibrium price. Excess supply, the condition where quantity

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supplied exceeds quantity demanded at the current price, will result. Now imagine what happens at your local store. As inventories pile up on the back shelves, managers will put the product on sale in order to unload some of it. As a result, market forces will pull the price down toward the equilibrium price. The amount of the surplus is the difference between quantity supplied and quantity demanded at that price.

Market Equilibrium
Changes in equilibrium The equilibrium price, and corresponding equilibrium quantity exchanged, will change when the demand for a product changes, the supply of a product changes, or both. Note that in order for either supply or demand to change, there must be a change in some factor other than the price of the good! Remember, only these "nonprice" factors will shift the supply or demand curves. Let us first consider what happens when there is a change in supply. Note that this must result in a change in the market conditions affecting supply, such as production costs, technology, or the prices of related goods. If a change in one (or more) of these factors causes supply to decrease, the supply curve will shift to the left. Draw a quick sketch of this situation on a piece of scratch paper. What happens to the equilibrium price? What happens to quantity? If you have done it correctly, you should see that price will rise and quantity will fall. This makes sense. If we read in the papers that large floods in California have wiped out much of the country's strawberry crop, there will be fewer strawberries sold and their price will be higher than before the floods. A similar situation is shown in the following figure for the coffee bean market after a frost damaged much of the coffee crop:

After the freeze, there was excess demand at the old market price of $1.20 per pound. The excess demand, as well as the competition among buyers trying to purchase coffee, pushed the price of coffee up to the new equilibrium price of $2.40. Now let us consider a situation where the demand for a product decreases. When demand falls, the demand curve shifts to the left. Sketch out this situation on your scratch paper. Do you see what happens to the equilibrium price and quantity? The price falls and so does the quantity. If for some reason (a change in tastes and preferences,

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income, or some other factor) consumers do not want a product as much as they did before, the price falls and fewer units are exchanged. You might recall the furor, and resulting lawsuit, that stemmed from the statement made on the Oprah Winfrey show that eating beef could infect people with "mad cow" disease. As a result of the show, the demand for beef dropped sharply, as did the amount of beef sold in the United States.

Demand and Supply in Product Markets: A Review

Here is a summary of the changes to equilibrium price and quantity that result from changes in either supply or demand. Do not try to memorize all of this! The best way to practice is to visualize the changes in the supply and demand curve and the resulting changes in price and quantity. Changes in supply result from changes in factors affecting producers, such as production costs, technology, or prices of goods that are related in production. When supply changes, price and quantity change in the following manner: Supply decrease P & Q Supply increase P & Q Changes in supply, and the resulting changes in price and quantity, are shown in the following figure:

Changes in demand stem from changes in factors affecting consumers, such as household tastes, income, wealth, or price of goods that are either substitutes or complements in consumption. When demand changes, price and quantity change as follows: Change in conditions affecting demand. Seasons, Values, Advertising, etc. Decrease in demand P & Q Increase in demand P & Q The changes resulting from changes in demand are shown in the following figure:

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Even people who are not economists can tell when there is a shortage in a market. Some years ago, there was a shortage of Cabbage Patch dolls. How do you think the shortage manifested itself? What happened?

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CHAPTER 2 The Price System, Supply and Demand, and Elasticity

The Price System: Rationing and Allocating Resources

We know that the interaction of supply and demand in a market system creates prices for the goods and services exchanged. Prices perform two major roles in market systems: 1. rationing the available goods and services, and 2. determining which goods and services are produced and how they're produced. Let us look at each of these in more detail. Price rationing First, prices perform a means of rationing scarce goods and services. This price rationing function answers the third basic question that economic systems must address: who gets the goods and services that are produced. Remember, goods are not freely available (there is no free lunch). For a good to be freely available, there must be enough to go around freely to everyone who wants it. While this may be true for a handful of goods, virtually all of the millions of goods and services exchanged in any economic system are not freely available. Because there is not enough to go around freely, not everyone who wants a good will be able to get it. Such goods must be rationed, which means there must be some mechanism for deciding who gets some of the goods and who does not. In market systems, such rationing is done by price. You can have a particular good if you are willing and able to pay the market price. If not, you look for some alternative. Consider the following figure that shows the effects of closing some of the lobster waters off the coast of Maine in order to reduce over-harvesting.

Since some of the lobster waters are closed, fewer lobsters will be harvested. A shifting of the supply curve to the left indicates this decrease in supply. There are fewer lobsters to go around, which means some people that used to eat lobsters will not be eating any, or at least not eating as many as they were before. Who decides which people will be cutting back and by how much? We do! As a result of the decrease in supply, there is an increase in

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price. Fewer people will be willing and able to pay the new, higher price for lobster. It is the price itself that rations the available lobsters. Constraints on the market and alternative rationing mechanisms Note that there are various possibilities for rationing goods. We could ration by age. We could ration by height or by weight. We could draw straws. Note that whatever mechanism we use to ration, some people will get the goods and some people will not. This means that all rationing systems discriminate against some people. If we ration by age, so that older people get the goods, young people will be discriminated against. If we ration by height, short people will be discriminated against. When we ration by price, we discriminate against people who are unwilling or unable to pay the market price. Sometimes, discriminating on the basis of price seems unfair and other rationing systems are employed. The price of a product is sometimes kept below the equilibrium price on the grounds that it makes the good more affordable to people with a low ability or willingness to pay. When the supply of gasoline was reduced, as a result of the OPEC embargo during the 1970s, the price of gasoline would, in an unregulated market, increase dramatically. However, the federal government stepped in to keep the price of gasoline artificially low. This form of price control, in which a maximum price is set below the equilibrium price for a good, is termed a price ceiling. This is illustrated in the following figure:

Rather than let the price of gasoline rise, the price was constrained to a little more than a third of its market clearing level. At the controlled price of $0.57, price is not fully performing its rationing role. Quantity demanded greatly exceeds quantity supplied. People want to buy much more gasoline at the low price than is available. Remember, goods must be rationed somehow! If price is not fully rationing a good, some other rationing mechanism must perform the rest of the rationing function. In the case of gasoline, that other mechanism was waiting in line. Many people lined up near gas stations for hours before getting to the gas pumps. Rationing by queuing is often used because it is perceived as being fairer than rationing by price. Does it really keep the total price of a good low? It does not when the opportunity cost of time is considered! In the case of the price ceiling on gasoline, consumers not only had to pay the money price, but they also had to wait in line for long periods of time. When the opportunity cost of this time is added to the money price, the total cost will actually be higher for most consumers than the equilibrium price!

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Have you ever tried to buy something when the quantity demanded, at the going price, was greater than the quantity supplied? What rationing system was used to deal with this shortage? Did this system seem fair to you? Why or why not? Would you be in favor of a free market in organs, whereby a person was paid a market determined price for an organ? What would be the pros and cons of such a system? Prices and the allocation of resources In addition to rationing goods and services, prices also address the other two basic questions that must be answered by economic systems: what gets produced and how does it get produced. A crucial role performed by prices is providing information. Prices transmit information about changing resource scarcity and changing consumer values. Consider an increase in resource scarcity. What will happen if the world's supply of oil begins to get exhausted? In an unregulated market, the price of oil will begin to increase. This signals consumers to use less of it and to switch to substitutes that are relatively more abundant. That is just what we would like to see occur people conserving a scarce resource! The rising price also signals producers to try to find more oil as well as to develop alternatives, such as solar power. That is also what we would like to see happen! It is the rising price that provides these incentive for both producers and consumers. Now let us consider a change in consumers' desires. Let us assume that, because of the proliferation of personal computers, people do not want as many typewriters as in years past. How does this information get transmitted to producers? The decrease in the demand for typewriters will cause the price to decrease. In response, quantity supplied will also go down. It works out nicely! People want fewer typewriters, so fewer resources are devoted to making them. Again, it is price that transmits this information from consumers to producers. In addition to what gets produced, the question of how things are produced is addressed by prices. There are a lot of different ways to produce any particular good. A producer could use a capital intensive production method or, alternatively, use a labor-intensive method. Let us use agriculture as an example. In less developed countries, farming activities such as planting, weeding, and harvesting are done by hand. In the United States, on the other hand, farming is generally more mechanized. Part of the reason for the different farming practices being used is that the price of labor is much lower in less developed countries. As the price of labor increases, producers will substitute capital for labor and become more capital intensive. Some roadways, bridges, and tunnels have tolls on them, while others do not. Identify some that do and some that don't. Are tolls collected primarily to deal with shortages?

Supply and Demand Analysis: An Oil Import Fee

You have probably heard commentators claim that the United States is overly reliant on foreign oil. This view stems from the fact that the United States produces less of its own oil and imports much more from foreign sources than in the past. The concern with the United States' dependency on foreign oil has led to a number of policy recommendations aimed at reducing the amount of oil imported into the United States. One such recommendation is an oil import fee, which amounts to a tax on imported oil. Such a tax on imported goods is known as a tariff. A tax on imported oil would make foreign oil relatively more expensive than domestically produced oil. This would enable domestic producers to supply a larger share of the oil consumed in the United States and reducing the reliance on foreign oil. However, there is a price for using less foreign oil! The price of gasoline to United States consumers will be higher as a result of the oil import fee. The situation is shown in the following figure:

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Before the tax on imported oil, the world price of oil is $18, as shown by the first graph. At that price, United States producers supply only part of the overall United States demand. This is shown by the second graph, where total quantity demanded at $18 is 13.6 million barrels per day. With an oil import fee, the price of oil in the United States rises to $24. At a price of $24, the third graph shows that U.S. producers supply more oil (from 7.7 to 9.0 million barrels) per day. However, in response to the higher price, consumption of oil in the U.S. falls from 13.6 to 12.2 million barrels per day. What is the overall result of such a policy? As we have shown, the oil import fee increases U.S. production of oil, reduces the amount of oil the United States imports from other countries, raises the price of oil in the United States, and reduces the amount of oil consumed in the United States. There are other effects as well. Because each barrel of oil imported into the United States is taxed, there is tax revenue that goes to the United States government. This helps reduce the budget deficit (or adds to the budget surplus). In addition, because oil and its derivative products, such as gasoline, are more expensive, less oil and gasoline will be used. This will help reduce air pollution in the United States.

Elasticity
Let us say you have opened a coffee shop and find you are losing money after your first year in business. The problem seems to be in the pricing. If you raise prices, you will make more money on each cup of coffee that is sold. The problem with this approach is that the law of demand states that less of a product will be demanded at a higher price. If you lower prices, the law of demand states that you will sell more coffee but will not make as much on each cup sold. Should you raise prices or should you lower prices? What you really need to know is how much will the quantity demanded change when the price changes. If you raise prices and only lose a little business, then you will likely make more money. If prices are raised and a lot of business is lost, then you will most likely make less money. The way an economist determines the sensitivity of quantity demanded to a change in price is called the price elasticity of demand. The price elasticity of demand lets us know the percentage change we could expect in the quantity demanded for a 1% change in price. The formula for the price elasticity of demand is: price elasticity of demand = (% change in quantity demanded) / (% change in price)

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Note that the law of demand implies that the price elasticity of demand is always negative, since a positive change in price implies a negative change in quantity demanded and visa versa. Since the sign is always negative, it is easier for to ignore the sign of price elasticity of demand and treat it as a positive number. There are two methods for computing elasticity using percentage changes and using the midpoint formula. We will first examine the formula using percentage changes. Consider the following demand curve:

To find the percentage changes in price and quantity demanded moving from point A to point B, let us begin by finding the percentage change in price. The general formula for percentage change is % change = (change) / (starting point) So the change in price moving from A to B is -1 and the starting point is 6, so the percentage change in price is -1/6. The change in quantity demanded moving from A to B is 1 and the starting point is 2, so the percentage change in quantity demanded is . Therefore, the price elasticity of demand is (1/2)/(-1/6) = -3. And since we are ignoring the negative sign, we say the price elasticity of demand between point A and point B is 3. Let us look at two other points on this demand curve.

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Let s find the price elasticity of demand when we move from point C to point D. The change in price is -1 and the starting price is 2, therefore the percentage change in price is -1/2. The change in quantity is 1 while the starting quantity is 7, so the percentage change in quantity is 1/7. Thus the price elasticity of demand between point C and D is (1/7)/(-1/2) = -2/7 or 2/7. It is important to notice that the price elasticity of demand changed when we looked at a different point on the demand curve. It was 3 between A and B, but it was 2/7 between C and D. As you move to the right along a demand curve the price elasticity of demand will always fall. Demand curves are more elastic at higher prices and less elastic at lower prices. Notice that the slope of the demand curve is -1. This slope is -1 everywhere on the demand curve, while the elasticity is not the same everywhere on the demand curve. There is a significant difference between slope and elasticity! This appears to be a problem! When we want to find the price elasticity of demand over the same range, but using different starting points, we get a different answer. When we started with C, the elasticity was 2/7, but when we start with D the elasticity is 1/8. The solution to this problem is to make the two points on the demand curve infinitely close together. We get an approximation of the true price elasticity of demand by using the midpoint formula. The midpoint formula for the price elasticity of demand uses a slightly different method for finding the percentage change. Instead of computing a percentage change as (the change) / (starting point), the midpoint formula computes percentage change as (the change) / (the average of the starting point and the ending point). To find the price elasticity of demand between point A and B using the midpoint formula, first, the percentage change in price must be found. The change in price is 1 and the average of the starting and ending prices is (6 + 5) = 5.5.

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So the percentage change in price is 1/(5.5) = -0.18. The change in quantity demanded is 1, and the average of the starting and ending quantities is (2 + 3) = 2.5. Thus, the percentage change in quantity demanded is 1/(2.5) = 0 .4. So the price elasticity of demand is 0.4/0.18 = 2.22. This is a slightly different number than that from using the other formula, but notice it does not matter which point is the starting point when using the midpoint formula. There is no obvious reason to use one formula over the other. The price elasticity of demand is the ratio of two percentages, so it has no units. So when the price elasticity of demand is 2.22 for a one percent change in price, we can expect a 2.22 percent change in quantity demanded. Price elasticity of demand The price elasticity of demand falls into three general categories: y Elastic y Unitary Elasticity y Inelastic The price elasticity of demand is elastic in a given range of the demand curve if the price elasticity of demand is strictly bigger than one. In the above example, there was a price elasticity of 2.22. Since this is clearly bigger than one, we say the demand curve is elastic between point A and point B. Another way of thinking of the definition of elastic is that the percentage change in quantity demanded is bigger than the percentage change in price. If demand is elastic then it will change more in response to smaller changes in price. The extreme case of an elastic demand curve is called perfectly elastic. In this case, the elasticity of demand is , meaning that even a small change in the price will cause the demand to completely disappear. Such a curve is shown below:

Unitary elasticity is when the price elasticity of demand is exactly equal to one. This means that when price changes by some percentage, the quantity demanded will change by the exact same percentage.

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The price elasticity of demand is called inelastic over the range of a demand curve where the price elasticity of demand is strictly less than one. Inelastic demand occurs when the percentage change in quantity demanded is less than the percentage change in the price. Inelastic demand will not change much when the price changes. The extreme case of inelastic demand is called perfectly inelastic. A perfectly inelastic demand curve will show no change at all in the quantity demanded when the price changes, so the price elasticity of demand is zero. An example of a perfectly inelastic demand curve is shown below.

Generally speaking, the greater the elasticity of demand, the flatter the demand curve, and the smaller the elasticity of demand, the steeper the demand curve.

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With some exceptions, like the perfectly elastic and inelastic curves, all demand curves are elastic at the top of the curve and become inelastic eventually as you move down the curve.

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CHAPTER 3 The Production Process: The Behavior of Profit-Maximizing Firms

The Role of the Firm

In the last chapter, we examined the right half of the circular-flow diagram, which illustrates the role of the household. Households supply the inputs and demand the outputs of the production process. Now it is time to examine the flip side of the economic coin the role of the firm. It is the firm that does the very production that makes up the core of our economy. The firm takes the inputs, the pieces, and puts them together to make a good (or service) that is wanted by households and provides utility to people.

Firms are motivated by one thing profit. We will begin to examine the profit-maximizing behavior of firms in this chapter, and we will continue examining this behavior for the following seven chapters.

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The environment in which a firm operates determines the rules by which the firm plays. If the firm is the only one who is producing a particular good (a monopolist), it will behave differently from a firm that is competing against a large number of similar firms, producing an identical product (i.e., a perfectly competitive firm). It is for this reason that we will consider each of these different business environments (or market organizations) separately. The first type of market organization we will examine is called perfect competition. For a market to be characterized as perfectly competitive there are a number of conditions that must hold true: y There are a large number of firms (suppliers) and a large number of households (demanders) y Each firm produces the exact same (homogeneous) product y Firms have easy entry into the market and exit from the market y The Role of the Firm (cont.) y Clearly, this is a very restrictive set of assumptions, and very few "real world" markets satisfy these conditions. The typical example is agricultural markets. We will be using the perfectly competitive model as a benchmark to compare to other, more realistic, market organizations. We will slowly remove these restrictions from the market and determine how firm behavior changes along with the assumptions. y The first and second assumptions imply that the firm is a price-taker. Because each firm is such a small part of the market, no one firm can change the market price. The firm must take whatever is the "going price" for a good. Since each firm makes the exact same thing, if one firm tries to raise its price, it will lose business to another firm that is making the same product. Also, since there are so many buyers, firms can sell as much of the product as they want at the going price. Graphically, this means that the price is determined by the market supply curve and market demand curve (shown on the left below). y Each individual firm faces a different demand curve than the market curve. The firms will find customers only when they sell at the market equilibrium price. So at any other price, there is no demand. Furthermore, at the market equilibrium price, there will be demand for any possible quantity. Thus, the demand curve for the firm is simply a flat line at the market-determined price (shown on the right below).

The final assumption of easy entry and exit allows firms to start up and close down with relative ease. This assumption will become important as we examine the long-run behavior of firms. If the market is easy to get into and out of, then when there are profits to be made in this market, you will see many startup firms.

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The Behavior of Profit-Maximizing Firms

Since firms are motivated by profit, what decisions can the perfectly competitive firm make to maximize its profit? Without the option to change the good's price, the firm must decide: 1. How much to produce. 2. How to produce (What method to use). 3. How much of each input to demand. Let us address these three decisions separately. Profits and economics costs Even though the firm is a price-taker, the decision of how much to produce is very important. One might think that you should produce as much as possible to make as much profit as possible. The problem is that there are different costs associated with making different quantities. It might be that making a large quantity is a lot more costly, per unit, than making a smaller quantity, and so the profit is larger with a smaller quantity. To begin to understand these complex decisions, we will start with dissecting the concept of profit. Profit is defined as: economic profit = total revenue - economic costs (total costs) Total revenue is simply the money that comes in from the firm's sales. It is the number of units sold multiplied by the price. Economic cost, on the other hand, is a bit more complicated. Part of economic cost is the money that is used to pay the firm's bills, called "accounting cost." Firms also use resources in the production of goods. Sometimes these resources are paid, such as the worker wages, and sometimes these resources are not paid. For example, if the firm is using a building that it already owns for production, then it is not paying rent, though it could be renting the building out to another firm. So there is an opportunity cost of using the resource. There is no bill for the cost of rent, only an opportunity cost. This opportunity cost is part of the economic cost of operating the firm. Normal rate of return Firms often require a financial investment to begin operation. Money also has an opportunity cost. The opportunity cost of using the money to invest in the firm is the outside investment opportunities. For an investor to put funds into a firm, it must be earning a profit that is more enticing than the outside investment opportunities. This profit is called the normal rate of return. The normal rate of return is a basic cost of running a firm, because if the firm can not pay this cost, it will not attract investment dollars. For the firm to entice the investor to put money in the firm, the firm must offer a high rate of return on the money. The riskier the investment, the higher the interest rate needed to bring in investment.

The Production Process

Production functions: Total product, marginal product, and average product Marginal product and the law of diminishing returns Another way of defining the marginal product of labor is the extra goods that could be made by hiring another worker.

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As you add workers, specialization tends to increase the marginal product. Think about how an assembly line works with one worker and then two, and then three, and so on. What happens after the each additional worker is added? The third worker will produce an additional 10 units of production, the fourth gives five, and the fifth will produce two additional units! Therefore, the benefits of specialization are exhausted. This phenomenon is called law of diminishing returns and can be seen clearly when the production function and the marginal product of labor are graphed.

The law of diminishing returns says that, in the short run, as you continue to add a variable input to a fixed input, the additional output from the variable input will eventually decline. When you have some fixed input, then adding more workers does not allow for additional production. In fact, it is possible that the marginal output would become negative as the workplace becomes cluttered with too many workers. Thomas Malthus, a renowned 18th and 19th century economist and political scientist, used the law of diminishing returns to make a grim prediction for the world. He basically argued that we could think of the increasing world population as the increasing of a variable input (labor). We can also think of the earth as fixed input. So, as we keep increasing the population, eventually each additional person would add so little output (specifically, food) that we would all starve to death. Do you think he was correct? Should we be limiting population growth based on his argument?

Choice of Technology
The simultaneous decisions that firms have to make in regards to technology are to choose a technology for production and to choose the quantity of inputs to demand, given that technology. A firm could choose to produce in a labor-intensive manner or it could invest in machines that operate without any human contact. The choice depends upon the cost of labor and the cost of capital. Consider the table below.

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According to the table, a firm can choose from the five different production technologies using different amounts of labor and capital. The right two columns calculate the firm s total cost by multiplying the amount of labor times the price of labor (the wage rate) to get the total cost of labor. The firm then multiplies the amount of capital used times the price of each unit of capital to get the total capital cost. The total labor cost is then added to the total capital cost to get the total cost of production. Notice that the cost-minimizing production technology depends on the prices. When labor is cheap (column 4), not surprisingly, the firm will choose a more labor-intensive technology. When capital is cheaper (column 5), it should choose the capital-intensive technology. We can use the insight from this model to gain a better understanding of the technologies used for production in the United States versus the technologies used for production elsewhere. Countries with higher wages tend to conduct a more capital-intensive production, while countries where labor is inexpensive have more labor-intensive production. In the next chapter, we will find out how perfectly competitive firms choose the profit-maximizing output, given their choice of technology and inputs.

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CHAPTER 4 Short-Run Costs and Output Decisions

Costs in the Short Run

A perfectly competitive firm has a limited number of actions that it can take in order to maximize profits. We also know that, while it can not set the price of the product that it is selling, it can decide how much to produce and what type of technology to use for that production. In this chapter, we will develop a detailed strategy for how a perfectly competitive firm makes these choices to maximize short-run profit. The basic strategy developed in this chapter will be used for other types of market organizations later on in the course. The profit of the firm is the total revenue less the total cost (economic cost). We will examine each of these elements in detail and then put them together to find a strategy for profit maximization in the short run. Costs are related to the choice of input used for production. The short-run, by definition, is made up of two kinds of cost fixed costs and variable costs. A fixed cost is a cost that does not change with the amount of output produced. For instance, if a firm is paying monthly rent for office space, that monthly rent does not change if the firm is making one unit or 1,000 units. A variable cost, on the other hand, is a cost that does change with amount produced. For many firms, labor is a variable cost. Generally speaking, the more you produce, the more labor you use. Fixed costs The total amount of fixed costs (TFC) and the total amount of variable costs (TVC) are added together to yield the total cost of production (TC). Following is a graph of the total fixed cost curve for a sandwich company. The fixed cost is the cost of the table and the two knives. Notice how the cost is fixed at $20 regardless of whether 0 or 40 sandwiches are produced.

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The shape of the total variable cost curve is rooted in the production function. The choice of technology to be used for production, as well as the cheapest input combination, determines the production function. Recall that the total product curve had an "S" shape to it. This was because, as you first add workers (or capital) they can specialize and produce more, but eventually the law of diminishing marginal returns kicks in, and the product does not rise as much when workers are added. The law of diminishing returns applies to the addition of any variable cost, not just labor. Since we are interested in how total variable costs change as we want to produce more, let us follow the story that made up the total product curve. Remember, when we are drawing the total variable cost curve we are putting output on the horizontal axis and total variable cost on the vertical axis. When no product is being produced, variable cost is zero. If no sandwiches are being made, then there is no reason to pay the workers. As output increases, total cost will rise, since more workers will need to be paid. The reason for this rise is that when adding workers, each worker will add more and more output. If we are paying the workers the same amount, then the total cost will be rising by less. Eventually, as production rises even more, there will be too many workers and the marginal product will fall. When the marginal product falls, the cost of making more will rise. Let us recall part of the output table from the previous lecture to determine total variable cost by assuming each worker is paid a lump sum of $10 for their work.

Labor Units 0 1 2

Total Product 0 10 25

Total Variable Cost 0 10 20

3 4 5 6

35 40 42 42

30 40 50 60

Now, let us graph the total variable cost.

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Note that the total variable cost curve also has an "S" shape. It gets flatter at first, when there is specialization and the marginal product is rising. The TVC curve then gets steeper when diminishing returns sets in and marginal product is falling. So the "S" shape of the total variable cost curve is determined by the law of diminishing returns. Now let us draw the total cost curve. Remember that total cost (TC) = TFC + TVC.

The TC curve looks just like the TVC curve, but it is shifted up by the amount of the TFC. This shift upwards happens when the TVC and TFC are added together.

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Fixed costs (cont.) Average fixed cost (AFC) The next set of cost curves that will be developed are the average cost curves, the first of which is the average fixed cost (AFC) curve. We will put dollars on the vertical axis and output (Q) on the horizontal axis. The formula for AFC is given below. AFC = TFC/Q Because the TFC does not change as Q increases, then the AFC will always get smaller as Q increases. We will compute the AFC using data from the previous example of the sandwich shop. Output (Q) 0 10 25 35 40 42 42 Total Variable Cost (TVC) Total Fixed Cost (TFC) 0 10 20 30 40 50 60 20 20 20 20 20 20 20 Total Cost (TC) 20 30 40 50 60 70 80 Average Fixed Cost (AFC) 2.0 0.8 0.6 0.5 0.47 0.47

The AFC curve is shown below.

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The average fixed cost is getting smaller and smaller due to the fact that the fixed cost ($20) is being spread over a large number of units produced. The decreasing of the AFC curve is sometimes called spreading overhead. Variable costs Average variable cost (AVC) The second average cost curve is the average variable cost (AVC) curve. The formula for the AVC is: AVC = TVC/Q The graph of the AVC is as follows: Output (Q) 0 10 25 35 40 42 42 Total Variable Cost (TVC) Total Fixed Cost (TFC) 0 10 20 30 40 50 60 20 20 20 20 20 20 20 Total Cost (TC) 20 30 40 50 60 70 80 Average Variable Cost (AVC) 1.00 0.80 0.86 1.00 1.19 1.43

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Total costs Average total cost (AVC) The final average cost curve is the average total cost (ATC). The formula for the ATC is ATC = TC/Q Using the data from above, we can graph the ATC along with the AFC and the AVC. Output (Q) 0 10 25 35 40 42 42 Total Variable Cost (TVC) Total Fixed Cost (TFC) 0 10 20 30 40 50 60 20 20 20 20 20 20 20 Total Cost (TC) 20 30 40 50 66 70 80 Average Total Cost (ATC) 3 1.66 1.43 1.50 1.67 1.9

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Notice that the ATC and AVC get closer together as the output increases. The two curves get closer together because the ATC = AVC + AFC. Since the AFC is getting smaller, the AVC and ATC must be coming closer together. Marginal costs The final and most important curve is the marginal cost (MC) curve. Marginal cost is the additional cost from producing one more unit. The formula for marginal cost is: MC = (change in TC)/(change in Q) Again using the data from the sandwich shop, we can derive the marginal cost for each quantity: Output (Q) 0 10 25 35 40 42 42 Marginal Product 10 15 10 5 2 0 Total Variable Cost (TVC) 0 10 20 30 40 50 60 Total Fixed Cost (TFC) 20 20 20 20 20 20 20 Total Cost (TC) 20 30 40 50 60 70 80 Marginal Cost (MC) 1 0.67 1 2 5 -

Notice how the marginal cost goes down and then back up again? By looking at the marginal product at the same time as the marginal cost, you can see that the marginal cost is going down while the marginal product is going up and visa versa. This relationship between marginal product and marginal cost is due to the fact that the MC will fall as production becomes more specialized. The MC then rises because of the law of diminishing returns. This distinction is a very important point. The marginal cost starts to rise because, as production increases more and more, the limitations created by the fixed input come into play. When the marginal cost curve is graphed along with the ATC, AVC, and AFC curves, it looks like the graph below.

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Note that the MC curve crosses the AVC and the ATC curves at the bottom of each of those curves. This is no coincidence. The MC curve will always cross the ATC and AVC at the bottom of those curves, thus illustrating a simple rule. When the marginal cost is above the average cost, the average cost must be rising; when the marginal cost is below the average cost, the average cost must be falling. We can see this rule illustrated by a student's grade point average (GPA). Just like the ATC is the average cost over the whole quantity produced, the GPA is the average grade over all classes you have taken. The marginal cost is the cost of making one more unit. The marginal grade would be the grade from taking one more class. If a student has a GPA of 3.0 and they get an A (4.0) in their next class, then the GPA will rise. If they receive a C (2.0) in the class, the GPA will fall. When the marginal grade is above the average grade, the average will rise. If the marginal grade is below the student's average grade, the average will fall. It works the same way for costs. When the marginal cost is above the average, the average will rise and visa versa. For further discussion on marginal cost as well as sunk cost, view the Internet Exercise entitled " Sunk Cost and Marginal Cost: An Auction Experiment." It illustrates these concepts through an experiment involving the auctioning of one dollar bills. With the inclusion of the Internet as a way of conducting business, economists are interested in how the costs of doing business have changed with this new technology. Would a firm that is using the Internet to do business have higher fixed costs and lower marginal costs than a firm that is using a typical storefront? If a firm produces software and is delivering their product through the download of software over the Internet, does this firm have any marginal cost? If not, how will that change the strategy of the firm?

Output Decisions: Revenues, Costs, and Profit Maximization

Total revenue (TR) and marginal revenue (MR) We now have a complete understanding of short-run costs. In order to examine profit, we need to look at the other half of the picture revenue. Total revenue (TR) is calculated as price multiplied by quantity. TR = P x Q We know that the perfectly competitive firm can sell as many units as it wants, as long as it charges the marketdetermined price. The total revenue (TR) curve is then drawn as an increasing straight line, where the slope of the

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line is equal to the market-determined price. For a product with a market price of $2, the total revenue curve is as follows. The total revenue for 10 units is $20; the total revenue from 30 units is $60; and so on.

The perfectly competitive firm must decide how much to produce. The firm will choose the quantity where profits are maximized. How does the firm find that quantity? We know that profit = total revenue - total cost. If the total revenue and total cost curves are drawn on the same graph, then the quantity to produce is found where the difference between the TR and TC curves is the largest.

From the graph, profit maximum occurs when 40 units are produced. At a quantity of 20 or 30 units, it is clear that the difference between TR and TC is smaller than at a quantity of 40. At a quantity of 10 units produced, the firm is actually losing money since the TC is more than the TR. How can a firm find this profit maximum without drawing TR and TC curves?

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Finding the profit maximum requires the use of the economic tool of marginal analysis. To use marginal analysis, we will need to introduce one last term and curve marginal revenue. The marginal revenue (MR) is the additional revenue the firm gets from selling one more unit. The formula for marginal revenue is: MR = (change in TR)/(change in Q) The marginal revenue for a perfectly competitive firm is simply the market price. This is because the firm can sell as many units of the good as it pleases without changing the price. The flat demand curve for the firm insures that the firm s price is always the market price. The marginal revenue curve is as follows:

If you were an advertising executive, would you suggest advertisement for a perfectly competitive firm? Can you think of an example of a perfectly competitive good being advertised? Total revenue (TR) and marginal revenue (MR) (cont.) You can think of marginal revenue as the amount of money a firm gets from selling one more unit. The profit maximizing strategy is for a firm is to find out if the additional money she it gets from selling one more unit is more than the cost of making one more unit. In other words, is the marginal revenue more than the marginal cost? If the answer is yes, then the firm would want to make one more because it will make money on that additional unit. As long as the MR is bigger than the MC, the firm should produce more. Once MR = MC the firm will want to stop production, because if it increases production, the MC will be bigger than the MR. If MC>MR, then the cost of making one additional unit is more than the amount of money received from selling one additional unit. Thus, the profit-maximizing quantity is where MC = MR.

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By looking at the previous graph, you can see that profit maximization occurs at a quantity of 40 units. You can also see the profit maximum by looking at the tables created during this lecture. Output (Q) 0 10 25 35 40 42 42 Marginal Cost (MC) Marginal Revenue (MR) 1 .67 1 2 5 5 2 2 2 2 2 2 Total Revenue (TR) Total Cost (TC) 0 20 50 70 80 84 84 20 30 40 50 60 70 80 Profit -20 -10 10 20 20 14 4

The profit maximum can be found by looking at the total revenue and total cost or the marginal revenue and marginal cost. Note how these two methods are related. The slope of the total cost curve is the marginal cost, and the slope of the total revenue curve is the marginal revenue. When the slopes of the two curves (TR and TC) are equal, then profit is at a maximum.

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Comparing costs and revenues to maximize profit As we study other forms of market organization besides perfect competition, you will find that the rule of producing where MR = MC is used in other market organizations. What is unique about perfect competition is that the MR = P (market price). Since MR = P and a profit-maximizing firm produces at a quantity where MC = MR, then a perfectly competitive firm will produce where P = MC. In other words, a perfectly competitive firm will find out what the price is and then it will look at its marginal cost curve to find the quantity to produce. If given a price, p, the MC curve tells the profit-maximizing firm how much to supply. The marginal cost curve is the (short-run) supply curve for a perfectly competitive firm! The supply and demand curves were introduced in an earlier lecture and it was shown without reason that the supply curve slopes up and the demand curve slopes down. It was learned in the previous lecture that the demand curve slopes down because of utility maximizationwhen the price of a good rises, the marginal utility per dollar falls, and so people buy more of other goods with higher marginal utility per dollar. In this lecture, it was shown that the supply curve slopes up because the marginal cost curve slopes upwards. Profit-maximizing firms use the marginal cost curve as a supply curve because marginal cost will equal marginal revenue at that quantity. This is how economists think in the short-run.

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CHAPTER 5 Introduction to Macroeconomics

The Roots of Macroeconomics

During the first two decades of the twentieth century, most economists believed that the economy was able to correct itself. For example, downturns in the economy, during which the economy slows down and people get laid off, are only temporary. During such a downturn, it was believed, wages would fall as unemployment rose because the decrease in demand for labor would push wage rates down. This lowers the costs of doing business for producers and they respond by lowering prices and increasing output. The lower wages and increased output leads to more workers being hired. Eventually, the output of the economy and the unemployment rate return to their original level. In the long run, the economy will be at full employment without the problems of unemployment inflation. This view seemed self-evident during the 1920s because jobs were plentiful, the economy was growing strongly, and prices were stable. Because of this, most economists thought there was little need for the government to try to influence the state of the economy. All of this changed, however, with the advent of the Great Depression. The Great Depression At the end of the 1920s, the U.S. economy began a steep and prolonged decline. The output of the economy plummeted. Unemployment began to soar from about 5% in 1928 to over 25% by 1933. Banks failed and many people saw their jobs and their wealth evaporate. Moreover, this was not a temporary downturn of the economy. The economy languished in this sorry state of affairs year after year. After several years in the depths of a severe economic downturn, the belief that the economy would fix itself seemed incorrect. Conditions were ripe for a different vision of how the economy operates. That vision was provided in a path-breaking book by British economist John Maynard Keynes entitled The General Theory of Employment, Interest, and Money. In Keynes' view, the economy's self-correcting feature does not work well, especially during an economic downturn. Recall that this self-correction relies on wages falling during slowdowns. Keynes maintained that wages are "sticky," especially in the downward direction. Not only are people more reluctant to take pay cuts than pay raises, but many workers are subject to long-term labor contracts in which wages are set. Thus, when the economy slows down and unemployment rises, wages are not likely to fall appreciably. In turn, producers are not likely to re-hire workers and increase production. The economy can languish in a state of low demand, low incomes, and high unemployment. Because the economy may not be able to correct itself, Keynes put forth the notion that the government can intervene to improve the economy. Keynes believed that the reason economies decline in the short run is that the overall level of demand falls. Because fewer goods are demanded, fewer are produced. In turn, fewer workers are needed, incomes fall and unemployment rises. To counter the fall in overall demand, Keynes believed that the government could stimulate demand and get the economy moving. Recent macroeconomic history It is hard to overstate the influence that Keynes had on economics and on policy makers of many industrialized countries. In the United States, President Franklin Roosevelt and Congress began to stimulate demand by creating federal job programs; beginning the construction of dams, roads, government buildings, and a host of other "New Deal" programs. (Take a look at the New Deal Network.) The end of the Great Depression saw massive increases in government spending, primarily for military hardware, operations, and personnel associated with the United States involvement in World War II.

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For more on Franklin D. Roosevelt and the Great Depression, visit the Internet resource site Franklin D. Roosevelt Library and Museum. During the post-war period, policy makers undertook to change taxes, interest rates, and the nation's money supply, in addition to government spending programs, in order to influence the state of the economy. During the Kennedy and Johnson administrations, economists believed that the economy could be fine-tuned to achieve the desired rates of economic growth, employment, and inflation. This rosy view was shattered by the oil shocks of the 1970s, when unemployment and inflation rose sharply and unexpectedly. The persistence of "stagflation" dealt a severe blow to the notion of fine tuning the economy. This crisis in macroeconomic thought led to the development of new theories and ways of looking at the economy. We will look at some of these theories and new ways in later lectures.

Macroeconomic Concerns
We will now take an introductory look at three of the main concerns of macroeconomics: inflation, the growth of output of the economy, and unemployment. Governments are often called upon to promote economic growth, low unemployment, and stability. Some of the questions that concern macroeconomists include the following: How can government achieve these goals? How can policymakers know when to implement measures to achieve these goals and judge whether they are successful? In this and following lectures, we will address these questions. One thing to keep in mind is that nearly all macroeconomic concerns are interrelated and attempts to prove one of these concerns invariably affects the others. Inflation One goal of macroeconomic policy is price stability. Thus far, we have talked about changes in relative prices. For example, when the demand for a particular good increases, its price will rise relative to other goods. Changes in relative prices are finethey are the price system performing its allocation and distribution functions. It is inflation, an increase in the overall price level, that is of concern to macroeconomists. We will look at some of the causes of inflation in later lectures, but for now we should recognize that the effects of inflation can seriously undermine an economy. When prices rise more rapidly than wages, people lose much of their purchasing power and living standards decline. Workers demanding higher wages can cause producers to raise prices even higher and a wageprice spiral can result. Among the other problems caused by inflation are the effects on interest rates, which can increase dramatically and impede the use of credit in an economy. The United States has been blessed with low rates of inflation. The worst inflation in recent years was the doubledigit inflation when prices rose at an annual rate of up to 13% during 1979 and 1980. President Reagan's efforts to "break the back of inflation" resulted in a severe economic downturn during the early 1980s. For a look at inflation, refer to the Economic Statistics Briefing Room at the White House. You'll see recent statistics on inflation. Peruse this site for interesting information about the different measures of inflation. For example, at the Consumer Price Indexes page, you'll get charts, historical information, and more on this common inflation measure. Output growth In addition to price stability, another goal of macroeconomic policy is stable output growth. Stable output growth means an avoidance of business cycles. These cycles consist of short-term booms and declines in the aggregate output of the economy. These fluctuations of the economy, consisting of cycles of recession and expansion, occur in every country. Overly rapid expansions can cause inflation and its resulting problems. Declines in economic output can send economies into recession or even depression.

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Determining the causes of business cycles and what can be done to minimize them are among the primary concern of macroeconomics and policy-makers. In addition, the more long-term question of what contributes to steady economic growth over time is also a major concern. Why is the growth of an economy over time important? To address this question, think of what would happen if there is no growth of the economy over time. In such a situation, the total amount of goods and services would remain constant over time. With increases in population, the economy would be dividing a given amount of goods and services among more and more people. The amount of goods and services per person would decline, amounting to a decline in the standard of living for the people in the economy. Remember the campaign question, "Are you better off than you were four years ago?" The answer would always be a resounding, "No!" Unemployment Yet another goal of macroeconomic policy is full employment. Full employment is not when everyone in the economy is working. It is expected, for example, that some people are between jobs and are looking for new and better work. For this and other reasons, there will always be some unemployment. The amount of unemployment in the economy is measured by the unemployment rate, the percentage of the labor force that is unemployed. Changes in the unemployment rate can occur because of changes in either the number of unemployed workers or the number of people in the labor force. During recessions, the unemployment rate goes up because some workers become unemployed due to the overall economic slowdown. It may also go up when there are large numbers of people entering the labor force who do not have jobs immediately. For example, the unemployment rate typically goes up in June slightly due to large numbers of new college graduates who may require a few weeks to find work. During the first part of 1998, the unemployment rate in the United States remained at just under 4.5%. This means that less that 4.5% of the labor force is not employed, but is looking for work. This is the lowest unemployment rate in nearly 30 years and represents a very good job market for workers. In the United States these conditions represent full employment.

Government in the Macroeconomy

How can the goals of price stability, steady economic growth, and full employment be achieved? That is the key question of macroeconomics! We will be looking in-depth at some of the ways the government may be able to influence the economy so as to achieve those goals. There are three types of policies the government employs to influence the economy. Fiscal policy involves changes in the government's spending or tax policies in order to affect the economy. We have mentioned this type of policy earlier in this lecture when discussing the innovations of John Maynard Keynes. Keynes advocated stimulating overall demand during a recession by "expansionary fiscal policy," which means increasing government spending and/or cutting taxes. Such measures will put more money into the hands of people in the economy and this money will get spent and re-spent on goods and services. This will increase economy-wide demand and begin to bring the economy out of the doldrums. Conversely, contractionary fiscal policy, raising taxes and/or cutting government spending, can be used to cool off an economy that is undergoing inflation. Monetary policy is another available policy tool the government can use to influence the economy. Governmental policy-makers can change the nation's money supply and interest rates in order to influence the economy. Supply-side policies are also used by the government to influence the economy. Advocates of this policy tool claim that, rather than focusing on the demand side of the economy, efforts to stimulate economic growth should concentrate on the supply side. Early proponents of these policies during the Reagan Administration emphasized the use of tax cuts and tax incentives to stimulate savings, investment, and labor supply. More recently, the focus

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has shifted toward promoting long-run economic growth by stimulating research and development, technological innovations, and other measures designed to increase productivity.

The Components of the Macroeconomy

The circular flow diagram Any market economy comprises the interactions of households, firms, the government, and other nations. We have discussed the interaction of two of these components, households and firms, in an earlier lecture. There, we introduced the circular flow between the input and output markets. Now, let us add the other components of the economy to the circular flow diagram.

This figure above shows that households work for firms and the government, receiving wages in return for supplying labor. In addition, households receive interest payments, dividends, profits, and rent from firms on their investments in stocks and bonds, ownership of companies, and land used by firms. Households also receive interest and transfer payments from the government for purchases of government bonds as well as for Social Security, welfare, and other transfer programs. The diagram also shows that firms and households pay taxes to the government. It also illustrates that households, the government, and foreigners purchase goods and services from firms. Finally, it shows that households purchase goods and services from foreigners. This complex interaction occurs within three basic types of markets: goods and services, the labor market, and the financial market. In essence, the circular flow diagram tracks the flows of these three components of the economy. Firms, both foreign and domestic, produce goods and services that are consumed by households and government in return for revenue. Households supply labor to firms and the government in return for wages. Finally, financial assets flow between firms, households, and foreigners. When households or foreigners purchase government bonds, such as Treasury bonds, notes, and bills, they receive interest payments. When households or foreigners purchase corporate bonds and shares of stock, they receive interest and dividend payments. When households or foreigners purchase real estate, they receive rents. Economic activity in a market economy consists of the flow of money for products, labor, and financial assets.

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The Methodology of Macroeconomics

Aggregate demand and aggregate supply Consider all the goods and services being demanded in the economy. These comprise aggregate demand. Aggregate demand consists of the following categories of spending: consumption spending by consumers, purchases of new factories and equipment by firms (this type of spending is called investment), purchases of goods and services by government, and net exports (the difference between goods and services produced in the U.S. and exported to other countries and those made in other countries and imported into the U.S.). All of these different components of the economy, consumers, firms, government and foreigners, demand the goods and services produced in the economy. If all of this demand is accumulated across the whole economy, it adds up to the economy's aggregate demand. Now consider all of the goods and services being produced in the economy. These comprise aggregate supply. If all of the goods and services produced by all of the firms in the economy at different price levels is summed, we get aggregate supply. As with aggregate demand, the total amount of goods and services supplied by the economy will vary with the price level. Producers prefer high output prices to low output prices. At high prices, producing output is more profitable and, as a result, producers will be willing to produce more output at high prices than low prices. Thus, aggregate supply increases with the overall price level. The aggregate supply and aggregate demand for an economy can be represented graphically. Although they resemble the market supply and demand curves that we introduced in an earlier lecture, they are vastly different. Instead of the price of an individual product on the vertical axis, there is the overall price level on the vertical axis here. Instead of the output of one good on the horizontal axis, there is the total aggregate output for the economy on the horizontal axis here. Let's look at the following figure:

The aggregate supply and demand diagram shows the overall price level and aggregate output on the axes. The aggregate supply curves slopes upward to the right to show that producers will be willing to supply more output at higher price levels than at low price levels. The aggregate demand curve slopes downward to the right to show that consumers are willing to buy more goods and services in total at low prices levels than at high price levels. When we discussed individual markets in earlier lectures, the point where the market demand and supply curves cross indicates the equilibrium price and quantity of a particular good. Now we have something analogous with the

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aggregate supply and demand curves except that instead of the quantity of a particular good, the intersection indicates the overall quantity of all goods and services produced in the economy. Similarly, rather than the equilibrium price of a particular good, it is the overall price level of all goods and services that is indicated. Later on, we'll utilize the aggregate demand and supply diagram to examine changes in the economy and the effects of fiscal, monetary, and supply-side policies. For example, expansionary fiscal policy, such as increasing government purchases, will increase the demand side of the economy. The reason is that, if the government increases its purchases of goods and services, for example, more will be demanded at any given price level. This increase in aggregate demand causes the aggregate demand curve to shift to the right which, in turn, leads to an increase in the equilibrium level of aggregate output. That's just what we claimed earlier in this chapter in the discussion on fiscal policy! Recall that we said Keynes claimed increases in government spending on goods and services can jump-start the economy and begin to bring it out of a recession. It is this improvement in the economy, following the implementation of fiscal policy, that is shown by the increase in equilibrium aggregate output on the aggregate demand and supply diagram.

The U.S. Economy in the Twentieth Century: Trends and Cycles

We will use the aggregate demand and supply framework to illustrate a wide range of economic activity. For example, changes in aggregate demand or aggregate supply can cause fluctuations in aggregate output. Recessions, for example, can be caused by decreases in aggregate demand. Keynes noted that recessions could begin when spending by consumers, businesses, or foreigners declines. This leads producers to reduce output and causes an overall decline in economic activity and aggregate output. The decline in aggregate demand is represented by a leftward shift in the aggregate demand curve, and the resulting recession is shown by the decrease in the equilibrium level of aggregate output. Expansion and contraction: The business cycle These short-term changes in aggregate demand or supply cause fluctuations in aggregate output. These fluctuations define the business cycle. While the U.S. economy tends to grow over time, there are short-term fluctuations around the long-run trend. Recessions are defined as declines in aggregate output over a period of time. When the economy has declined to its lowest level, it is in what is known as the trough of the recession. When the economy begins to improve and aggregate output increases, the economy is said to be in expansion. When the economy reaches its highest level, it is said to be at its peak. A typical business cycle is illustrated in the following figure:

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Note that when the economy is in recession, aggregate output (noted as Gross Domestic Product in the figure) declines over time. Although the figure above shows recessions and expansions as being roughly symmetric, that is not really the case. According to the National Bureau of Economic Research (NBER), "a recession is a recurring period of decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy." Expansions can range in duration from several months to several years. You will have a chance to go to the NBER Web site to find out more about business cycles in the United States for the following in-line exercise. After you complete the exercise, we will look briefly at the pattern of expansions and contractions of the United States economy since 1970.

The U.S. Economy in the Twentieth Century: Trends and Cycles (cont.)
The U.S. economy since 1970 Since 1970, the U.S. economy has grown steadily. Both aggregate output and the number of people working has increased significantly overall. However, the economy has experienced three recessions of varying duration since 1970. During those recessions, aggregate output has fallen and unemployment has risen. These recessions are shown in the following figures:

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The three recessions show up as declines in aggregate output (labeled "real GDP" here) and as increases in unemployment over the same period. The recession of the early 1980s was the most severe recession of the post World War II period in terms of duration and the severity of unemployment, which reached 11 percent.

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CHAPTER 6 Measuring National Output and National Income

Gross Domestic Product

Recall one of the goals of the government's economic policies: stable economic growth. What is desirable is economic stability and avoiding business cycles. Recall also that one aspect of business cycles is the fluctuations of aggregate output, but how is this aggregate output measured? There are different ways of measuring it. By looking at these ways, we will get a better idea of not only what aggregate output is, but also how the economy works. Gross domestic product (GDP) is the most common way of measuring the total output of the economywhat we have been calling aggregate output up until now. The two principle methods of measuring it are the expenditure approach and the income approach. In the expenditure approach, the spending on goods and services by households, government, firms, and foreigners are added-up. The income approach involves adding-up the income received by various components of the economy. Broadly speaking, GDP is the dollar value of all final goods and services produced within the domestic economy during a specified time period. In the news, you may hear about GDP for a given quarter or for a year, as these are the two most common time periods used. You can find the GDP figures for the most recent years, as well as the most recent quarterly data, at the U.S. Commerce Department's Bureau of Economic Analysis (BEA) Web site. As shown there, the U.S. GDP for 1998 was $8,511 billion. Let us look at what is and is not counted in measuring GDP. Final goods and services Only final goods and services are counted in GDP. This means goods that are sold to their final consumer. Intermediate goods are not counted in calculating GDP. Intermediate goods are those used in the production of other goods. Let us assume that you get a large pepperoni pizza for $13.95 for dinner. You and your friends are the final consumers of the pizza, so the $13.95 gets counted toward GDP. But what about the pepperoni, cheese, and other ingredients used to make the pizza? Let us say that the pizzeria used $1.15 worth of pepperoni on your pizza. Should that be counted? The answer is; it already is! When the pizzeria sells you the pizza, the value of all the ingredients is already included in the final selling price. Counting those ingredients separately and then counting the value of the pizza would, in effect, count those ingredients twice. Another way to calculate the value of final goods is to include the value added by the intermediate goods or services, rather than counting the total value of each intermediate good. The following table from the text illustrates this nicely:

Here, four intermediate steps are involved in bringing a gallon of gasoline to the final consumer. The oil is drilled, refined, shipped, and then sold to the retailer. Rather than adding the value of the product exchanged at each step, only the added value of each step is added. Either way it is done, counting the value of the final product or the value added along the way to a product's final sale, the result is the same.

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Exclusion of used goods and paper transactions Let us say you come into some money and decide to buy a few things. You need a car, so you get a great deal on a used car (maybe the '57 Chevy, mentioned in the Lecture Objectives). You need a place to live, so you buy the house where your aunt used to live. You need to furnish it, so you get a used refrigerator for the kitchen. You have spent thousands of dollars and must have added a lot to this year's GDP, right? You may be surprised to learn that none of the purchases mentioned are counted in GDP because they are all used goods. The value of the used car was counted when the car was produced. Counting it now would mean that it was counted twice. It is only a single car and should be counted only once! Similarly, the sale of an existing home, used refrigerator, and other preowned items are not counted toward GDP. Now let us say that, after buying all the items mentioned above, you put some of your money in the stock market. Assume that you buy 1,000 shares of Microsoft stock at the beginning of the year and sell several months later for a tidy profit. Surely, that has to count in GDP? Although these types of paper transactions amount to billions of dollars every day, they are not counted in GDP. Even though the sales of stocks and bonds are not counted, any commissions that are paid are counted toward GDP because the broker involved is performing a service. Exclusion of output produced abroad by domestically owned factors of production Let us say that you take some of the profits from your sale of stock and buy a new, sporty foreign car (perhaps the Porsche Boxster mentioned in the Lecture Objectives). Does this sale, involving tens of thousands of dollars, count in GDP? Although you bought the car from an automobile dealer in the United States, the car was made abroad. As a result, it does not count in GDP. In this case, the car was not produced in the United States and the company is German. What about a Chevrolet made in Mexico and sold in the United States? To be counted in the GDP of the United States, the product must be produced in the United States. Products made in other countries, even if domestic companies make them, are not counted. This brings us to the distinction between gross domestic product and gross national product (GNP). In GNP, goods that are produced by domestic companies are counted, regardless of whether they were made in plants in the United States or abroad. Similarly, goods made by foreign-owned companies, even if they were produced in a factory located in the United States, are not counted in GNP. Thus, a Toyota Camry made in a factory in Tennessee would not be counted in GNP, but would be counted in GDP.

Calculating GDP
As we mentioned earlier, GDP can be calculated by either adding up all of the expenditures on goods and services produced in the economy or by adding up all of the income received by labor and other inputs in the economy. These are the expenditure and income approaches to calculating GDP. We will focus on the expenditure approach in this lecture, but we will also introduce the income approach. The expenditure approach The expenditure approach involves counting expenditures on goods and services by different groups in the economy. The four main components are consumption expenditures by households (C), gross private investment spending principally by firms (I), government purchases of goods and services (G), and net exports (exports minus imports EX - IM). Here is an equation that sums it up: GDP = C + I + G + (EX - IM)

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Let us look at the following table:

As you can see, expenditures can be broken down into the four components given in the equation above. The largest is personal consumption spending by households on final goods and services. Households can buy durable goods, those that last for some period of time, such as motor vehicles and furniture, as listed in the table. In addition, households can purchase non-durable goods, which are goods not intended for long-term use, such as food, clothing, and gasoline. Households also purchase services, which are actions rather than physical items. Examples of services range from medical care, car repairs and other transportation expenses, to haircuts and tax preparation services. The second largest component of GDP consists of purchases by federal, state, and local governments on final goods and services. These purchases include spending on schools, roads, and military hardware. In addition, the wages of government employees are included because such employees are performing services in exchange for those wages. This category does not include income transfers, such as Social Security payments to retired persons, unemployment compensation, or welfare payments. Investment spending comprises the third largest component of GDP. The table shows that there are also three main types of investment spending. The first is nonresidential investment spending by firms on machines, factories, tools, office buildings, and similar expenditures. Residential investment consists of expenditures by households on new houses, condominiums, and apartment buildings. Business inventories are goods that firms produce in one time period with the intent to sell later. The smallest component of GDP is net exports. The expenditure approach includes the value of exports, goods produced in the United States and purchased in other countries. The value of imports, the purchases by United States citizens of foreign-produced goods, is subtracted from the value of exports. The income approach The expenditures on goods and services by consumers provide income for firms. Similarly, government expenditures on goods and services provide income for the firms supplying products and the workers supplying services. Thus, the flip side of the expenditure approach is to add together the income for different components of the economy. The components used in the income approach are illustrated in the following table:

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As shown in the table above, the general approach to income accounting is to begin with national income. This consists of the compensation of employees (wages and salaries paid to households), proprietors' income (the income of proprietorships and partnerships), corporate profits (the income of corporations), net interest (the interest paid by businesses), and rental income (the income received by property owners). This yields all the relevant income flowing to each segment of the economy. Once national income is determined, a few adjustments need to be made. First, depreciation is added because the replacement of physical capital (machinery, factories, buildings) in the economy that has undergone wear and tear over time is not included in national income. In addition, national income needs to be adjusted because of differences in how national income and GDP treat income earned by foreigners working in the United States, and income earned by United States citizens working abroad. National income includes income made by United States citizens who are abroad, but GDP does not. GDP includes income earned by foreigners working in the United States, but national income does not. Thus, payments made to United States citizens working abroad must be deducted from national income and the payments made to foreign citizens working in the United States must be added. These additions and subtractions are termed the net factor payments to the rest of the world in the table above. A couple of other minor adjustments still need to be made. First, the value of subsidies paid by the government (for example, payments made to farmers for not planting crops) are also deducted because no services are received in exchange for those payments. Finally, because indirect taxes (sales taxes, fees) are included in the price of goods and services in the expenditure approach, they should also be included in the income approach. Therefore, payments for indirect taxes are added to national income.

From GDP to Disposable Personal Income

An important distinction is the difference between gross national product (GNP) and GDP. Many people (such as your parents or grandparents) grew up with GNP as the primary measure of the output of the economy. Now, however, GDP is more commonly used. If your parents or grandparents ask about the differences between these two concepts, would it not be nice to be able to answer them? Let us take a brief look at the difference. Conceptually, GNP measures the output of all domestically owned factors of production, while GDP measures the output of factors of production located within the domestic economy. How do these differences translate into the real world? Consider, for example, a Honda automobile assembled in Tennessee. If the car is sold in the United States, it will be counted in GDP because the factory is located within the United States. It would not be counted in GNP, however, because the factory is owned by a foreign company. Conversely, consider a Chevrolet factory located in Mexico. Because it is owned by a United States corporation, the value of the cars produced there would be counted in GNP. Since the cars are not produced within the United States, the value of these cars would not be included in GDP.

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To get a firmer grasp of the idea, think of a country like Saudi Arabia. Which is larger, GNP or GDP? On the one hand, there are many foreign workers employed in Saudi Arabia. The output of these foreign workers is part of Saudi GDP, but not GNP. On the other hand, Saudi Arabians own businesses, real estate, and other assets in other countries. The income derived from these assets is included in Saudi GNP, but not GDP, because the production takes place abroad. In theory, either answer could be correct, but in fact, Saudi earnings from foreign assets are so large that they dominate the foreign worker effect. Saudi Arabia's GNP is significantly larger than its GDP. The concept of GNP leads directly to the economic measure of national income, discussed above, and to the measures of per-capita income, such as personal income and disposable personal income. The path from GDP to the other measures of economic output is shown by the following table:

Nominal Versus Real GDP

There are some limitations to the use of GDP as a measure of our economic well being. We will look at one of these now and discuss other limitations later in this lecture. What if you read that GDP has increased over the last year? Does that mean the economy has produced more goods and services during the year? This is not necessarily true. Recall that GDP is the value of final goods and services. How is this value measured? GDP is measured in current year dollars, meaning the year in which the goods and services are produced. Current dollars are also known as nominal dollars and, thus, this measure of GDP is known as nominal GDP. Because nominal GDP uses current dollars to measure value, it gives rise to a limitation. With inflation, prices increase across the economy. This means the prices used to measure GDP go up. An increase in GDP, therefore, can stem from an increase in aggregate output and/or an increase in prices. Therefore, if a news report cites an increase in GDP, it may simply be due to an increase in inflation. Consider a situation where the economy simultaneously experiences both recession and high inflation, as it did during the "stagflation" of the late 1970s. If the rate of inflation exceeds the rate of contraction of the economy, GDP could increase even though aggregate output declines! Let us look at another measure of GDP as given on the BEA National Accounts Data Web page. As you will notice, this table measures output in "billions of chained (1992) dollars." Why measure today's output in 1992 dollars? The main reason is to control for the effects of inflation. We will now look at how and why this is done.

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Calculating real GDP As we just discussed, nominal GDP can increase solely due to inflation. We are interested in whether the economy is really growing or declining. To know this, we need another measure of aggregate output, one that corrects for the effects of inflation. Such a measure is termed real GDP. One way to do this is to use the same dollars when determining the value of goods and services. In other words, GDP could be measured in constant year prices, meaning the dollars of the same year. For example, if 1998 output is measured in the prices for goods and services that prevailed in 1997, then the output for one year can be compared to another. In this example, where 1997 prices are used to calculate the GDP of another year, 1997 is known as the base year. Until 1995, real GDP was calculated using 1987 prices, meaning that 1987 was the base year used for the early 1990s. Look at the example of an economy with three goods for two years as given in the following table:

The prices and quantities of each good in each year are given. Column (5) gives the nominal GDP for year 1. For each good, the quantity is multiplied by the price. Then, the value of the goods is calculated by aggregating the resulting dollar values. Similarly, column (8) gives the nominal GDP for year 2. Column (6) illustrates the traditional method for calculating real GDP. Here, the quantities of each good produced in year 2 are multiplied by the prices for each good in the base year (year 1 in this case). Since 1995, the BEA has used a new method to calculate real GDP. This new method uses what is known as "chaintype annual weights" which, in essence, uses an average of base years. Let us take another quick look at the BEA's table for real GDP. As you will see, the BEA measures real GDP in billions of chained dollars. This means that a rolling, geometric average is used to calculate the prices used for calculating real GDP. Calculating the GDP price index Both real and nominal GDP are measures of the overall quantity of goods and services produced by an economy. The difference between them is that real GDP corrects for inflation. The method for correcting for inflation, by using a rolling average of prices from year to year, can be used to estimate inflation. This estimate is the GDP price index. One advantage of this measure of inflation is that economy-wide prices are used to calculate inflation. In the next lecture, we will look at other measures of inflation that use the prices for only a small number of goods and services.

Limitations of the GDP Concept

There are a number of aspects of economic activity that are not included in the measures of nominal and real GDP. In order to be counted, goods and services must be sold in a market. This excludes much activity for many economies.

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Household production, for example, is not counted. Although the value of a loaf of bread that is bought in a store is counted, the value of a similar loaf baked at home is not. In this instance, only the value of the flour, yeast, and other ingredients bought in the store will be counted. Similarly, if you spend the day cleaning your house or apartment, only the cleaning products you used will be counted in GDP. However, if you hire a cleaning service to do the job, the price you pay will be counted. One result of this is that the GDPs of less developed countries, in which household production plays an important role, can be biased downward in comparison to those of GDPs of more industrialized countries. Other aspects that affect the standard of living for the participants in an economy are not included in GDP. Some destructive events can actually add to GDP. For example, if a hurricane rips through an area and billions of dollars are spent rebuilding homes, businesses, and other structures, those expenditures will add to GDP. In addition, some destructive aspects of economic activity are not subtracted from GDP. For example, although the value of electricity sold is counted, the negative effects of the air pollution that is created during the generation process are not deducted. We should also note that goods and services have to be sold legally in order to be counted in the GDP. This excludes the underground economy. For example, marijuana is one of the major cash crops grown in some states, but it is excluded from GDP. For some countries, such as Columbia and Mexico, the exclusion of illegal economic activities results in a downward bias to estimate their GDP. Per capita GDP/GNP An increase in real GDP means an economy has grown from one period to the next. Does that mean the standard of living for the participants of the economy has improved? In addition to the limitations of GDP just discussed, changes in the population should also be considered. Consider, for example, an economy with an increase in real GDP of 2% and an increase in population of 10% per year for several years. Although the total output of the economy has gone up, each person in the economy will, on average, have a lower standard of living as time goes by. The participants of such an economy will therefore experience a decline in living standards. To measure the economic output on a per-person basis, economists use per capita GDP or GNP. To arrive at this measure of economic well being, GDP or GNP is divided by the population. Although not perfect, this measure gives a good indication of the average economic standard of living for a society. The table to the right shows per capita GNP for 1997 in several countries. It shows that some countries have a much lower level of economic well being than others.

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CHAPTER7 Macroeconomic Concerns: Unemployment, Inflation, and Growth People fortunate enough to grow up during the 1990s have experienced extraordinary economic times. They have seen strong economic growth, low inflation, and low unemployment. Although the overall trend of the economy is overwhelmingly positive, with stable prices and increasing output and employment, things are not always rosy. There are times when the economy declines and times when it expands too fast. At such times, the economy experiences problems with the twin evils of inflation and unemployment. Let us look more closely at these fluctuations and their associated problems.

Recessions, Depressions, and Unemployment

Depressions are severe and prolonged economic downturns during which millions of people can be out of work for several years. The Great Depression was the worst economic calamity experienced in the United States during this century. Recessions, you will recall, are less severe and do not last as long. In terms of severity and duration, the difference between recessions and depressions is somewhat murky. As we mentioned in a previous lecture, the worst recession of recent years occurred in the early 1980s. The following table compares the downturns of the 1930s and 1980s:

You will notice that the number of unemployed persons and the unemployment rate rose during recessions and depressions. Let us look at the problem of unemployment in a bit more detail. Defining and measuring unemployment The most common measure of unemployment is the unemployment rate. The unemployment rate is the ratio that compares the number of unemployed people to the number of people in the labor force. In other words,

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It is important to keep in mind that the labor force is not the same as the population. To be in the labor force, a person must be over 15 years old, be available to work, and either be employed or unemployed. In other words,

We should note a couple of things here. First, a person can work for as little as one hour per week and be considered employed! Second, not all people who are without work are considered to be unemployed. Unemployed people are out of work members of the labor force who have made specific efforts to find work during the previous four weeks. People without a job and who are not looking for work are not considered to be in the labor force. The distinction between those considered to be unemployed and those not in the labor force is important and tends to bias the unemployment rate. For example, discouraged workers who have given up looking for a job are not counted as being unemployed! This bias gives rise to two counter-intuitive features about recessions and recoveries. During the trough of a recession, when the number of people out of work is the highest, the unemployment rate can actually go down! This phenomenon, known as the discouraged-worker effect, occurs because discouraged workers drop out of the labor force. During the beginning of recoveries, on the other hand, the number of people with jobs generally increases, but the unemployment rate often goes up! This happens because discouraged workers, who have not been included in the labor force or in the unemployment rate, begin to feel more optimistic about their job prospects and begin to look for work. This influx into the labor force will increase the unemployment rate because these workers are counted as unemployed until they find work The costs of unemployment As surprising as it may seem, some types of unemployment are not considered to be a problem, while other types are. To realize why, we should recognize the different reasons for being unemployed and why some unemployment is a necessary, and perhaps even desirable, part of a dynamic economy. Let us look first at the different types of unemployment. Consider a recent college graduate with a degree in business administration. Although this person could easily get a relatively low-skilled job, such as taking orders at a fast food restaurant, he or she wants to put that education to work, and is looking for a job in a large investment firm. Such a person is an example of frictional unemployment. There will always be people who are out of work while looking for jobs for which they are well qualified or which are more desirable. As a result, there will always be some unemployment due to job search activities. Frictional unemployment will exist in any economy where people are free to choose their own jobs. Another type of unemployment that arises naturally in a dynamic economy is structural unemployment. This type of unemployment is due to changes in economic institutions, geographic displacement, technological change, and similar factors. For example, one result of the technological revolution is that personal computers have become more common than typewriters in the homes and workplaces of the United States. The dramatic decline in the number of typewriters sold in the United States means many workers, who were formerly making typewriters, are now employed in other industries. Such changes are inevitable in an ever-changing economy.

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The costs of unemployment (cont.) Cyclical unemployment and lost output Consider the following table from the Bureau of Labor Statistics (BLS):

This chart shows how employment in several sectors of the economy is expected to change over the next 10 years. Because the economy continually undergoes structural changes over time, there will always be some structural unemployment. The presence of frictional and structural unemployment is considered a natural, necessary, and even healthy part of an economic system. The combination of these two types of unemployment is called the natural rate of unemployment. This occurs as a natural part of a normal economy. One type of unemployment, on the other hand, is indicative of an economy that is not normal and healthy. Cyclical unemployment arises when the economy takes a turn for the worse. Recall that business cycles are fluctuations in the economy that cause changes in output and unemployment. The increase in unemployment over the natural rate is considered to be cyclical unemployment.

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You can see from this figure that during recessions, the unemployment rate climbs. Cyclical unemployment consists of this increase in unemployment during recessions and depressions. When the unemployment rate goes above the natural rate, there are personal, social, and economic costs that are borne by the economy and the people within it. The personal costs stem from the fact that many people lose their jobs, their income, and perhaps their homes and families. Many people are thrown into poverty during recessions and depressions. This gives rise to many of the social costs associated with unemployment. An increase in unemployment means the number of poor people also increases. For example, during the recession of the early 1980s, the number of people in poverty rose by 10 million. This gives rise to an increasing number of welfare recipients and expenditures for unemployment and welfare programs. The following figure shows the relationship between unemployment and welfare recipients over a 20-year period. As you can see, the recessions of the early 1980s and 1990s not only resulted in higher unemployment, but in an increase in the share of the population on welfare.

Unemployment results in additional costs to the economy. With a decrease in the number of people who are working, there are fewer workers producing goods and services and is therefore a commensurate decrease in

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output. In short, the economy is not producing as much as it could be producing. This is lost output that cannot be recouped. The estimates of lost output for the U.S. economy due to recessions since 1974 range up to $1.5 trillion. The benefits of recessions After the discussion of the severe costs of recessions, it may seem strange to think there can be benefits associated with recessions. As mentioned in the lecture for chapter 21, government policy during the early part of President Reagan's administration deliberately incurred the recession of the early 1980s in order to break the back of the high inflation of the late 1970s. The following table shows that inflation declined during the recessions of the mid1970s and early 1980s.

Inflation
Inflation is an increase in the overall level of money prices in an economy. An increase in the price level causes a decrease in the purchasing power of each dollar, meaning each dollar buys less than it did before. Keep in mind that an increase in the price of a particular good does not, by itself, constitute inflation. For example, an increase in the demand for organic cotton leads to an increase in its price relative to other goods. Inflation, on the other hand, occurs when there is an overall increase in the price of goods in an economy. Price indexes During inflation, some prices may increase more rapidly than other prices. How, then, is the overall increase in prices measured? There are a number of price indexes used to measure inflation. We have seen one of these already: the GDP price index discussed in the previous lecture. The measure of inflation most often cited in news reports is the consumer price index (CPI). Rather than use prices for all the goods and services in the economy, the CPI uses the prices of a few goods that represent those consumed by typical households. Each month, employees of the Bureau of Labor Statistics (BLS) go to retail stores, doctors' offices, and a host of other locations to collect about 90,000 prices for the items included in its typical market basket of goods and services. Once the prices are collected, an index of these prices is calculated. For more on how the CPI is constructed and what it is used for, check out the Internet resource site "The Consumer Price Index: Why the Published Averages Don't Always Match An Individual's Inflation Experience." The indexes of these consumer prices can be compared to determine the rate at which prices are rising. Please take a look at the list of the CPI and corresponding inflation rates at this Web site from the Bureau of Labor Statistics (BLS) . To further better understand the problems with the CPI, its importance, and its overstatement of the inflation rate, look up the Internet resource article "Why Inflation Figures Are Inflated." In addition to the CPI, other indexes of prices are constructed. Another common index is the producer price index (PPI) which uses the prices that producers receive for products, rather than the prices that consumers pay. Regardless of which index is used, the basic way of using these price indexes to measure the rate of inflation is the same. Inflation is measured by calculating the rate of change in a given price index from one time period to the

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next. For example, annual rates of inflation using the PPI are calculated by calculating the rate of change of PPI from one year to the next. The basic formula is:

Note: the fraction in the formula has been multiplied by 100 in order to convert it to a percentage. Let us use some of the data for 1996 and 1997 from the BLS table mentioned above to calculate the rate of inflation using the CPI. From the table, we can see that the CPI averaged 156.9 for 1996 and 160.5 for 1997 (note, these numbers may be revised somewhat by the time you read this). Using 1996 as year 1 and 1997 as year 2, the rate of inflation from 1996 is calculated as

This is the figure given in the BLS table for the inflation rate using the average CPI for these years. The costs of inflation Although people often complain about the high prices these days, they often miss an important point: it is the price of goods and services relative to income that matters. You can think of it this way: Suppose the prices of all products doubled and incomes doubled during the same time period. Although things cost twice as much, people have twice as much income to buy them with. Nothing has really changed! But, let us get back to the real world where incomes do not necessarily keep up with inflation and other factors come into play. The general rule of thumb is that inflation redistributes wealth away from those who underestimate it. Let us look at two effects of inflation in this regard. First, inflation hurts people whose incomes increase less rapidly than prices. Welfare recipients, for example, have incomes that are fixed over periods of time because welfare benefits are typically not indexed for inflation. An increase in overall prices hurts them because they can afford to buy fewer goods and services than before. Because people with low income tend to have a higher percentage of their income not indexed for inflation, inflation can change the distribution of income in society. Second, unexpected increases in inflation tend to hurt people that lend money and help people that borrow money. When people take out loans, they get money in one period and repay with money in a later period. With inflation, lenders are getting paid back with money that is worth less than at the time the loan was originally issued. Lenders take this into account by charging borrowers interest rates that include expected inflation. The difference between the interest rate charged on a loan and the inflation rate is the real rate of interest. In other words, Real interest rate on a loan = interest rate charged - inflation rate However, if inflation is higher than is expected, the unexpected decrease in the value of money hurts lenders and benefits borrowers by decreasing the real interest rate. Lenders who may be hurt by the negative effects of unexpected inflation will react by charging higher interest rates over time. This increases the cost of borrowing and discourages firms from investing in physical capital. The reduction in investment tends to reduce the long-term rate of growth in an economy.

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Global Unemployment and Inflation

Unemployment and inflation are global problems. The following table shows rates of inflation and unemployment in different countries. Compare these numbers for 1998 with the performance of the U.S. economy for 1998, with an inflation rate of about 1.6% and an unemployment rate of about 4.2%.

Output Growth
Our focus on the fluctuations in unemployment and inflation should not obscure the fact that the overall trend of the U.S. economy is overwhelmingly positive. What are some of the causes of this long-term growth? In essence, whatever increases the efficiency and productivity in an economy contributes to its economic growth. With more capital (machines, factories) and more labor, an economy will be able to produce more. More efficient workers and use of capital will enable an economy to produce more output from a given stock of capital and labor. Thus, investments in physical capital and in research and development can foster economic growth by increasing the efficiency and productivity of the available capital. Through investments in the education and training of the labor force, workers become more skilled and productive. These investments in both physical capital and human capital are vital to the long-term growth of any economy.

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CHAPTPER 8 The Money Supply and the Federal Reserve System We now begin our look at the monetary system. Thus far, we have been concerned primarily with the flow of goods and services between households, firms, and the government. In other words, we have been concentrating on the goods market. Now our focus shifts to the money market. As we will see, one of the functions of money is to facilitate the exchange of goods and services. In addition, however, money has several other important roles in economic systems.

An Overview of Money
It is interesting to note that money exists in all cultures, from tribes living in rainforests to the most industrialized nations. The use of money spontaneously arises early in the development of virtually all societies. The question that naturally arises is why money? Let us look at what money does and see why it is so fundamental to every kind of society. What is money? To answer the question why money arises spontaneously in all societies, think of the alternatives. Without money, how would we get the things that we want? How would we sell the things that we make? The most often-used alternative to money is barter, which is when people exchange one good for another. It is primarily because the barter system is so inefficient that monetary systems naturally arise. Think for a moment about how you would go about your day-to-day business. Let s say that you are a computer programmer and you went shopping. With the barter system, you would trade your programming skills for milk, bread, and the other things you want. What if the grocery does not need any programming done? You are out of luck. One major problem with the barter system is the double coincidence of wants. This means that, when looking for people to trade with, you must want what they have and they must want what you have. So, if you are a programmer who wants to get bread, you can not just go to any bakery. You have to find a baker who needs some programming done. Because barter is so inefficient, monetary systems arise naturally. We tend to think of money as coins and little slips of gray-green paper. Money, however, can be virtually anything. Cigarettes, stones, feathers, plant leaves, and a host of other things have been used as money. In order for something to be money, it must perform the functions of money. You may have heard the expression, "If it waddles, has feathers, and quacks, it is probably a duck." In this case, if it performs the functions of money, it is probably money. Money performs three major functions. One of the most important functions of money is as a medium of exchange. This means that people accept money in exchange for goods and services. This greatly facilitates our trading labor and getting goods and services. Think back to the earlier example of a computer programmer wanting to buy bread. With money, the programmer does not need to find a baker who needs programming. He or she can exchange programming services for money, then take that money to any baker and get bread. The baker takes the money in exchange for bread because that money can be easily exchanged for anything he or she might want. Another function of money is as a store of value. Money is a convenient way to save for the future. It is possible to store one's wealth without money, but it is nowhere near as easy. The computer programmer could, for example, trade some programming for some real estate, collectibles, or durable goods and hope that they hold their value over time. Money, however, is much more convenient. One reason is because of the liquidity property of money. This means that money is readily accepted as a means of payment. If you store your wealth by buying land, for

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example, it may be more difficult at some future time to find people who will take land in exchange for the goods that you want. The third major function of money is as a unit of account. This means that money is used as a gauge of relative value. People can compare the value of goods and services in terms of money. As the saying goes, how can you compare apples with oranges? Is an apple worth two oranges? It might be hard to tell. However, if an apple sells for 50 cents and an orange sells for $1.00, then we can easily compare them in terms of their dollar value. Commodity and fiat monies A lot of different items are used for money: feathers, stones, beads, cigarettes, and more. A famous example is the monetary system that arose in prisoner of war camps during World War II. Prisoners in these camps used cigarettes as money in many camps. Parcels would arrive from aid agencies containing cigarettes and other provisions, such as canned ham and jars of jam. Non-smokers began trading cigarettes with smokers. Prices became established. For example, a canned ham might trade for 20 cigarettes while a jar of jam might only be worth 10 cigarettes. Thus, cigarettes became the unit of account in the camps. Cigarettes were widely accepted in trades. Even non-smokers would accept cigarettes in exchange for other goods because they knew they could easily trade them for what they wanted. Thus, cigarettes became the medium of exchange in the camps. In addition, prisoners could save up cigarettes in order to buy something big in the future. Cigarettes were also the store of value in the camps. The cigarettes were money for those societies because the cigarettes performed the three functions of money in the camps. Cigarettes are a form of money called commodity money. This means that they have some intrinsic value. Other forms of commodity money include jewels, gold, and cattle. In addition to its value as money, each of these items also has a value in and of itself. In contrast, fiat money has no intrinsic value. An example of fiat money is the little green strips of paper called dollar bills. They really have no value except as money. The principal advantage of fiat money is its convenience. It is much easier to carry around than stone wheels or cartons of cigarettes. The value of fiat money is not that it is "backed" by some commodity such as gold, but that it is readily accepted in exchange for goods and services. When this acceptance is diminished, the value of fiat money disappears rapidly. For this reason, the principal danger of a monetary system using fiat money is that of currency debasement. When governments print money too rapidly, for example, the value of each unit of currency diminishes. Commodity money is also subject to debasement, however. In the POW camps, for example, cigarettes were "shaved" of some tobacco, which was then collected and rolled into new cigarettes. For a very nice overview of the history of money, go to the Federal Reserve Bank of Minneapolis homepage. Measuring the supply of money in the United States There are several measures of the money supply in the United States. The reason for this is that there are several kinds of money in the United States. Recall that the primary function of money is as a medium of exchange. Some forms of money are accepted in exchange more readily than are others. Thus, the different measures of money correspond to the different degrees of liquidity of the various forms of money. Let us start with a measure of the most liquid forms of money, called M1 or transactions money. This is the most narrow definition of money and includes currency, checkable deposits (called demand deposits), traveler's checks, and other checkable accounts. M2, or broad money, includes the items in M1 plus household savings deposits, money market funds, and time deposits. The list of measures of the money supply continues with each measure comprising a broader definition of money and less liquid forms of money. M3, for example, includes M2 plus institutional money funds, large time deposits, repurchase agreements, and Eurodollars.

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The Federal Reserve maintains an updated list of the amounts in each of these categories, called the H.6. You'll see that the broader the monetary measure, the larger the amount of money included in the measure. For example, M2 is much larger than M1, reflecting the fact that forms of money are included in M2 that are omitted from M1.

It is tempting to say that whatever the government declares is money must perform as money. Interestingly, it is not that simple. For example, have you ever been in a situation where M1 money (currency, coin, and checks) fails to be accepted as a means of payment? Have you ever been in a situation where something other than M1 must be presented to make payment? The private banking system Although we tend to think of money as the currency in our wallets and purses, most of the money supply in the United States comprises deposits in checking and other bank accounts. When you deposit your paycheck into your checking account at your bank, the bank only keeps some of it on hand. The remainder gets loaned out to other individuals or businesses. Banks and similar institutions are called financial intermediaries because they act as intermediaries between savers and lenders.

How Banks Create Money

In this section, we will learn how banks and other financial intermediaries create money by taking in deposits and making loans. First, we will give a brief overview of the modern banking system. The modern banking system As indicated above, banks keep a fraction of the amount that savers deposit. This amount is called the bank's reserves. Banks keep these reserves either as cash on hand or as deposits with the Federal Reserve System (the Fed), the nation's central bank. Banks are required by the Fed to keep a given fraction of deposits on reserve. This fraction is called the required reserve ratio. It is the percentage of total deposits that banks must keep as reserves. The amount of deposits over and above the amount in reserves is called excess reserves. It is the excess reserves that are loaned out by the bank. In essence, a substantial part of banks' profits come from the difference between the interest paid on deposits and the higher rates of interest banks charge on loans. This type of banking system, in which banks are required to only have a fraction of their deposits on reserves, is called a fractional banking system. A bank's assets consist of its reserves and the amount it has loaned out. Its liabilities consist primarily of its deposits. Many people think it is strange that the deposits in a bank are a liability for the bank and the loans it has made are assets. Remember, though, that the amount of money a bank has loaned to someone means that individual must pay the bank that amount plus interest. The amount in an individual's savings account, on the other hand, means the bank must pay that person that amount upon demand. The following table shows the balance sheet (T account) for a typical bank. As you can see, the bank's assets and liabilities must balance.

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As surprising as it may seem, individual banks create money when they loan out deposits. Suppose, for example, that you deposit $1,000 in cash into your checking account. Thus far, M1 has not changed because you have just exchanged the cash for a demand deposit of $1,000. The situation soon changes! With a required reserve ratio of 10 percent, the bank must put $100 in its reserves and can loan out the remaining $900. Suppose your bank loans the $900 to a friend of yours, who deposits the money into her checking account. What is M1 now? You have $1,000 in your checking account and she has $900 in her checking account. M1 is now $1,900! Your friend's bank must keep 10 percent of her $900 deposit in its reserves and can loan out the remaining $810. If someone else borrows that money and deposits it into his checking account, M1 will have grown by another $810. This process of making loans and deposits continues as follows:

Notice that at each step, the money supply increases by 90 percent of the previous deposit because that is the maximum amount that can be loaned out and then redeposited. How do we know that it will eventually add up to $10,000? We know this because of something called the money multiplier. The money multiplier shows by how much the money supply will eventually increase as a result of an initial deposit. The money multiplier formula is:

Note that the smaller the required reserve ratio, the bigger the multiplier. With a required reserve ratio of 0.10, the money multiplier is 10. With a required reserve ratio of 0.20, the money multiplier is 5. The modern banking system (cont.) There are a few things to keep in mind here. First, the money multiplier is different from the spending and tax multipliers that we learned about in the previous two lectures. Recall that those showed the eventual increase in real GDP with a given spending increase or tax cut. This shows how the money supply increases due to a cash deposit into a bank. Second, the money multiplier shows the maximum increase in the money supply from a cash deposit. It assumes that no cash leaves the banking system. In other words, there is no cash leakage from the system. If your friend, for example, borrows the $900 from your bank to buy a computer and the computer dealer deposits all of the money into a bank, no cash has left the system. If, however, your friend borrows $900 from your bank, spends $800 on a computer and keeps $100 in a cookie jar for a rainy day, that $100 has left the system and is no longer available to be redeposited and reloaned. With cash leakage from the system, the actual increase in the money supply will be smaller.

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Third, the formula above assumes that banks do not hold any of their excess reserves. If they did hold some deposits in excess of their required reserves, there would be less loaned out at each step of the process and the money multiplier would be smaller. Finally, we should note that the process works in reverse. If you withdrew $1,000 from your checking account and put it into your cookie jar, the money supply would shrink by more than the $1,000. The exact amount depends on the required reserve ratio, the amount of the cash leakage, the amount of excess reserves held by banks, and other factors. We have seen how money is created by a fractional banking system. The amount of money that is created from initial cash deposits depends on the required reserve ratio, which is set by the Fed. The Fed also controls additional aspects of the banking system. In the next section, we will examine some of the main functions of the Fed.

The Federal Reserve System

The Federal Reserve System is a system of 12 regional banks that act as the central bank of the United States. The following figure gives an overview of the structure of the Federal Reserve System.

The Fed is governed by the "Board of Governors" (BOG). Each governor of the BOG is nominated by the president of the United States, and confirmed by the Senate, to 14-year terms. For a short summary of the Federal Reserve System, please go to the Federal Reserve Board's Web page about the Federal Reserve System. For a description of the Board of Governors, go to the BOG's biography page.

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Functions of the Fed The Fed acts as the banker's bank. If you need a loan, you can go to your bank. If your bank needs a loan, it can go to the Fed. The Fed clears interbank payments and performs a host of regulatory functions. For example, the Fed supervises and regulates the banking system in the United States, including the domestic and international operations of U.S. banking organizations, as well as the U.S. operations of foreign banking organizations. They regulate bank acquisitions and mergers, as well as write and enforce consumer protection regulations. There is a lot of discussion now about the upcoming Y2K problem. Y2K stands for the Year 2000. The problem concerns computers that will have a hard time making the transition to the next century because of the way early computer systems identified dates. They might confuse the year 2000 with the year 1900 or with some other date! This could be a problem in a bank. For example, if you try to withdraw money in the year 2000, the bank may tell you that you have no funds in your account because the bank s computer thinks you deposited it, not in 1999, but in 2099! That means your account doesn't yet have the funds! Fortunately, banks are working on this problem, and should solve it in time. Nevertheless, some people are worried about what might happen. What do you think could happen if a lot of people do become worried as we approach the year 2000? Would it matter if the depositors' fears were unfounded?

How the Fed Controls the Money Supply

There are three main tools the Fed can use to control the nation's money supply. The Fed can alter the reserve requirement. The Fed can change the so-called discount rate. Finally, the Fed can conduct what are called "open market operations." Let us look at each of these in more detail. The required reserve ratio The simplest tool to understand is the Fed's use of the required reserve ratio. This ratio is determined by the Fed, and by changing it, the Fed can change the money supply. Recall the money multiplier formula. If the Fed lowers the required reserve ratio, the money multiplier becomes larger and each deposit results in a larger increase in the money supply. In essence, by lowering the required reserve ratio, the Fed frees up some of the banks' reserves to be loaned out and, thereby increase the money supply. Conversely, if the Fed wishes to reduce the money supply, it can increase the required reserve ratio. The Fed rarely makes changes in the required reserve ratio. Although the Fed can set the reserve requirement anywhere from 8 to 14 percent on transaction deposits, the reserve requirement in the U.S. has remained at 10 percent for several years. One of the most important reasons for this lack of change is that this tool is a blunt instrument. Small changes in the reserve requirement can yield large changes in the money supply. In addition, because of reporting delays, there are time lags between changes in the reserve requirement and changes in the money supply. The Fed uses the other tools of monetary policy, the discount rate and open market operations, much more frequently. The discount rate Banks may borrow from the Fed. The interest rate charged by the Fed is termed the "discount rate." In turn, banks loan out money at higher interest rates. When the Fed lowers the discount rate, banks find it less costly to borrow from the Fed and as a result, increase the amount of money borrowed from the Fed. The more money they borrow, the more they can loan out and the higher the money supply becomes. As a result, when the Fed wants to increase the money supply, it can lower the discount rate. Conversely, the Fed can raise the discount rate in order to lower the money supply.

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One of the Fed's most important responsibilities is to be the lender of last resort. This is important because it gives the Fed the ability to stem any run on the banking system. This is a guarantee to depositors that the Fed will be there to meet their withdrawal demands, no matter how large the demands. This is a type of insurance. Though this type of insurance helps to guarantee the stability of the banking system, it is not without any problems. A problem with all insurance programs is that they tend to change the behavior of the organizations being insured. Why do you think being insured might change behavior in an undesirable way? Think in terms of the insurance that households buy: fire insurance, medical insurance, and personal liability insurance. Suppose that the insurance covered all losses, without limit. What about banks? Open market operations The primary tool the Fed uses to influence the money supply is the use of open market operations. In essence, this tool involves the sale and purchase of U.S. government securities in the open market. It allows a more precise and rapid control of the money supply than any of the other monetary policy tools. The Fed holds large amounts of government securities and can purchase more. When the Fed buys government securities in the open market, the money supply goes up. Consider the case of the Fed purchasing a government security from a bank. In essence, the bank gives the Fed a bond certificate and gets money in exchange. This money increases the bank's reserves, which enables the bank to make more loans. This, in turn, increases the money supply. Conversely, when the Fed purchases government securities from the open market, the Fed gives the banks government securities in exchange for cash. This decreases the bank's required reserves and, as a result, lowers the money supply. Thus, an open market purchase of government securities by the Fed results in an increase in banks' reserves. This increases the amount of loans made by banks, which leads to an increase in M1. An open market sale of government securities will decrease the money supply A global guide to central banking systems all over the world is available through the Internet resource "Mark Bernkopf's Central Banking Resource Center." It is excellent for a comparison of the U.S. banking system to various foreign banking systems. A good overview of the U.S. Banking system, the Fed, and the role of monetary policy in the U.S. economy is available through the Internet resource site "U.S. Financial Data." This site contains up-to-date information on the U.S. money supply, reserves, the money multiplier, as well as various financial information. The supply curve for money At any point in time, the money supply is a fixed amount. If we graph change in the money supply with a change in interest rate, the line of the money supply curve is vertical, meaning it is a fixed amount in the short run. This is shown by the following figure:

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