Macroeconomics – project – part 1

micro economics project and need support to help me learn.

Make sure to:
1. must mention the question number clearly in their answers.
2. Avoid plagiarism.
3. No pictures containing text will be accepted and will be considered plagiarism.
4. All answers must be typed using Times New Roman (size 12, double-spaced.
Q1: Define price ceiling and price floor and give an example of each. Which leads to a shortage? Which leads to a surplus? Why?
Q2: Export or Import, what is the option available for a nation if it has a comparative advantage in the production of agricultural produce over the other country? Explain. Why do a group of economists favor the policies that restrict imports? (Minimum 500 words).
Q3: Pick any two principles of economics from Chapter 1 and explain each with an example. (From the slides)
Q4: Take an example of a two-goods economy and explain the concept of opportunity cost with the help of the Production possibility curve (PPC). Also, draw a PPC and explain why any combination outside the PPC is not possible.

Requirements: Question 1,3,4 100-200 Words. Question 2 Minimum 500 words.
College of Administrative and Financial Sciences
Assignment 1
Macroeconomics (ECON 201)
For Instructor’s Use only
General Instructions – PLEASE READ THEM CAREFULLY
The Assignment must be submitted on Blackboard (WORD format only) via the allocated folder.
The due date for Assignment 1 is 7/10/2023.
Assignments submitted through email will not be accepted.
Students are advised to make their work clear and well-presented, marks may be reduced for poor presentation. This includes filling in your information on the cover page.
Students must mention the question number clearly in their answers.
Late submissions will NOT be accepted.
Avoid plagiarism, the work should be in your own words, copying from students or other resources without proper referencing will result in ZERO marks. No exceptions.
All answers must be typed using Times New Roman (size 12, double-spaced) font. No pictures containing text will be accepted and will be considered plagiarism).
Submissions without this cover page will NOT be accepted.
Assignment 1 Questions: Week 1, 2 & 3
Q1: Define price ceiling and price floor and give an example of each. Which leads to a shortage? Which leads to a surplus? Why? [2.5 Marks]
Q2: Export or Import, what is the option available for a nation if it has a comparative advantage in the production of agricultural produce over the other country? Explain. Why do a group of economists favor the policies that restrict imports? (Minimum 500 words). [2.5 Marks]
Q3: Pick any two principles of economics from Chapter 1 and explain each with an example. [2.5 Marks]
Q4: Take an example of a two-goods economy and explain the concept of opportunity cost with the help of the Production possibility curve (PPC). Also, draw a PPC and explain why any combination outside the PPC is not possible. [2.5 Marks]
Answer:
1 Ten Principles of Economics Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What kinds of questions does economics address? •What are the principles of how people make decisions? •What are the principles of how people interact? •What are the principles of how the economy as a whole works?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What Economics Is All About ▪Scarcity: the limited nature of society’s resources ▪Economics: the study of how society manages its scarce resources, e.g. ▪how people decide what to buy, how much to work, save, and spend ▪how firms decide how much to produce, how many workers to hire ▪how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs
The principles of HOW PEOPLE MAKE DECISIONS
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #1: People Face Tradeoffs All decisions involve tradeoffs. Examples: ▪Going to a party the night before your midterm leaves less time for studying. ▪Having more money to buy stuff requires working longer hours, which leaves less time for leisure. ▪Protecting the environment requires resources that could otherwise be used to produce consumer goods.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #1: People Face Tradeoffs ▪Society faces an important tradeoff: efficiency vs. equality ▪Efficiency: when society gets the most from its scarce resources ▪Equality: when prosperity is distributed uniformly among society’s members ▪Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie.”
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #2: The Cost of Something Is What You Give Up to Get It ▪Making decisions requires comparing the costs and benefits of alternative choices. ▪The opportunity cost of any item is whatever must be given up to obtain it. ▪It is the relevant cost for decision making.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #2: The Cost of Something Is What You Give Up to Get It Examples: The opportunity cost of… …going to college for a year is not just the tuition, books, and fees, but also the foregone wages. …seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #3: Rational People Think at the Margin Rational people ▪systematically and purposefully do the best they can to achieve their objectives. ▪make decisions by evaluating costs and benefits of marginal changes, incremental adjustments to an existing plan.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #3: Rational People Think at the Margin Examples: ▪When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education. ▪When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #4: People Respond to Incentives ▪Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment. ▪Rational people respond to incentives. Examples: ▪When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs. ▪When cigarette taxes increase, teen smoking falls.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Applying the principles You are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired? Explain. A. Blue book value (what you could get for the car) is $6500 if transmission works, $5700 if it doesn’t B. Blue book value is $6000 if transmission works, $5500 if it doesn’t © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers Cost of fixing transmission = $600 A. Blue book value is $6500 if transmission works, $5700 if it doesn’t Benefit of fixing the transmission = $800 ($6500 – 5700). It’s worthwhile to have the transmission fixed. B. Blue book value is $6000 if transmission works, $5500 if it doesn’t Benefit of fixing the transmission is only $500. Paying $600 to fix transmission is not worthwhile. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Observations ▪The $1000 you previously spent on repairs is irrelevant. What matters is the cost and benefit of the marginal repair (the transmission). ▪The change in incentives from scenario A to scenario B caused your decision to change. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The principles of HOW PEOPLE INTERACT
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #5: Trade Can Make Everyone Better Off ▪Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods. ▪Countries also benefit from trade and specialization: ▪Get a better price abroad for goods they produce ▪Buy other goods more cheaply from abroad than could be produced at home
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #6: Markets Are Usually A Good Way to Organize Economic Activity ▪Market: a group of buyers and sellers (need not be in a single location) ▪“Organize economic activity” means determining ▪what goods to produce ▪how to produce them ▪how much of each to produce ▪who gets them
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #6: Markets Are Usually A Good Way to Organize Economic Activity ▪A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets. ▪Famous insight by Adam Smith in The Wealth of Nations (1776): Each of these households and firms acts as if “led by an invisible hand” to promote general economic well-being.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #6: Markets Are Usually A Good Way to Organize Economic Activity ▪The invisible hand works through the price system: ▪The interaction of buyers and sellers determines prices. ▪Each price reflects the good’s value to buyers and the cost of producing the good. ▪Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-being.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #7: Governments Can Sometimes Improve Market Outcomes ▪Important role for govt: enforce property rights (with police, courts) ▪People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #7: Governments Can Sometimes Improve Market Outcomes ▪Market failure: when the market fails to allocate society’s resources efficiently ▪Causes of market failure: ▪Externalities, when the production or consumption of a good affects bystanders (e.g. pollution) ▪Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly) ▪Public policy may promote efficiency.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #7: Governments Can Sometimes Improve Market Outcomes ▪Govt may alter market outcome to promote equity. ▪If the market’s distribution of economic well-being is not desirable, tax or welfare policies can change how the economic “pie” is divided.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Discussion Question In each of the following situations, what is the government’s role? Does the government’s intervention improve the outcome? a. Public schools for K-12 b. Workplace safety regulations c. Public highways d. Patent laws, which allow drug companies to charge high prices for life-saving drugs © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The principles of HOW THE ECONOMY AS A WHOLE WORKS
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services ▪Huge variation in living standards across countries and over time: ▪Average income in rich countries is more than ten times average income in poor countries. ▪The U.S. standard of living today is about eight times larger than 100 years ago.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services ▪The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor. ▪Productivity depends on the equipment, skills, and technology available to workers. ▪Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #9: Prices Rise When the Government Prints Too Much Money ▪Inflation: increases in the general level of prices. ▪In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall. ▪The faster the govt creates money, the greater the inflation rate.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PRINCIPLE #10: Society Faces a Short-run Tradeoff Between Inflation and Unemployment ▪In the short-run (1–2 years), many economic policies push inflation and unemployment in opposite directions. ▪Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: How to Read Your Textbook 1. Read before class. You’ll get more out of class. 2. Summarize, don’t highlight. Highlighting is a passive activity that won’t improve your comprehension or retention. Instead, summarize each section in your own words. Then, compare your summary to the one at the end of the chapter.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: How to Read Your Textbook 3. Test yourself. Try the “Quick Quiz” that follows each section before moving on to the next section. Write your answers down, compare them to the answers in the back of the book. If your answers are incorrect, review the section before moving on. 4. Practice, practice, practice. Work through the end-of-chapter review questions and problems. They are often good practice for the exams. And the more you use your new knowledge, the more solid it will become.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: How to Read Your Textbook 5. Go online. The book comes with excellent web resources, including practice quizzes, tools to strengthen your graphing skills, helpful video clips, and other resources to help you learn the textbook material more easily and effectively. Visit: http://academic.cengage.com/economics/mankiw 6. Study in groups. Get together with a few classmates to review each chapter, quiz each other, and help each other understand the material.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: How to Read Your Textbook 7. Teach someone. The best way to learn something is to teach it to someone else, such as a study partner or friend. 8. Don’t skip the real world examples. Read the Case Studies and “In The News” boxes in each chapter. They will help you see how the new terms, concepts, models, and graphs apply to the real world. As you read the newspaper or watch the evening news, see if you can find the connections with what you’re learning in the textbook.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY The principles of decision making are: •People face tradeoffs. •The cost of any action is measured in terms of foregone opportunities. •Rational people make decisions by comparing marginal costs and marginal benefits. •People respond to incentives. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY The principles of interactions among people are: •Trade can be mutually beneficial. •Markets are usually a good way of coordinating trade. •Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY The principles of the economy as a whole are: •Productivity is the ultimate source of living standards. •Money growth is the ultimate source of inflation. •Society faces a short-run tradeoff between inflation and unemployment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Thinking Like an Economist Premium PowerPoint Slides by Ron Cronovich N. Gregory Mankiw Macroeconomics Principles of Sixth Edition
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What are economists’ two roles? How do they differ? •What are models? How do economists use them? •What are the elements of the Circular-Flow Diagram? What concepts does the diagram illustrate? •How is the Production Possibilities Frontier related to opportunity cost? What other concepts does it illustrate? •What is the difference between microeconomics and macroeconomics? Between positive and normative?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Economist as Scientist ▪Economists play two roles: 1. Scientists: try to explain the world 2. Policy advisors: try to improve it ▪In the first, economists employ the scientific method, the dispassionate development and testing of theories about how the world works.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Assumptions & Models ▪Assumptions simplify the complex world, make it easier to understand. ▪Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to learn and gives useful insights about the real world. ▪Model: a highly simplified representation of a more complicated reality. Economists use models to study economic issues.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Some Familiar Models A road map
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Some Familiar Models A model of human anatomy from high school biology class
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Some Familiar Models A model airplane
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Some Familiar Models The model teeth at the dentist’s office Don’t forget to floss!
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Our First Model: The Circular-Flow Diagram ▪The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms ▪Two types of ―actors‖: ▪households ▪firms ▪Two markets: ▪the market for goods and services ▪the market for ―factors of production‖
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Factors of Production ▪Factors of production: the resources the economy uses to produce goods & services, including ▪labor ▪land ▪capital (buildings & machines used in production)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FIGURE 1: The Circular-Flow Diagram Households: ▪Own the factors of production, sell/rent them to firms for income ▪Buy and consume goods & services Households Firms Firms: ▪Buy/hire factors of production, use them to produce goods and services ▪Sell goods & services
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FIGURE 1: The Circular-Flow Diagram Markets for Factors of Production Households Firms Income Wages, rent, profit Factors of production Labor, land, capital Spending G & S bought G & S sold Revenue Markets for Goods & Services
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Our Second Model: The Production Possibilities Frontier ▪The Production Possibilities Frontier (PPF): a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology ▪Example: ▪Two goods: computers and wheat ▪One resource: labor (measured in hours) ▪Economy has 50,000 labor hours per month available for production.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PPF Example ▪Producing one computer requires 100 hours labor. ▪Producing one ton of wheat requires 10 hours labor. 5,000 0 4,000 100 2,500 250 1,000 400 50,000 0 40,000 10,000 25,000 25,000 10,000 40,000 0 500 0 50,000 E D C B A Wheat Computers Wheat Computers Production Employment of labor hours
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Point on graph Production Com-puters Wheat A 500 0 B 400 1,000 C 250 2,500 D 100 4,000 E 0 5,000 A B C D E PPF Example
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Points off the PPF A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not? B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers ▪Point F: 100 computers, 3000 tons wheat ▪Point F requires 40,000 hours of labor. Possible but not efficient: could get more of either good w/o sacrificing any of the other. F © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers ▪Point G: 300 computers, 3500 tons wheat ▪Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours. G © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The PPF: What We Know So Far Points on the PPF (like A – E) ▪possible ▪efficient: all resources are fully utilized Points under the PPF (like F) ▪possible ▪not efficient: some resources underutilized (e.g., workers unemployed, factories idle) Points above the PPF (like G) ▪not possible
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The PPF and Opportunity Cost ▪Recall: The opportunity cost of an item is what must be given up to obtain that item. ▪Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other. ▪Society faces a tradeoff: Getting more of one good requires sacrificing some of the other. ▪The slope of the PPF tells you the opportunity cost of one good in terms of the other.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The PPF and Opportunity Cost The slope of a line equals the ―rise over the run,‖ the amount the line rises when you move to the right by one unit. –1000 100 slope = = –10 Here, the opportunity cost of a computer is 10 tons of wheat.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 PPF and Opportunity Cost In which country is the opportunity cost of cloth lower? FRANCE ENGLAND
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers England, because its PPF is not as steep as France’s. FRANCE ENGLAND
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Economic Growth and the PPF With additional resources or an improvement in technology, the economy can produce more computers, more wheat, or any combination in between. Economic growth shifts the PPF outward.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Shape of the PPF ▪The PPF could be a straight line or bow-shaped ▪Depends on what happens to opportunity cost as economy shifts resources from one industry to the other. ▪If opp. cost remains constant, PPF is a straight line. (In the previous example, opp. cost of a computer was always 10 tons of wheat.) ▪If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the PPF Might Be Bow-Shaped Mountain Bikes Beer As the economy shifts resources from beer to mountain bikes: ▪PPF becomes steeper ▪opp. cost of mountain bikes increases
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the PPF Might Be Bow-Shaped At point A, most workers are producing beer, even those who are better suited to building bikes. So, do not have to give up much beer to get more bikes. A Mountain Bikes Beer At A, opp. cost of mtn bikes is low.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the PPF Might Be Bow-Shaped At B, most workers are producing bikes. The few left in beer are the best brewers. Producing more bikes would require shifting some of the best brewers away from beer production, causing a big drop in beer output. B Mountain Bikes Beer At B, opp. cost of mtn bikes is high.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the PPF Might Be Bow-Shaped ▪So, PPF is bow-shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other. ▪The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs (E.g., different types of land suited for different uses).
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The PPF: A Summary ▪The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology. ▪The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth. ▪A bow-shaped PPF illustrates the concept of increasing opportunity cost.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Microeconomics and Macroeconomics ▪Microeconomics is the study of how households and firms make decisions and how they interact in markets. ▪Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth. ▪These two branches of economics are closely intertwined, yet distinct—they address different questions.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Economist as Policy Advisor ▪As scientists, economists make positive statements, which attempt to describe the world as it is. ▪As policy advisors, economists make normative statements, which attempt to prescribe how the world should be. ▪Positive statements can be confirmed or refuted, normative statements cannot. ▪Govt employs many economists for policy advice. E.g., the U.S. President has a Council of Economic Advisors, which the author of this textbook chaired from 2003 to 2005.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Identifying positive vs. normative Which of these statements are ―positive‖ and which are ―normative‖? How can you tell the difference? a. Prices rise when the government increases the quantity of money. b. The government should print less money. c. A tax cut is needed to stimulate the economy. d. An increase in the price of burritos will cause an increase in consumer demand for music downloads. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers a. Prices rise when the government increases the quantity of money. Positive – describes a relationship, could use data to confirm or refute. b. The government should print less money. Normative – this is a value judgment, cannot be confirmed or refuted. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers c. A tax cut is needed to stimulate the economy. Normative – another value judgment. d. An increase in the price of burritos will cause an increase in consumer demand for music downloads. Positive – describes a relationship. Note that a statement need not be true to be positive. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why Economists Disagree ▪Economists often give conflicting policy advice. ▪They sometimes disagree about the validity of alternative positive theories about the world. ▪They may have different values and, therefore, different normative views about what policy should try to accomplish. ▪Yet, there are many propositions about which most economists agree.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Propositions about Which Most Economists Agree (and % who agree) ▪A ceiling on rents reduces the quantity and quality of housing available. (93%) ▪Tariffs and import quotas usually reduce general economic welfare. (93%) ▪The United States should not restrict employers from outsourcing work to foreign countries. (90%) ▪The United States should eliminate agriculture subsidies. (85%) continued…
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Propositions about Which Most Economists Agree (and % agreeing) ▪The gap between Social Security funds and expenditures will become unsustainably large within the next fifty years if current policies remain unchanged. (85%) ▪A large federal budget deficit has an adverse effect on the economy. (83%) ▪A minimum wage increases unemployment among young and unskilled workers. (79%) ▪Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: Who Studies Economics? ▪Ronald Reagan, President of the United States ▪Barbara Boxer, U.S. Senator ▪Sandra Day-O’Connor, Former Supreme Court Justice ▪Anthony Zinni, Former General, U.S. Marine Corps ▪Kofi Annan, Former Secretary General, United Nations ▪Meg Witman, Chief Executive Officer, eBay ▪Steve Ballmer, Chief Executive Officer, Microsoft ▪Arnold Schwarzenegger, Former Gov. of California, Actor ▪Ben Stein, Political Speechwriter, Actor, Game Show Host ▪Mick Jagger, Singer for the Rolling Stones ▪John Elway, NFL Quarterback ▪Tiger Woods, Golfer ▪Diane von Furstenburg, Fashion Designer
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •As scientists, economists try to explain the world using models with appropriate assumptions. •Two simple models are the Circular-Flow Diagram and the Production Possibilities Frontier. •Microeconomics studies the behavior of consumers and firms, and their interactions in markets. Macroeconomics studies the economy as a whole. •As policy advisers, economists offer advice on how to improve the world. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3 Interdependence and the Gains from Trade Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •Why do people—and nations—choose to be economically interdependent? •How can trade make everyone better off? •What is absolute advantage? What is comparative advantage? How are these concepts similar? How are they different?
Interdependence Every day you rely on many people from around the world, most of whom you’ve never met, to provide you with the goods and services you enjoy. coffee from Kenya dress shirt from China cell phone from Taiwan hair gel from Cleveland, OH
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interdependence ▪One of the Ten Principles from Chapter 1: Trade can make everyone better off. ▪We now learn why people—and nations—choose to be interdependent, and how they can gain from trade.
Our Example ▪Two countries: the U.S. and Japan ▪Two goods: computers and wheat ▪One resource: labor, measured in hours ▪We will look at how much of both goods each country produces and consumes ▪if the country chooses to be self-sufficient ▪if it trades with the other country © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Production Possibilities in the U.S. ▪The U.S. has 50,000 hours of labor available for production, per month. ▪Producing one computer requires 100 hours of labor. ▪Producing one ton of wheat requires 10 hours of labor.
4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 0 Computers Wheat (tons) The U.S. PPF The U.S. has enough labor to produce 500 computers, or 5000 tons of wheat, or any combination along the PPF. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 0 Computers Wheat (tons) The U.S. Without Trade Suppose the U.S. uses half its labor to produce each of the two goods. Then it will produce and consume 250 computers and 2500 tons of wheat. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Derive Japan’s PPF Use the following information to draw Japan’s PPF. ▪Japan has 30,000 hours of labor available for production, per month. ▪Producing one computer requires 125 hours of labor. ▪Producing one ton of wheat requires 25 hours of labor. Your graph should measure computers on the horizontal axis. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Computers Wheat (tons) 2,000 1,000 200 0 100 300 Japan’s PPF Japan has enough labor to produce 240 computers, or 1200 tons of wheat, or any combination along the PPF. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Japan Without Trade Computers Wheat (tons) 2,000 1,000 200 0 100 300 Suppose Japan uses half its labor to produce each good. Then it will produce and consume 120 computers and 600 tons of wheat. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Consumption With and Without Trade ▪Without trade, ▪U.S. consumers get 250 computers and 2500 tons wheat. ▪Japanese consumers get 120 computers and 600 tons wheat. ▪We will compare consumption without trade to consumption with trade. ▪First, we need to see how much of each good is produced and traded by the two countries.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Production under trade 1. Suppose the U.S. produces 3400 tons of wheat. How many computers would the U.S. be able to produce with its remaining labor? Draw the point representing this combination of computers and wheat on the U.S. PPF. 2. Suppose Japan produces 240 computers. How many tons of wheat would Japan be able to produce with its remaining labor? Draw this point on Japan’s PPF. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 0 Computers Wheat (tons) U.S. Production With Trade Producing 3400 tons of wheat requires 34,000 labor hours. The remaining 16,000 labor hours are used to produce 160 computers. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Japan’s Production With Trade Producing 240 computers requires all of Japan’s 30,000 labor hours. Computers Wheat (tons) 2,000 1,000 200 0 100 300 So, Japan would produce 0 tons of wheat. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exports & Imports ▪Exports: goods produced domestically and sold abroad To export means to sell domestically produced goods abroad. ▪Imports: goods produced abroad and sold domestically To import means to purchase goods produced in other countries.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Consumption under trade Suppose the U.S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan. (So, Japan imports 700 tons wheat and exports 110 computers.) ▪How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF. ▪How much of each good is consumed in Japan? Plot this combination on Japan’s PPF. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 0 Computers Wheat (tons) U.S. Consumption With Trade 2700 270 = amount consumed 0 110 + imported 700 0 – exported 3400 160 produced wheat computers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Japan’s Consumption With Trade Computers Wheat (tons) 2,000 1,000 200 0 100 300 700 130 = amount consumed 700 0 + imported 0 110 – exported 0 240 produced wheat computers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Trade Makes Both Countries Better Off 200 2700 2500 wheat 20 270 250 computers gains from trade consumption with trade consumption without trade U.S. 100 700 600 wheat 10 130 120 computers gains from trade consumption with trade consumption without trade Japan © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Where Do These Gains Come From? ▪Absolute advantage: the ability to produce a good using fewer inputs than another producer ▪The U.S. has an absolute advantage in wheat: producing a ton of wheat uses 10 labor hours in the U.S. vs. 25 in Japan. ▪If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Where Do These Gains Come From? ▪Which country has an absolute advantage in computers? ▪Producing one computer requires 125 labor hours in Japan, but only 100 in the U.S. ▪The U.S. has an absolute advantage in both goods! So why does Japan specialize in computers? Why do both countries gain from trade?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Two Measures of the Cost of a Good ▪Two countries can gain from trade when each specializes in the good it produces at lowest cost. ▪Absolute advantage measures the cost of a good in terms of the inputs required to produce it. ▪Recall: Another measure of cost is opportunity cost. ▪In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Opportunity Cost and Comparative Advantage ▪Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer ▪Which country has the comparative advantage in computers? ▪To answer this, must determine the opportunity cost of a computer in each country.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Opportunity Cost and Comparative Advantage ▪The opportunity cost of a computer is ▪10 tons of wheat in the U.S., because producing one computer requires 100 labor hours, which instead could produce 10 tons of wheat. ▪5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat. ▪So, Japan has a comparative advantage in computers. Lesson: Absolute advantage is not necessary for comparative advantage!
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparative Advantage and Trade ▪Gains from trade arise from comparative advantage (differences in opportunity costs). ▪When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s ―economic pie‖ is bigger, and all countries can gain from trade. ▪The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 4 Absolute and comparative advantage Argentina and Brazil each have 10,000 hours of labor per month. In Argentina, ▪producing one pound coffee requires 2 hours ▪producing one bottle wine requires 4 hours In Brazil, ▪producing one pound coffee requires 1 hour ▪producing one bottle wine requires 5 hours Which country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 4 Answers Brazil has an absolute advantage in coffee: ▪Producing a pound of coffee requires only one labor-hour in Brazil, but two in Argentina. Argentina has a comparative advantage in wine: ▪Argentina’s opp. cost of wine is two pounds of coffee, because the four labor-hours required to produce a bottle of wine could instead produce two pounds of coffee. ▪Brazil’s opp. cost of wine is five pounds of coffee. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Unanswered Questions… ▪We made a lot of assumptions about the quantities of each good that each country produces, trades, and consumes, and the price at which the countries trade wheat for computers. ▪In the real world, these quantities and prices would be determined by the preferences of consumers and the technology and resources in both countries. ▪We will begin to study this in the next chapter. ▪For now, though, our goal was merely to see how trade can make everyone better off.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Interdependence and trade allow everyone to enjoy a greater quantity and variety of goods & services. •Comparative advantage means being able to produce a good at a lower opportunity cost. Absolute advantage means being able to produce a good with fewer inputs. •When people—or countries—specialize in the goods in which they have a comparative advantage, the economic ―pie‖ grows and trade can make everyone better off. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 The Market Forces of Supply and Demand Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What factors affect buyers’ demand for goods? •What factors affect sellers’ supply of goods? •How do supply and demand determine the price of a good and the quantity sold? •How do changes in the factors that affect demand or supply affect the market price and quantity of a good? •How do markets allocate resources?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Markets and Competition ▪A market is a group of buyers and sellers of a particular product. ▪A competitive market is one with many buyers and sellers, each has a negligible effect on price. ▪In a perfectly competitive market: ▪All goods exactly the same ▪Buyers & sellers so numerous that no one can affect market price—each is a “price taker” ▪In this chapter, we assume markets are perfectly competitive.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Demand ▪The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. ▪Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Demand Schedule ▪Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded ▪Example: Helen’s demand for lattes. ▪Notice that Helen’s preferences obey the law of demand. Price of lattes Quantity of lattes demanded $0.00 16 1.00 14 2.00 12 3.00 10 4.00 8 5.00 6 6.00 4
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Price of Lattes Quantity of Lattes Helen’s Demand Schedule & Curve Price of lattes Quantity of lattes demanded $0.00 16 1.00 14 2.00 12 3.00 10 4.00 8 5.00 6 6.00 4
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Market Demand versus Individual Demand ▪The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. ▪Suppose Helen and Ken are the only two buyers in the Latte market. (Qd = quantity demanded) 4 6 8 10 12 14 16 Helen’s Qd 2 3 4 5 6 7 8 Ken’s Qd + + + + = = = = 6 9 12 15 + = 18 + = 21 + = 24 Market Qd $0.00 6.00 5.00 4.00 3.00 2.00 1.00 Price
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q The Market Demand Curve for Lattes P Qd (Market) $0.00 24 1.00 21 2.00 18 3.00 15 4.00 12 5.00 9 6.00 6
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Demand Curve Shifters ▪The demand curve shows how price affects quantity demanded, other things being equal. ▪These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price). ▪Changes in them shift the D curve…
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Demand Curve Shifters: # of Buyers ▪Increase in # of buyers increases quantity demanded at each price, shifts D curve to the right.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q Suppose the number of buyers increases. Then, at each P, Qd will increase (by 5 in this example). Demand Curve Shifters: # of Buyers
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Demand Curve Shifters: Income ▪Demand for a normal good is positively related to income. ▪Increase in income causes increase in quantity demanded at each price, shifts D curve to the right. (Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ▪Two goods are substitutes if an increase in the price of one causes an increase in demand for the other. ▪Example: pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right. ▪Other examples: Coke and Pepsi, laptops and desktop computers, CDs and music downloads Demand Curve Shifters: Prices of Related Goods
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ▪Two goods are complements if an increase in the price of one causes a fall in demand for the other. ▪Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left. ▪Other examples: college tuition and textbooks, bagels and cream cheese, eggs and bacon Demand Curve Shifters: Prices of Related Goods
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Demand Curve Shifters: Tastes ▪Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right. ▪Example: The Atkins diet became popular in the ’90s, caused an increase in demand for eggs, shifted the egg demand curve to the right.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Demand Curve Shifters: Expectations ▪Expectations affect consumers’ buying decisions. ▪Examples: ▪If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now. ▪If the economy sours and people worry about their future job security, demand for new autos may fall now.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary: Variables That Influence Buyers Variable A change in this variable… Price …causes a movement along the D curve # of buyers …shifts the D curve Income …shifts the D curve Price of related goods …shifts the D curve Tastes …shifts the D curve Expectations …shifts the D curve
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Demand Curve © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Q2 Price of music down-loads Quantity of music downloads D1 D2 P1 Q1 Music downloads and iPods are complements. A fall in price of iPods shifts the demand curve for music downloads to the right. ACTIVE LEARNING 1 A. Price of iPods falls © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The D curve does not shift. Move down along curve to a point with lower P, higher Q. Price of music down-loads Quantity of music downloads D1 P1 Q1 Q2 P2 ACTIVE LEARNING 1 B. Price of music downloads falls © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P1 Q1 CDs and music downloads are substitutes. A fall in price of CDs shifts demand for music downloads to the left. Price of music down-loads Quantity of music downloads D1 D2 Q2 ACTIVE LEARNING 1 C. Price of CDs falls © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Supply ▪The quantity supplied of any good is the amount that sellers are willing and able to sell. ▪Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ▪Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied. ▪Example: Starbucks’ supply of lattes. The Supply Schedule ▪Notice that Starbucks’ supply schedule obeys the law of supply. Price of lattes Quantity of lattes supplied $0.00 0 1.00 3 2.00 6 3.00 9 4.00 12 5.00 15 6.00 18
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Starbucks’ Supply Schedule & Curve Price of lattes Quantity of lattes supplied $0.00 0 1.00 3 2.00 6 3.00 9 4.00 12 5.00 15 6.00 18 P Q
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Market Supply versus Individual Supply ▪The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. ▪Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied) 18 15 12 9 6 3 0 Starbucks 12 10 8 6 4 2 0 Jitters + + + + = = = = 30 25 20 15 + = 10 + = 5 + = 0 Market Qs $0.00 6.00 5.00 4.00 3.00 2.00 1.00 Price
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q P QS (Market) $0.00 0 1.00 5 2.00 10 3.00 15 4.00 20 5.00 25 6.00 30 The Market Supply Curve
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Supply Curve Shifters ▪The supply curve shows how price affects quantity supplied, other things being equal. ▪These “other things” are non-price determinants of supply. ▪Changes in them shift the S curve…
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Supply Curve Shifters: Input Prices ▪Examples of input prices: wages, prices of raw materials. ▪A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q Suppose the price of milk falls. At each price, the quantity of lattes supplied will increase (by 5 in this example). Supply Curve Shifters: Input Prices
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Supply Curve Shifters: Technology ▪Technology determines how much inputs are required to produce a unit of output. ▪A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Supply Curve Shifters: # of Sellers ▪An increase in the number of sellers increases the quantity supplied at each price, shifts S curve to the right.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Supply Curve Shifters: Expectations ▪Example: ▪Events in the Middle East lead to expectations of higher oil prices. ▪In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price. ▪S curve shifts left. ▪In general, sellers may adjust supply* when their expectations of future prices change. (*If good not perishable)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variable A change in this variable… Summary: Variables that Influence Sellers Price …causes a movement along the S curve Input Prices …shifts the S curve Technology …shifts the S curve # of Sellers …shifts the S curve Expectations …shifts the S curve
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Supply Curve
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. S curve does not shift. Move down along the curve to a lower P and lower Q. Price of tax return software Quantity of tax return software S1 P1 Q1 Q2 P2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 A. Fall in price of tax return software
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. S curve shifts to the right: at each price, Q increases. Price of tax return software Quantity of tax return software S1 P1 Q1 S2 Q2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 B. Fall in cost of producing the software
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. This shifts the demand curve for tax preparation software, not the supply curve. Price of tax return software Quantity of tax return software S1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 C. Professional preparers raise their price
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q Supply and Demand Together D S Equilibrium: P has reached the level where quantity supplied equals quantity demanded
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. D S P Q Equilibrium price: P QD QS $0 24 0 1 21 5 2 18 10 3 15 15 4 12 20 5 9 25 6 6 30 the price that equates quantity supplied with quantity demanded
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. D S P Q Equilibrium quantity: P QD QS $0 24 0 1 21 5 2 18 10 3 15 15 4 12 20 5 9 25 6 6 30 the quantity supplied and quantity demanded at the equilibrium price
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Surplus Example: If P = $5, then QD = 9 lattes and QS = 25 lattes resulting in a surplus of 16 lattes
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price. This causes QD to rise Surplus …which reduces the surplus. and QS to fall…
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price. This causes QD to rise and QS to fall. Surplus Prices continue to fall until market reaches equilibrium.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q D S Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied Example: If P = $1, then QD = 21 lattes and QS = 5 lattes resulting in a shortage of 16 lattes Shortage
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q D S Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied Facing a shortage, sellers raise the price, causing QD to fall …which reduces the shortage. and QS to rise, Shortage
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q D S Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied Facing a shortage, sellers raise the price, causing QD to fall and QS to rise. Shortage Prices continue to rise until market reaches equilibrium.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Three Steps to Analyzing Changes in Eq’m To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply—demand diagram to see how the shift changes eq’m P and Q.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE: The Market for Hybrid Cars P Q D1 S1 P1 Q1 price of hybrid cars quantity of hybrid cars
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. STEP 1: D curve shifts because price of gas affects demand for hybrids. S curve does not shift, because price of gas does not affect cost of producing hybrids. STEP 2: D shifts right because high gas price makes hybrids more attractive relative to other cars. EXAMPLE 1: A Shift in Demand EVENT TO BE ANALYZED: Increase in price of gas. P Q D1 S1 P1 Q1 D2 P2 Q2 STEP 3: The shift causes an increase in price and quantity of hybrid cars.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE 1: A Shift in Demand P Q D1 S1 P1 Q1 D2 P2 Q2 Notice: When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted. Always be careful to distinguish b/w a shift in a curve and a movement along the curve.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Terms for Shift vs. Movement Along Curve ▪Change in supply: a shift in the S curve occurs when a non-price determinant of supply changes (like technology or costs) ▪Change in the quantity supplied: a movement along a fixed S curve occurs when P changes ▪Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes (like income or # of buyers) ▪Change in the quantity demanded: a movement along a fixed D curve occurs when P changes
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. STEP 1: S curve shifts because event affects cost of production. D curve does not shift, because production technology is not one of the factors that affect demand. STEP 2: S shifts right because event reduces cost, makes production more profitable at any given price. EXAMPLE 2: A Shift in Supply P Q D1 S1 P1 Q1 S2 P2 Q2 EVENT: New technology reduces cost of producing hybrid cars. STEP 3: The shift causes price to fall and quantity to rise.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE 3: A Shift in Both Supply and Demand P Q D1 S1 P1 Q1 S2 D2 P2 Q2 EVENTS: Price of gas rises AND new technology reduces production costs STEP 1: Both curves shift. STEP 2: Both shift to the right. STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE 3: A Shift in Both Supply and Demand STEP 3, cont. P Q D1 S1 P1 Q1 S2 D2 P2 Q2 EVENTS: price of gas rises AND new technology reduces production costs But if supply increases more than demand, P falls.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads. Event A: A fall in the price of CDs Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Event C: Events A and B both occur. ACTIVE LEARNING 3 Shifts in supply and demand © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. D shifts left P Q D1 S1 P1 Q1 D2 The market for music downloads P2 Q2 1. D curve shifts 3. P and Q both fall. STEPS © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 A. Fall in price of CDs
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q D1 S1 P1 Q1 S2 The market for music downloads Q2 P2 1. S curve shifts 2. S shifts right 3. P falls, Q rises. STEPS (Royalties are part of sellers’ costs) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 B. Fall in cost of royalties
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. STEPS 1. Both curves shift (see parts A & B). 2. D shifts left, S shifts right. 3. P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 C. Fall in price of CDs and fall in cost of royalties
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION: How Prices Allocate Resources ▪One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. ▪In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •A competitive market has many buyers and sellers, each of whom has little or no influence on the market price. •Economists use the supply and demand model to analyze competitive markets. •The downward-sloping demand curve reflects the law of demand, which states that the quantity buyers demand of a good depends negatively on the good’s price. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Besides price, demand depends on buyers’ incomes, tastes, expectations, the prices of substitutes and complements, and number of buyers. If one of these factors changes, the D curve shifts. •The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good’s price. •Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded. •If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market price is below equilibrium, a shortage results, causing the price to rise. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •We can use the supply-demand diagram to analyze the effects of any event on a market: First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one. •In market economies, prices are the signals that guide economic decisions and allocate scarce resources. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6 Supply, Demand, and Government Policies Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 1 In this chapter, look for the answers to these questions: •What are price ceilings and price floors? What are some examples of each? •How do price ceilings and price floors affect market outcomes? •How do taxes affect market outcomes? How do the effects depend on whether the tax is imposed on buyers or sellers? •What is the incidence of a tax? What determines the incidence?
Government Policies That Alter the Private Market Outcome  Price controls Price ceiling: a legal maximum on the price of a good or service Example: rent control Price floor: a legal minimum on the price of a good or service Example: minimum wage  Taxes The govt can make buyers or sellers pay a specific amount on each unit. We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and eq’m quantity).
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 3 EXAMPLE 1: The Market for Apartments Eq’m w/o price controls P Q D S Rental price of apts $800 300 Quantity of apts
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 4 How Price Ceilings Affect Market Outcomes A price ceiling above the eq’m price is not binding— has no effect on the market outcome. P Q D S $800 300 Price ceiling $1000
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 5 How Price Ceilings Affect Market Outcomes The eq’m price ($800) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, causes a shortage. P Q D S $800 Price ceiling $500 250 400 shortage
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 6 How Price Ceilings Affect Market Outcomes In the long run, supply and demand are more price-elastic. So, the shortage is larger. P Q D S $800 150 Price ceiling $500 450 shortage
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 7 Shortages and Rationing With a shortage, sellers must ration the goods among buyers. Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers’ biases These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly. In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair).
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 8 EXAMPLE 2: The Market for Unskilled Labor Eq’m w/o price controls W L D S Wage paid to unskilled workers $6.00 500 Quantity of unskilled workers
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 9 How Price Floors Affect Market Outcomes W L D S $6.00 500 Price floor $5.00 A price floor below the eq’m price is not binding – has no effect on the market outcome.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 10 How Price Floors Affect Market Outcomes W L D S $6.00 Price floor $7.25 The eq’m wage ($6) is below the floor and therefore illegal. The floor is a binding constraint on the wage, causes a surplus (i.e., unemployment). 400 550 labor surplus
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 11 Min wage laws do not affect highly skilled workers. They do affect teen workers. Studies: A 10% increase in the min wage raises teen unemployment by 1–3%. The Minimum Wage W L D S $6.00 Min. wage $7.25 400 550 unemp-loyment
ACTIVE LEARNING 1 Price controls © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4050607080901001101201301405060708090100110120130Q P S 0 The market for hotel rooms D Determine effects of: A. $90 price ceiling ( shortage) B. $90 price floor( not binding ) C. $120 price floor ( surplus )
ACTIVE LEARNING 1 A. $90 price ceiling © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4050607080901001101201301405060708090100110120130Q P S 0 The market for hotel rooms D The price falls to $90. Buyers demand 120 rooms, sellers supply 90, leaving a shortage. shortage = 30 Price ceiling
ACTIVE LEARNING 1 B. $90 price floor © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4050607080901001101201301405060708090100110120130Q P S 0 The market for hotel rooms D Eq’m price is above the floor, so floor is not binding. P = $100, Q = 100 rooms. Price floor
ACTIVE LEARNING 1 C. $120 price floor © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4050607080901001101201301405060708090100110120130Q P S 0 The market for hotel rooms D The price rises to $120. Buyers demand 60 rooms, sellers supply 120, causing a surplus. surplus = 60 Price floor
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 16 Evaluating Price Controls Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices. Price controls often intended to help the poor, but often hurt more than help.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 17 Taxes The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. The govt can make buyers or sellers pay the tax. The tax can be a % of the good’s price, or a specific amount for each unit sold. For simplicity, we analyze per-unit taxes only.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 18 S1 EXAMPLE 3: The Market for Pizza Eq’m w/o tax P Q D1 $10.00 500
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 19 S1 D1 $10.00 500 A Tax on Buyers The price buyers pay is now $1.50 higher than the market price P. P would have to fall by $1.50 to make buyers willing to buy same Q as before. E.g., if P falls from $10.00 to $8.50, buyers still willing to purchase 500 pizzas. P Q D2 Effects of a $1.50 per unit tax on buyers $8.50 Hence, a tax on buyers shifts the D curve down by the amount of the tax. Tax
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 20 S1 D1 $10.00 500 A Tax on Buyers P Q D2 $11.00 PB = $9.50 PS = Tax Effects of a $1.50 per unit tax on buyers New eq’m: Q = 450 Sellers receive PS = $9.50 Buyers pay PB = $11.00 Difference between them = $1.50 = tax 450
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 21 450 S1 The Incidence of a Tax: how the burden of a tax is shared among market participants P Q D1 $10.00 500 D2 $11.00 PB = $9.50 PS = Tax In our example, buyers pay $1.00 more, sellers get $0.50 less.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 22 S1 A Tax on Sellers P Q D1 $10.00 500 S2 Effects of a $1.50 per unit tax on sellers The tax effectively raises sellers’ costs by $1.50 per pizza. Sellers will supply 500 pizzas only if P rises to $11.50, to compensate for this cost increase. $11.50 Hence, a tax on sellers shifts the S curve up by the amount of the tax. Tax
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 23 S1 A Tax on Sellers P Q D1 $10.00 500 S2 450 $11.00 PB = $9.50 PS = Tax Effects of a $1.50 per unit tax on sellers New eq’m: Q = 450 Buyers pay PB = $11.00 Sellers receive PS = $9.50 Difference between them = $1.50 = tax
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 24 S1 The Outcome Is the Same in Both Cases! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. P Q D1 $10.00 500 450 $9.50 $11.00 PB = PS = Tax The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers!
ACTIVE LEARNING 2 Effects of a tax © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4050607080901001101201301405060708090100110120130Q P S 0 The market for hotel rooms D Suppose govt imposes a tax on buyers of $30 per room. Find new Q, PB, PS, and incidence of tax.
ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4050607080901001101201301405060708090100110120130Q P S 0 The market for hotel rooms D Q = 80 PB = $110 PS = $80 Incidence buyers: $10 sellers: $20 Tax PB = PS =
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 27 Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax PB PS It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 28 Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax PB PS It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 29 CASE STUDY: Who Pays the Luxury Tax? 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. Goal: raise revenue from those who could most easily afford to pay—wealthy consumers. But who really pays this tax?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 30 CASE STUDY: Who Pays the Luxury Tax? The market for yachts P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden PB PS Demand is price-elastic. In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax.
ACTIVE LEARNING 3 The 2011 payroll tax cut Prior to 2011, the Social Security payroll tax was 6.2% taken from workers’ pay and 6.2% paid by employers (total 12.4%). The Tax Relief Act (2010) reduces the worker’s portion from 6.2% to 4.2% (for 2011 only), but leaves the employer’s portion at 6.2%. QUESTION: Will the typical worker’s take-home pay rise by exactly 2%, more than 2%, or less than 2%? Do any elasticities affect your answer? Explain. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 3 Answers As long as labor supply and labor demand both have price elasticity > 0, the tax cut will be shared by workers and employers, i.e., workers’ take-home pay will rise less than 2%. The answer does NOT depend on whether labor demand is more or less elastic than labor supply. FOLLOW-UP QUESTION: Who gets the bigger share of this tax cut, workers or employers? How do elasticities determine the answer? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 3 Answers to follow-up question If labor demand is more elastic than labor supply, workers get more of the tax cut than employers. If labor demand is less elastic than labor supply, employers get the larger share of the tax cut. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34 34 CONCLUSION: Government Policies and the Allocation of Resources Each of the policies in this chapter affects the allocation of society’s resources. Example 1: A tax on pizza reduces eq’m Q. With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. Example 2: A binding minimum wage causes a surplus of workers, a waste of resources. So, it’s important for policymakers to apply such policies very carefully.
SUMMARY •A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the eq’m price, it is binding and causes a shortage. •A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq’m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY •A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq’m quantity to fall, whether the tax is imposed on buyers or sellers. •The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers. •The incidence of the tax depends on the price elasticities of supply and demand. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Consumers, Producers, and the Efficiency of Markets Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What is consumer surplus? How is it related to the demand curve? •What is producer surplus? How is it related to the supply curve? •Do markets produce a desirable allocation of resources? Or could the market outcome be improved upon?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Welfare Economics ▪Recall, the allocation of resources refers to: ▪how much of each good is produced ▪which producers produce it ▪which consumers consume it ▪Welfare economics studies how the allocation of resources affects economic well-being. ▪First, we look at the well-being of consumers.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Willingness to Pay (WTP) A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good. name WTP Anthony $250 Chad 175 Flea 300 John 125 Example: 4 buyers’ WTP for an iPod
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. WTP and the Demand Curve Q: If price of iPod is $200, who will buy an iPod, and what is quantity demanded? A: Anthony & Flea will buy an iPod, Chad & John will not. Hence, Qd = 2 when P = $200. name WTP Anthony $250 Chad 175 Flea 300 John 125
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. WTP and the Demand Curve Derive the demand schedule: 4 John, Chad, Anthony, Flea 0 – 125 3 Chad, Anthony, Flea 126 – 175 2 Anthony, Flea 176 – 250 1 Flea 251 – 300 0 nobody $301 & up Qd who buys P (price of iPod) name WTP Anthony $250 Chad 175 Flea 300 John 125
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. WTP and the Demand Curve P Qd $301 & up 0 251 – 300 1 176 – 250 2 126 – 175 3 0 – 125 4 P Q
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. About the Staircase Shape… This D curve looks like a staircase with 4 steps – one per buyer. P Q If there were a huge # of buyers, as in a competitive market, there would be a huge # of very tiny steps, and it would look more like a smooth curve.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. WTP and the Demand Curve At any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher. P Q Flea’s WTP Anthony’s WTP Chad’s WTP John’s WTP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays: CS = WTP – P name WTP Anthony $250 Chad 175 Flea 300 John 125 Suppose P = $260. Flea’s CS = $300 – 260 = $40. The others get no CS because they do not buy an iPod at this price. Total CS = $40.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CS and the Demand Curve P Q Flea’s WTP P = $260 Flea’s CS = $300 – 260 = $40 Total CS = $40
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CS and the Demand Curve P Q Flea’s WTP Anthony’s WTP Instead, suppose P = $220 Flea’s CS = $300 – 220 = $80 Anthony’s CS = $250 – 220 = $30 Total CS = $110
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CS and the Demand Curve P Q The lesson: Total CS equals the area under the demand curve above the price, from 0 to Q.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q $ CS with Lots of Buyers & a Smooth D Curve The demand for shoes D 1000s of pairs of shoes Price per pair At Q = 5(thousand), the marginal buyer is willing to pay $50 for pair of shoes. Suppose P = $30. Then his consumer surplus = $20.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q CS with Lots of Buyers & a Smooth D Curve The demand for shoes D CS is the area b/w P and the D curve, from 0 to Q. Recall: area of a triangle equals ½ x base x height Height = $60 – 30 = $30. So, CS = ½ x 15 x $30 = $225. h $
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q How a Higher Price Reduces CS D If P rises to $40, CS = ½ x 10 x $20 = $100. Two reasons for the fall in CS. 1. Fall in CS due to buyers leaving market 2. Fall in CS due to remaining buyers paying higher P
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q demand curve A. Find marginal buyer’s WTP at Q = 10. B. Find CS for P = $30. Suppose P falls to $20. How much will CS increase due to… C. buyers entering the market D. existing buyers paying lower price $ ACTIVE LEARNING 1 Consumer surplus
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P $ Q demand curve A. At Q = 10, marginal buyer’s WTP is $30. B. CS = ½ x 10 x $10 = $50 P falls to $20. C. CS for the additional buyers = ½ x 10 x $10 = $50 D. Increase in CS on initial 10 units = 10 x $10 = $100
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost and the Supply Curve name cost Jack $10 Janet 20 Chrissy 35 A seller will produce and sell the good/service only if the price exceeds his or her cost. Hence, cost is a measure of willingness to sell. ▪Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost). ▪Includes cost of all resources used to produce good, including value of the seller’s time. ▪Example: Costs of 3 sellers in the lawn-cutting business.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost and the Supply Curve 3 35 & up 2 20 – 34 1 10 – 19 0 $0 – 9 Qs P Derive the supply schedule from the cost data: name cost Jack $10 Janet 20 Chrissy 35
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost and the Supply Curve P Q P Qs $0 – 9 0 10 – 19 1 20 – 34 2 35 & up 3
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost and the Supply Curve P Q At each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower. Chrissy’s cost Janet’s cost Jack’s cost
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Producer Surplus P Q Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost PS = P – cost
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Producer Surplus and the S Curve P Q PS = P – cost Suppose P = $25. Jack’s PS = $15 Janet’s PS = $5 Chrissy’s PS = $0 Total PS = $20 Janet’s cost Jack’s cost Total PS equals the area above the supply curve under the price, from 0 to Q. Chrissy’s cost
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q PS with Lots of Sellers & a Smooth S Curve The supply of shoes S 1000s of pairs of shoes Price per pair Suppose P = $40. At Q = 15(thousand), the marginal seller’s cost is $30, and her producer surplus is $10.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q PS with Lots of Sellers & a Smooth S Curve The supply of shoes S PS is the area b/w P and the S curve, from 0 to Q. The height of this triangle is $40 – 15 = $25. So, PS = ½ x b x h = ½ x 25 x $25 = $312.50 h
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q How a Lower Price Reduces PS If P falls to $30, PS = ½ x 15 x $15 = $112.50 Two reasons for the fall in PS. S 1. Fall in PS due to sellers leaving market 2. Fall in PS due to remaining sellers getting lower P
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Producer surplus © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q supply curve A. Find marginal seller’s cost at Q = 10. B. Find total PS for P = $20. Suppose P rises to $30. Find the increase in PS due to: C. selling 5 additional units D. getting a higher price on the initial 10 units
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. P Q supply curve A. At Q = 10, marginal cost = $20 B. PS = ½ x 10 x $20 = $100 P rises to $30. C. PS on additional units = ½ x 5 x $10 = $25 D. Increase in PS on initial 10 units = 10 x $10 = $100
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CS, PS, and Total Surplus CS = (value to buyers) – (amount paid by buyers) = buyers’ gains from participating in the market PS = (amount received by sellers) – (cost to sellers) = sellers’ gains from participating in the market Total surplus = CS + PS = total gains from trade in a market = (value to buyers) – (cost to sellers)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market’s Allocation of Resources ▪In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers. ▪Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off? ▪To answer this, we use total surplus as a measure of society’s well-being, and we consider whether the market’s allocation is efficient. (Policymakers also care about equality, though our focus here is on efficiency.)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Efficiency An allocation of resources is efficient if it maximizes total surplus. Efficiency means: ▪The goods are consumed by the buyers who value them most highly. ▪The goods are produced by the producers with the lowest costs. ▪Raising or lowering the quantity of a good would not increase total surplus. = (value to buyers) – (cost to sellers) Total surplus
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Evaluating the Market Equilibrium Market eq’m: P = $30 Q = 15,000 Total surplus = CS + PS Is the market eq’m efficient? P Q S D CS PS
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Which Buyers Consume the Good? P Q S D Every buyer whose WTP is ≥ $30 will buy. Every buyer whose WTP is < $30 will not. So, the buyers who value the good most highly are the ones who consume it. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Which Sellers Produce the Good? P Q S D Every seller whose cost is ≤ $30 will produce the good. Every seller whose cost is > $30 will not. So, the sellers with the lowest cost produce the good.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Does Eq’m Q Maximize Total Surplus? P Q S D At Q = 20, cost of producing the marginal unit is $35 value to consumers of the marginal unit is only $20 Hence, can increase total surplus by reducing Q. This is true at any Q greater than 15.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Does Eq’m Q Maximize Total Surplus? P Q S D At Q = 10, cost of producing the marginal unit is $25 value to consumers of the marginal unit is $40 Hence, can increase total surplus by increasing Q. This is true at any Q less than 15.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Does Eq’m Q Maximize Total Surplus? P Q S D The market eq’m quantity maximizes total surplus: At any other quantity, can increase total surplus by moving toward the market eq’m quantity.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adam Smith and the Invisible Hand ―Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only. Adam Smith, 1723-1790 Passages from The Wealth of Nations, 1776 He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them… It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest….
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adam Smith and the Invisible Hand ―Every individual…neither intends to promote the public interest, nor knows how much he is promoting it…. Adam Smith, 1723-1790 Passages from The Wealth of Nations, 1776 He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.‖ an invisible hand
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Free Market vs. Govt Intervention ▪The market equilibrium is efficient. No other outcome achieves higher total surplus. ▪Govt cannot raise total surplus by changing the market’s allocation of resources. ▪Laissez faire (French for ―allow them to do‖): the notion that govt should not interfere with the market.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Free Market vs. Central Planning ▪Suppose resources were allocated not by the market, but by a central planner who cares about society’s well-being. ▪To allocate resources efficiently and maximize total surplus, the planner would need to know every seller’s cost and every buyer’s WTP for every good in the entire economy. ▪This is impossible, and why centrally-planned economies are never very efficient.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪This chapter used welfare economics to demonstrate one of the Ten Principles: Markets are usually a good way to organize economic activity. ▪Important note: We derived these lessons assuming perfectly competitive markets. ▪In other conditions we will study in later chapters, the market may fail to allocate resources efficiently…
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪Such market failures occur when: ▪a buyer or seller has market power—the ability to affect the market price. ▪transactions have side effects, called externalities, that affect bystanders. (example: pollution) ▪We’ll use welfare economics to see how public policy may improve on the market outcome in such cases. ▪Despite the possibility of market failure, the analysis in this chapter applies in many markets, and the invisible hand remains extremely important.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The height of the D curve reflects the value of the good to buyers—their willingness to pay for it. •Consumer surplus is the difference between what buyers are willing to pay for a good and what they actually pay. •On the graph, consumer surplus is the area between P and the D curve. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The height of the S curve is sellers’ cost of producing the good. Sellers are willing to sell if the price they get is at least as high as their cost. •Producer surplus is the difference between what sellers receive for a good and their cost of producing it. •On the graph, producer surplus is the area between P and the S curve. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •To measure society’s well-being, we use total surplus, the sum of consumer and producer surplus. •Efficiency means that total surplus is maximized, that the goods are produced by sellers with lowest cost, and that they are consumed by buyers who most value them. •Under perfect competition, the market outcome is efficient. Altering it would reduce total surplus. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Application: The Costs of Taxation Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •How does a tax affect consumer surplus, producer surplus, and total surplus? •What is the deadweight loss of a tax? •What factors determine the size of this deadweight loss? •How does tax revenue depend on the size of the tax?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Review from Chapter 6 ▪A tax ▪drives a wedge between the price buyers pay and the price sellers receive. ▪raises the price buyers pay and lowers the price sellers receive. ▪reduces the quantity bought & sold. ▪These effects are the same whether the tax is imposed on buyers or sellers, so we do not make this distinction in this chapter.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. QT The Effects of a Tax P Q D S Eq’m with no tax: Price = PE Quantity = QE PS PB PE QE Eq’m with tax = $T per unit: Sellers receive PS Quantity = QT Buyers pay PB Size of tax = $T
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effects of a Tax P Q D S Revenue from tax: $T x QT PS PB PE QE QT Size of tax = $T
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effects of a Tax ▪Next, we apply welfare economics to measure the gains and losses from a tax. ▪We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax. ▪Tax revenue can fund beneficial services (e.g., education, roads, police), so we include it in total surplus.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effects of a Tax P Q D S Without a tax, PE QE QT A B C D E F CS = A + B + C PS = D + E + F Tax revenue = 0 Total surplus = CS + PS = A + B + C + D + E + F
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effects of a Tax P Q D S PS PB QE QT A B C D E F CS = A PS = F Tax revenue = B + D Total surplus = A + B + D + F With the tax, The tax reduces total surplus by C + E
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effects of a Tax P Q D S PS PB QE QT A B C D E F C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. About the Deadweight Loss P Q D S PS PB QE QT Because of the tax, the units between QT and QE are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax prevents some mutually beneficial trades.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Analysis of tax © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A. Compute CS, PS, and total surplus without a tax. B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL. D S P Q $ The market for airplane tickets
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers to A © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. D S CS = ½ x $200 x 100 = $10,000 P Q $ Total surplus = $10,000 + $10,000 = $20,000 PS = ½ x $200 x 100 = $10,000 P = The market for airplane tickets
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers to B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. D S CS = ½ x $150 x 75 = $5,625 P Q $ Total surplus = $18,750 PS = $5,625 Tax revenue = $100 x 75 = $7,500 DWL = $1,250 PS = PB = A $100 tax on airplane tickets
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What Determines the Size of the DWL? ▪Which goods or services should govt tax to raise the revenue it needs? ▪One answer: those with the smallest DWL. ▪When is the DWL small vs. large? Turns out it depends on the price elasticities of supply and demand. ▪Recall: The price elasticity of demand (or supply) measures how much QD (or QS) changes when P changes.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. When supply is inelastic, it’s harder for firms to leave the market when the tax reduces PS. So, the tax only reduces Q a little, and DWL is small. DWL and the Elasticity of Supply P Q D S Size of tax
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. DWL and the Elasticity of Supply P Q D S Size of tax The more elastic is supply, the easier for firms to leave the market when the tax reduces PS, the greater Q falls below the surplus-maximizing quantity, the greater the DWL.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. DWL and the Elasticity of Demand P Q D S Size of tax When demand is inelastic, it’s harder for consumers to leave the market when the tax raises PB. So, the tax only reduces Q a little, and DWL is small.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. DWL and the Elasticity of Demand P Q D S Size of tax The more elastic is demand, the easier for buyers to leave the market when the tax increases PB, the more Q falls below the surplus-maximizing quantity, and the greater the DWL.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Elasticity and the DWL of a tax Would the DWL of a tax be larger if the tax were on: A. Breakfast cereal or sunscreen? B. Hotel rooms in the short run or hotel rooms in the long run? C. Groceries or meals at fancy restaurants? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers A. Breakfast cereal or sunscreen From Chapter 5: Breakfast cereal has more close substitutes than sunscreen, so demand for breakfast cereal is more price-elastic than demand for sunscreen. So, a tax on breakfast cereal would cause a larger DWL than a tax on sunscreen. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers B. Hotel rooms in the short run or long run From Chapter 5: The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers C. Groceries or meals at fancy restaurants From Chapter 5: Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Discussion question ▪The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants. ▪Which should it tax? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How Big Should the Government Be? ▪A bigger government provides more services, but requires higher taxes, which cause DWLs. ▪The larger the DWL from taxation, the greater the argument for smaller government. ▪The tax on labor income is especially important; it’s the biggest source of govt revenue. ▪For the typical worker, the marginal tax rate (the tax on the last dollar of earnings) is about 40%. ▪How big is the DWL from this tax? It depends on elasticity….
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How Big Should the Government Be? ▪If labor supply is inelastic, then this DWL is small. ▪Some economists believe labor supply is inelastic, arguing that most workers work full-time regardless of the wage.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How Big Should the Government Be? Other economists believe labor taxes are highly distorting because some groups of workers have elastic supply and can respond to incentives: ▪Many workers can adjust their hours, e.g., by working overtime. ▪Many families have a 2nd earner with discretion over whether and how much to work. ▪Many elderly choose when to retire based on the wage they earn. ▪Some people work in the “underground economy” to evade high taxes.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effects of Changing the Size of the Tax ▪Policymakers often change taxes, raising some and lowering others. ▪What happens to DWL and tax revenue when taxes change? We explore this next….
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Q2 Q1 DWL and the Size of the Tax P Q D S causes the DWL to more than double. Doubling the tax 2T T Initially, the tax is T per unit. initial DWL new DWL
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Q3 DWL and the Size of the Tax P Q D S Q1 3T T causes the DWL to more than triple. Tripling the tax Initially, the tax is T per unit. initial DWL new DWL
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. DWL and the Size of the Tax DWL Tax size Summary When a tax increases, DWL rises even more. Implication When tax rates are low, raising them doesn’t cause much harm, and lowering them doesn’t bring much benefit. When tax rates are high, raising them is very harmful, and cutting them is very beneficial.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Q2 Revenue and the Size of the Tax P Q D S Q1 PB PS PB PS 2T T When the tax is small, increasing it causes tax revenue to rise.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Q3 Revenue and the Size of the Tax P Q D S Q2 PB PS PB PS 3T 2T When the tax is larger, increasing it causes tax revenue to fall.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Laffer curve shows the relationship between the size of the tax and tax revenue. Revenue and the Size of the Tax Tax size Tax revenue The Laffer curve
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •A tax on a good reduces the welfare of buyers and sellers. This welfare loss usually exceeds the revenue the tax raises for the govt. •The fall in total surplus (consumer surplus, producer surplus, and tax revenue) is called the deadweight loss (DWL) of the tax. •A tax has a DWL because it causes consumers to buy less and producers to sell less, thus shrinking the market below the level that maximizes total surplus. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The price elasticities of demand and supply measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher DWLs. •An increase in the size of a tax causes the DWL to rise even more. •An increase in the size of a tax causes revenue to rise at first, but eventually revenue falls because the tax reduces the size of the market. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Application: International Trade Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What determines how much of a good a country will import or export? •Who benefits from trade? Who does trade harm? Do the gains outweigh the losses? •If policymakers restrict imports, who benefits? Who is harmed? Do the gains from restricting imports outweigh the losses? •What are some common arguments for restricting trade? Do they have merit?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction ▪Recall from Chapter 3: A country has a comparative advantage in a good if it produces the good at lower opportunity cost than other countries. Countries can gain from trade if each exports the goods in which it has a comparative advantage. ▪Now we apply the tools of welfare economics to see where these gains come from and who gets them.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The World Price and Comparative Advantage ▪PW = the world price of a good, the price that prevails in world markets ▪PD = domestic price without trade ▪If PD < PW, ▪country has comparative advantage in the good ▪under free trade, country exports the good ▪If PD > PW, ▪country does not have comparative advantage ▪under free trade, country imports the good
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Small Economy Assumption ▪A small economy is a price taker in world markets: Its actions have no effect on PW. ▪Not always true—especially for the U.S.—but simplifies the analysis without changing its lessons. ▪When a small economy engages in free trade, PW is the only relevant price: ▪No seller would accept less than PW, since she could sell the good for PW in world markets. ▪No buyer would pay more than PW, since he could buy the good for PW in world markets.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Country That Exports Soybeans Without trade, PD = $4 Q = 500 PW = $6 Under free trade, ▪domestic consumers demand 300 ▪domestic producers supply 750 ▪exports = 450 P Q D S $6 $4 500 300 Soybeans exports 750
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Country That Exports Soybeans Without trade, CS = A + B PS = C Total surplus = A + B + C With trade, CS = A PS = B + C + D Total surplus = A + B + C + D P Q D S $6 $4 Soybeans exports A B D C gains from trade
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Without trade, PD = $3000, Q = 400 In world markets, PW = $1500 Under free trade, how many TVs will the country import or export? Identify CS, PS, and total surplus without trade, and with trade. P Q D S $1500 200 $3000 400 600 Plasma TVs © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Analysis of trade
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Under free trade, ▪domestic consumers demand 600 ▪domestic producers supply 200 ▪imports = 400 P Q D S $1500 200 $3000 600 Plasma TVs imports ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Without trade, CS = A PS = B + C Total surplus = A + B + C With trade, CS = A + B + D PS = C Total surplus = A + B + C + D P Q D S $1500 $3000 Plasma TVs A B D C gains from trade imports ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. total surplus producer surplus consumer surplus direction of trade rises falls rises imports PD > PW rises rises falls exports PD < PW Summary: The Welfare Effects of Trade Whether a good is imported or exported, trade creates winners and losers. But the gains exceed the losses. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Other Benefits of International Trade ▪Consumers enjoy increased variety of goods. ▪Producers sell to a larger market, may achieve lower costs by producing on a larger scale. ▪Competition from abroad may reduce market power of domestic firms, which would increase total welfare. ▪Trade enhances the flow of ideas, facilitates the spread of technology around the world. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Then Why All the Opposition to Trade? ▪Recall one of the Ten Principles from Chapter 1: Trade can make everyone better off. ▪The winners from trade could compensate the losers and still be better off. ▪Yet, such compensation rarely occurs. ▪The losses are often highly concentrated among a small group of people, who feel them acutely. The gains are often spread thinly over many people, who may not see how trade benefits them. ▪Hence, the losers have more incentive to organize and lobby for restrictions on trade. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tariff: An Example of a Trade Restriction ▪Tariff: a tax on imports ▪Example: Cotton shirts PW = $20 Tariff: T = $10/shirt Consumers must pay $30 for an imported shirt. So, domestic producers can charge $30 per shirt. ▪In general, the price facing domestic buyers & sellers equals (PW + T ). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. $30 Analysis of a Tariff on Cotton Shirts PW = $20 Free trade: buyers demand 80 sellers supply 25 imports = 55 T = $10/shirt price rises to $30 buyers demand 70 sellers supply 40 imports = 30 P Q D S $20 25 Cotton shirts 40 70 80 imports imports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. $30 Analysis of a Tariff on Cotton Shirts Free trade CS = A + B + C + D + E + F PS = G Total surplus = A + B + C + D + E + F + G Tariff CS = A + B PS = C + G Revenue = E Total surplus = A + B + C + E + G P Q D S $20 25 Cotton shirts 40 A B D E G F C 70 80 deadweight loss = D + F © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. $30 Analysis of a Tariff on Cotton Shirts D = deadweight loss from the overproduction of shirts F = deadweight loss from the under-consumption of shirts P Q D S $20 25 Cotton shirts 40 A B D E G F C 70 80 deadweight loss = D + F © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Import Quotas: Another Way to Restrict Trade ▪An import quota is a quantitative limit on imports of a good. ▪Mostly has the same effects as a tariff: ▪Raises price, reduces quantity of imports. ▪Reduces buyers’ welfare. ▪Increases sellers’ welfare. ▪A tariff creates revenue for the govt. A quota creates profits for the foreign producers of the imported goods, who can sell them at higher price. ▪Or, govt could auction licenses to import to capture this profit as revenue. Usually it does not. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Arguments for Restricting Trade 1. The jobs argument Trade destroys jobs in industries that compete with imports. Economists’ response: Look at the data to see whether rising imports cause rising unemployment… © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. U.S. Imports & Unemployment, Decade averages, 1961–2010 1961- 1970 1971- 1980 1981- 1990 1991- 2000 2001- 2010 Imports (% of GDP) Unemployment (% of labor force) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Arguments for Restricting Trade 1. The jobs argument Trade destroys jobs in the industries that compete against imports. Economists’ response: Total unemployment does not rise as imports rise, because job losses from imports are offset by job gains in export industries. Even if all goods could be produced more cheaply abroad, the country need only have a comparative advantage to have a viable export industry and to gain from trade. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Arguments for Restricting Trade 2. The national security argument An industry vital to national security should be protected from foreign competition, to prevent dependence on imports that could be disrupted during wartime. Economists’ response: Fine, as long as we base policy on true security needs. But producers may exaggerate their own importance to national security to obtain protection from foreign competition. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Arguments for Restricting Trade 3. The infant-industry argument A new industry argues for temporary protection until it is mature and can compete with foreign firms. Economists’ response: Difficult for govt to determine which industries will eventually be able to compete and whether benefits of establishing these industries exceed cost to consumers of restricting imports. Besides, if a firm will be profitable in the long run, it should be willing to incur temporary losses. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Arguments for Restricting Trade 4. The unfair-competition argument Producers argue their competitors in another country have an unfair advantage, e.g. due to govt subsidies. Economists’ response: Great! Then we can import extra-cheap products subsidized by the other country’s taxpayers. The gains to our consumers will exceed the losses to our producers. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Arguments for Restricting Trade 5. The protection-as-bargaining-chip argument Example: The U.S. can threaten to limit imports of French wine unless France lifts their quotas on American beef. Economists’ response: Suppose France refuses. Then the U.S. must choose between two bad options: A) Restrict imports from France, which reduces welfare in the U.S. B) Don’t restrict imports, which reduces U.S. credibility. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Trade Agreements ▪A country can liberalize trade with ▪unilateral reductions in trade restrictions ▪multilateral agreements with other nations ▪Examples of trade agreements: ▪North American Free Trade Agreement (NAFTA), 1993 ▪General Agreement on Tariffs and Trade (GATT), ongoing ▪World Trade Organization (WTO), est. 1995, enforces trade agreements, resolves disputes © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •A country will export a good if the world price of the good is higher than the domestic price without trade. Trade raises producer surplus, reduces consumer surplus, and raises total surplus. •A country will import a good if the world price is lower than the domestic price without trade. Trade lowers producer surplus but raises consumer and total surplus. •A tariff benefits producers and generates revenue for the govt, but the losses to consumers exceed these gains. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Common arguments for restricting trade include: protecting jobs, defending national security, helping infant industries, preventing unfair competition, and responding to foreign trade restrictions. •Some of these arguments have merit in some cases, but economists believe free trade is usually the better policy. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Country That Imports Plasma TVs Without trade, PD = $3000 Q = 400 PW = $1500 Under free trade, ▪domestic consumers demand 600 ▪domestic producers supply 200 ▪imports = 400 P Q D S $1500 200 $3000 400 600 Plasma TVs imports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Country That Imports Plasma TVs Without trade, CS = A PS = B + C Total surplus = A + B + C With trade, CS = A + B + D PS = C Total surplus = A + B + C + D P Q D S $1500 $3000 Plasma TVs A B D C gains from trade imports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. On 12/31/2004, U.S. quotas on apparel & textile products expired. During Jan 2005: ▪U.S. imports of these products from China increased over 70%. ▪Loss of 12,000 jobs in U.S. textile industry. The U.S. textile industry & labor unions fought for new trade restrictions. The National Retail Federation opposed any restrictions. In the News: Textile Imports from China November 2005: Bush administration agreed to limit growth in imports from China. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Measuring a Nation’s Income Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What is Gross Domestic Product (GDP)? •How is GDP related to a nation’s total income and spending? •What are the components of GDP? •How is GDP corrected for inflation? •Does GDP measure society’s well-being? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Micro vs. Macro ▪Microeconomics: The study of how individual households and firms make decisions, interact with one another in markets. ▪Macroeconomics: The study of the economy as a whole. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Income and Expenditure ▪Gross Domestic Product (GDP) measures total income of everyone in the economy. ▪GDP also measures total expenditure on the economy’s output of g&s. For the economy as a whole, income equals expenditure because every dollar a buyer spends is a dollar of income for the seller. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Circular-Flow Diagram ▪a simple depiction of the macroeconomy ▪illustrates GDP as spending, revenue, factor payments, and income ▪Preliminaries: ▪Factors of production are inputs like labor, land, capital, and natural resources. ▪Factor payments are payments to the factors of production (e.g., wages, rent). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Circular-Flow Diagram Households: ▪own the factors of production, sell/rent them to firms for income ▪buy and consume goods & services Households Firms Firms: ▪buy/hire factors of production, use them to produce goods and services ▪sell goods & services © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Circular-Flow Diagram Markets for Factors of Production Households Firms Income (=GDP) Wages, rent, profit (=GDP) Factors of production Labor, land, capital Spending (=GDP) G & S bought G & S sold Revenue (=GDP) Markets for Goods & Services © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What This Diagram Omits ▪The government ▪collects taxes, buys g&s ▪The financial system ▪matches savers’ supply of funds with borrowers’ demand for loans ▪The foreign sector ▪trades g&s, financial assets, and currencies with the country’s residents © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Goods are valued at their market prices, so: ▪All goods measured in the same units (e.g., dollars in the U.S.) ▪Things that don’t have a market value are excluded, e.g., housework you do for yourself. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Final goods: intended for the end user Intermediate goods: used as components or ingredients in the production of other goods GDP only includes final goods—they already embody the value of the intermediate goods used in their production. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP includes tangible goods (like DVDs, mountain bikes, beer) and intangible services (dry cleaning, concerts, cell phone service). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP includes currently produced goods, not goods produced in the past. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP measures the value of production that occurs within a country’s borders, whether done by its own citizens or by foreigners located there. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Usually a year or a quarter (3 months) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Components of GDP ▪Recall: GDP is total spending. ▪Four components: ▪Consumption (C) ▪Investment (I) ▪Government Purchases (G) ▪Net Exports (NX) ▪These components add up to GDP (denoted Y): Y = C + I + G + NX © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Consumption (C) ▪is total spending by households on g&s. ▪Note on housing costs: ▪For renters, consumption includes rent payments. ▪For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Investment (I) ▪is total spending on goods that will be used in the future to produce more goods. ▪includes spending on ▪capital equipment (e.g., machines, tools) ▪structures (factories, office buildings, houses) ▪inventories (goods produced but not yet sold) Note: “Investment” does not mean the purchase of financial assets like stocks and bonds. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Government Purchases (G) ▪is all spending on the g&s purchased by govt at the federal, state, and local levels. ▪G excludes transfer payments, such as Social Security or unemployment insurance benefits. They are not purchases of g&s. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Net Exports (NX) ▪NX = exports – imports ▪Exports represent foreign spending on the economy’s g&s. ▪Imports are the portions of C, I, and G that are spent on g&s produced abroad. ▪Adding up all the components of GDP gives: Y = C + I + G + NX © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. U.S. GDP and Its Components, 2010 –1,772 9,727 6,139 33,365 $47,459 per capita –3.7 20.5 12.9 70.3 100.0 % of GDP –550 3,022 1,907 10,366 $14,745 billions NX G I C Y © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 GDP and its components In each of the following cases, determine how much GDP and each of its components is affected (if at all). A. Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston. B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China. C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. D. General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers A. Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston. Consumption and GDP rise by $200. B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China. Investment rises by $1800, net exports fall by $1800, GDP is unchanged. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. Current GDP and investment do not change, because the computer was built last year. D. General Motors builds $500 million worth of cars, but consumers only buy $470 million of them. Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Real versus Nominal GDP ▪Inflation can distort economic variables like GDP, so we have two versions of GDP: ▪Nominal GDP ▪values output using current prices ▪not corrected for inflation ▪Real GDP ▪values output using the prices of a base year ▪is corrected for inflation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE: Compute nominal GDP in each year: 2011: $10 x 400 + $2 x 1000 = $6,000 2012: $11 x 500 + $2.50 x 1100 = $8,250 2013: $12 x 600 + $3 x 1200 = $10,800 Pizza Latte year P Q P Q 2011 $10 400 $2.00 1000 2012 $11 500 $2.50 1100 2013 $12 600 $3.00 1200 37.5% Increase: 30.9% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE: Compute real GDP in each year, using 2011 as the base year: Pizza Latte year P Q P Q 2011 $10 400 $2.00 1000 2012 $11 500 $2.50 1100 2013 $12 600 $3.00 1200 20.0% Increase: 16.7% $10 $2.00 2011: $10 x 400 + $2 x 1000 = $6,000 2012: $10 x 500 + $2 x 1100 = $7,200 2013: $10 x 600 + $2 x 1200 = $8,400 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE: In each year, ▪nominal GDP is measured using the (then) current prices. ▪real GDP is measured using constant prices from the base year (2011 in this example). year Nominal GDP Real GDP 2011 $6000 $6000 2012 $8250 $7200 2013 $10,800 $8400 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE: ▪The change in nominal GDP reflects both prices and quantities. year Nominal GDP Real GDP 2011 $6000 $6000 2012 $8250 $7200 2013 $10,800 $8400 20.0% 16.7% 37.5% 30.9% ▪The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation). Hence, real GDP is corrected for inflation. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Nominal and Real GDP in the U.S., 1965–2010 Real GDP (base year 2005) Nominal GDP billions © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The GDP Deflator ▪The GDP deflator is a measure of the overall level of prices. ▪Definition: ▪One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next. GDP deflator = 100 x nominal GDP real GDP © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE: Compute the GDP deflator in each year: year Nominal GDP Real GDP GDP Deflator 2011 $6000 $6000 2012 $8250 $7200 2013 $10,800 $8400 2011: 100 x (6000/6000) = 100.0 100.0 2012: 100 x (8250/7200) = 114.6 114.6 2013: 100 x (10,800/8400) = 128.6 128.6 14.6% 12.2% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Computing GDP © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Use the above data to solve these problems: A. Compute nominal GDP in 2011. B. Compute real GDP in 2012. C. Compute the GDP deflator in 2013. 2011 (base yr) 2012 2013 P Q P Q P Q Good A $30 900 $31 1000 $36 1050 Good B $100 192 $102 200 $100 205 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A. Compute nominal GDP in 2011. $30 x 900 + $100 x 192 = $46,200 B. Compute real GDP in 2012. $30 x 1000 + $100 x 200 = $50,000 2011 (base yr) 2012 2013 P Q P Q P Q Good A $30 900 $31 1,000 $36 1050 Good B $100 192 $102 200 $100 205 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. C. Compute the GDP deflator in 2013. Nom GDP = $36 x 1050 + $100 x 205 = $58,300 Real GDP = $30 x 1050 + $100 x 205 = $52,000 GDP deflator = 100 x (Nom GDP)/(Real GDP) = 100 x ($58,300)/($52,000) = 112.1 2011 (base yr) 2012 2013 P Q P Q P Q Good A $30 900 $31 1,000 $36 1050 Good B $100 192 $102 200 $100 205 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP and Economic Well-Being ▪Real GDP per capita is the main indicator of the average person’s standard of living. ▪But GDP is not a perfect measure of well-being. ▪Robert Kennedy issued a very eloquent yet harsh criticism of GDP: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Gross Domestic Product… “… does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans.” - Senator Robert Kennedy, 1968 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP Does Not Value: ▪the quality of the environment ▪leisure time ▪non-market activity, such as the child care a parent provides his or her child at home ▪an equitable distribution of income © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Then Why Do We Care About GDP? ▪Having a large GDP enables a country to afford better schools, a cleaner environment, health care, etc. ▪Many indicators of the quality of life are positively correlated with GDP. For example… © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP and Life Expectancy in 12 countries Life expectancy (years) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Pakistan Bangladesh Nigeria © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP and Literacy in 12 countries Adult Literacy (% of population) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Nigeria Pakistan Bangladesh © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP and Internet Usage in 12 countries Internet Usage (% of population) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Nigeria Bangladesh Pakistan © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Gross Domestic Product (GDP) measures a country’s total income and expenditure. •The four spending components of GDP include: Consumption, Investment, Government Purchases, and Net Exports. •Nominal GDP is measured using current prices. Real GDP is measured using the prices of a constant base year and is corrected for inflation. •GDP is the main indicator of a country’s economic well-being, even though it is not perfect. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Measuring the Cost of Living Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What is the Consumer Price Index (CPI)? How is it calculated? What’s it used for? •What are the problems with the CPI? How serious are they? •How does the CPI differ from the GDP deflator? •How can we use the CPI to compare dollar amounts from different years? Why would we want to do this, anyway? •How can we correct interest rates for inflation? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Consumer Price Index (CPI) ▪measures the typical consumer’s cost of living ▪the basis of cost of living adjustments (COLAs) in many contracts and in Social Security © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How the CPI Is Calculated 1.Fix the “basket.” The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.” 2.Find the prices. The BLS collects data on the prices of all the goods in the basket. 3.Compute the basket’s cost. Use the prices to compute the total cost of the basket. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How the CPI Is Calculated 4.Choose a base year and compute the index. The CPI in any year equals 5.Compute the inflation rate. The percentage change in the CPI from the preceding period. 100 x cost of basket in current year cost of basket in base year CPI this year – CPI last year CPI last year Inflation rate x 100% = © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE basket: {4 pizzas, 10 lattes} $12 x 4 + $3 x 10 = $78 $11 x 4 + $2.5 x 10 = $69 $10 x 4 + $2 x 10 = $60 cost of basket $3.00 $2.50 $2.00 price of latte $12 2012 $11 2011 $10 2010 price of pizza year Compute CPI in each year 2010: 100 x ($60/$60) = 100 2011: 100 x ($69/$60) = 115 2012: 100 x ($78/$60) = 130 Inflation rate: 15% 115 – 100 100 x 100% = 13% 130 – 115 115 x 100% = using 2010 base year: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Calculate the CPI © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2010, the base year. A. Compute the CPI in 2011. B. What was the CPI inflation rate from 2011–2012? price of beef price of chicken 2010 $4 $4 2011 $5 $5 2012 $9 $6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A. Compute the CPI in 2011: Cost of CPI basket in 2011 = ($5 x 10) + ($5 x 20) = $150 CPI in 2011 = 100 x ($150/$120) = 125 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2010, the base year. price of beef price of chicken 2010 $4 $4 2011 $5 $5 2012 $9 $6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. price of beef price of chicken 2010 $4 $4 2011 $5 $5 2012 $9 $6 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2010, the base year. B. What was the inflation rate from 2011–2012? Cost of CPI basket in 2012 = ($9 x 10) + ($6 x 20) = $210 CPI in 2012 = 100 x ($210/$120) = 175 CPI inflation rate = (175 – 125)/125 = 40% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What’s in the CPI’s Basket? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Substitution bias © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CPI basket: {10# beef, 20# chicken} 2010–11: Households bought CPI basket. 2012: Households bought {5 lbs beef, 25 lbs chicken}. beef chicken cost of CPI basket 2010 $4 $4 $120 2011 $5 $5 $150 2012 $9 $6 $210 A. Compute cost of the 2012 household basket. B. Compute % increase in cost of household basket over 2011–12, compare to CPI inflation rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A. Compute cost of the 2012 household basket. ($9 x 5) + ($6 x 25) = $195 CPI basket: {10# beef, 20# chicken} Household basket in 2012: {5# beef, 25# chicken} beef chicken cost of CPI basket 2010 $4 $4 $120 2011 $5 $5 $150 2012 $9 $6 $210 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. B. Compute % increase in cost of household basket over 2011–12, compare to CPI inflation rate. Rate of increase: ($195 – $150)/$150 = 30% CPI inflation rate from previous problem = 40% CPI basket: {10# beef, 20# chicken} Household basket in 2012: {5# beef, 25# chicken} beef chicken cost of CPI basket 2010 $4 $4 $120 2011 $5 $5 $150 2012 $9 $6 $210 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Problems with the CPI: Substitution Bias ▪Over time, some prices rise faster than others. ▪Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. ▪The CPI misses this substitution because it uses a fixed basket of goods. ▪Thus, the CPI overstates increases in the cost of living. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Problems with the CPI: Introduction of New Goods ▪The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. ▪In effect, dollars become more valuable. ▪The CPI misses this effect because it uses a fixed basket of goods. ▪Thus, the CPI overstates increases in the cost of living. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Problems with the CPI: Unmeasured Quality Change ▪Improvements in the quality of goods in the basket increase the value of each dollar. ▪The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. ▪Thus, the CPI overstates increases in the cost of living. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Problems with the CPI ▪Each of these problems causes the CPI to overstate cost of living increases. ▪The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year. ▪This is important because Social Security payments and many contracts have COLAs tied to the CPI. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Two Measures of Inflation, 1950–2010 Percent per year © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Imported consumer goods: ▪included in CPI ▪excluded from GDP deflator The basket: ▪CPI uses fixed basket ▪GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. Capital goods: ▪excluded from CPI ▪included in GDP deflator (if produced domestically) Contrasting the CPI and GDP Deflator © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 CPI vs. GDP deflator In each scenario, determine the effects on the CPI and the GDP deflator. A. Starbucks raises the price of Frappuccinos. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. C. Armani raises the price of the Italian jeans it sells in the U.S. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers A. Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. The GDP deflator rises, the CPI does not. C. Armani raises the price of the Italian jeans it sells in the U.S. The CPI rises, the GDP deflator does not. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Correcting Variables for Inflation: Comparing Dollar Figures from Different Times ▪Inflation makes it harder to compare dollar amounts from different times. ▪Example: the minimum wage ▪$1.15 in Dec 1964 ▪$7.25 in Dec 2010 ▪Did min wage have more purchasing power in Dec 1964 or Dec 2010? ▪To compare, use CPI to convert 1964 figure into “today’s dollars”… © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ▪In our example, ▪“year T” is 12/1964, “today” is 12/2010 ▪Min wage was $1.15 in year T ▪CPI = 31.3 in year T, CPI = 220.3 today Correcting Variables for Inflation: Comparing Dollar Figures from Different Times Amount in today’s dollars Amount in year T dollars Price level today Price level in year T = x $8.09 $1.15 220.3 31.3 = x The minimum wage in 1964 was $8.09 in today’s (2010) dollars. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Correcting Variables for Inflation: Comparing Dollar Figures from Different Times ▪Researchers, business analysts, and policymakers often use this technique to convert a time series of current-dollar (nominal) figures into constant-dollar (real) figures. ▪They can then see how a variable has changed over time after correcting for inflation. ▪Example: the minimum wage, from Jan 1960 to Dec 2010… © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The U.S. Minimum Wage in Current Dollars and Today’s Dollars, 1960–2010 Dollars per hour 2010 dollars current dollars © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 4 Comparing tuition increases Tuition and Fees at U.S. Colleges and Universities 1990 2010 Private non-profit 4-year $9,340 $27,293 Public 4-year $1,908 $7,605 Public 2-year $906 $2,713 CPI 130.7 218.1 Instructions: Express the 1990 tuition figures in 2010 dollars, then compute the percentage increase for all three types of schools. Which type experienced the largest increase in real tuition costs? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 4 Answers 1990 2010 % change CPI 130.7 218.1 66.9% Private non-profit 4-year (current $) $9,340 $27,293 Private non-profit 4-year (2010 $) $15,586 $27,293 75.1% Public 4-year (current $) $1,908 $7,605 Public 4-year (2010 $) $3,184 $7,605 138.9% Public 2-year (current $) $906 $2,713 Public 2-year (2010 $) $1,512 $2,713 79.4% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Correcting Variables for Inflation: Indexation For example, the increase in the CPI automatically determines ▪the COLA in many multi-year labor contracts ▪adjustments in Social Security payments and federal income tax brackets A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Correcting Variables for Inflation: Real vs. Nominal Interest Rates The nominal interest rate: ▪the interest rate not corrected for inflation ▪the rate of growth in the dollar value of a deposit or debt The real interest rate: ▪corrected for inflation ▪the rate of growth in the purchasing power of a deposit or debt Real interest rate = (nominal interest rate) – (inflation rate) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Correcting Variables for Inflation: Real vs. Nominal Interest Rates Example: ▪Deposit $1,000 for one year. ▪Nominal interest rate is 9%. ▪During that year, inflation is 3.5%. ▪Real interest rate = Nominal interest rate – Inflation = 9.0% – 3.5% = 5.5% ▪The purchasing power of the $1000 deposit has grown 5.5%. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Real and Nominal Interest Rates in the U.S., 1950–2010 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the typical consumer’s “basket” of goods & services. •The CPI is used to make Cost of Living Adjustments and to correct economic variables for the effects of inflation. •The real interest rate is corrected for inflation and is computed by subtracting the inflation rate from the nominal interest rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Production and Growth Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What are the facts about living standards and growth rates around the world? •Why does productivity matter for living standards? •What determines productivity and its growth rate? •How can public policy affect growth and living standards? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A typical family with all their possessions in the U.K., an advanced economy GDP per capita: $36,130 Life expectancy: 80 years Adult literacy: 99% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A typical family with all their possessions in Mexico, a middle income country GDP per capita: $14,270 Life expectancy: 76 years Adult literacy: 86% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A typical family with all their possessions in Mali, a poor country GDP per capita: $1,090 Life expectancy: 52 years Adult literacy: 46% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP per capita, 2009 Growth rate, 1970–2009 China $6,828 7.4% Singapore $50,633 4.7% India $3,296 3.3% Japan $32,418 2.2% Spain $32,150 2.1% Israel $27,656 2.1% Colombia $8,959 1.9% United States $45,989 1.8% Canada $37,808 1.7% Philippines $3,542 1.3% Rwanda $1,136 1.1% New Zealand $28,993 1.1% Argentina $14,538 1.0% Saudi Arabia $23,480 0.6% Chad $1,300 0.4% Incomes and Growth Around the World FACT 1: There are vast differences in living standards around the world. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP per capita, 2009 Growth rate, 1970–2009 China $6,828 7.4% Singapore $50,633 4.7% India $3,296 3.3% Japan $32,418 2.2% Spain $32,150 2.1% Israel $27,656 2.1% Colombia $8,959 1.9% United States $45,989 1.8% Canada $37,808 1.7% Philippines $3,542 1.3% Rwanda $1,136 1.1% New Zealand $28,993 1.1% Argentina $14,538 1.0% Saudi Arabia $23,480 0.6% Chad $1,300 0.4% Incomes and Growth Around the World FACT 2: There is also great variation in growth rates across countries. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Incomes and Growth Around the World Since growth rates vary, the country rankings can change over time: ▪Poor countries are not necessarily doomed to poverty forever, e.g. Singapore incomes were low in 1960 and are quite high now. ▪Rich countries can’t take their status for granted: They may be overtaken by poorer but faster-growing countries. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Incomes and Growth Around the World Questions: ▪Why are some countries richer than others? ▪Why do some countries grow quickly while others seem stuck in a poverty trap? ▪What policies may help raise growth rates and long-run living standards? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Productivity ▪Recall one of the Ten Principles from Chap. 1: A country’s standard of living depends on its ability to produce g&s. ▪This ability depends on productivity, the average quantity of g&s produced per unit of labor input. ▪Y = real GDP = quantity of output produced L = quantity of labor so productivity = Y/L (output per worker) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why Productivity Is So Important ▪When a nation’s workers are very productive, real GDP is large and incomes are high. ▪When productivity grows rapidly, so do living standards. ▪What, then, determines productivity and its growth rate? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Physical Capital Per Worker ▪Recall: The stock of equipment and structures used to produce g&s is called [physical] capital, denoted K. ▪K/L = capital per worker. ▪Productivity is higher when the average worker has more capital (machines, equipment, etc.). ▪i.e., an increase in K/L causes an increase in Y/L. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Human Capital Per Worker ▪Human capital (H): the knowledge and skills workers acquire through education, training, and experience ▪H/L = the average worker’s human capital ▪Productivity is higher when the average worker has more human capital (education, skills, etc.). ▪i.e., an increase in H/L causes an increase in Y/L. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Natural Resources Per Worker ▪Natural resources (N): the inputs into production that nature provides, e.g., land, mineral deposits ▪Other things equal, more N allows a country to produce more Y. In per-worker terms, an increase in N/L causes an increase in Y/L. ▪Some countries are rich because they have abundant natural resources (e.g., Saudi Arabia has lots of oil). ▪But countries need not have much N to be rich (e.g., Japan imports the N it needs). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Technological Knowledge ▪Technological knowledge: society’s understanding of the best ways to produce g&s ▪Technological progress does not only mean a faster computer, a higher-definition TV, or a smaller cell phone. ▪It means any advance in knowledge that boosts productivity (allows society to get more output from its resources). ▪e.g., Henry Ford and the assembly line. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tech. Knowledge vs. Human Capital ▪Technological knowledge refers to society’s understanding of how to produce g&s. ▪Human capital results from the effort people expend to acquire this knowledge. ▪Both are important for productivity. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Production Function ▪The production function is a graph or equation showing the relation between output and inputs: Y = A F(L, K, H, N) F( ) is a function that shows how inputs are combined to produce output ―A‖ is the level of technology ▪―A‖ multiplies the function F( ), so improvements in technology (increases in ―A‖) allow more output (Y) to be produced from any given combination of inputs. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Production Function ▪The production function has the property constant returns to scale: Changing all inputs by the same percentage causes output to change by that percentage. For example, ▪Doubling all inputs (multiplying each by 2) causes output to double: Y = A F(L, K, H, N) 2Y = A F(2L, 2K, 2H, 2N) ▪Increasing all inputs 10% (multiplying each by 1.1) causes output to increase by 10%: 1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Production Function ▪If we multiply each input by 1/L, then output is multiplied by 1/L: Y/L = A F(1, K/L, H/L, N/L) ▪This equation shows that productivity (output per worker) depends on: ▪the level of technology (A) ▪physical capital per worker ▪human capital per worker ▪natural resources per worker Y = A F(L, K, H, N) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Discussion Question Which of the following policies do you think would be most effective at boosting growth and living standards in a poor country over the long run? a. Offer tax incentives for investment by local firms b. ‖ ‖ ‖ ‖ ‖ by foreign firms c. Give cash payments for good school attendance d. Crack down on govt corruption e. Restrict imports to protect domestic industries f. Allow free trade g. Give away condoms © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ECONOMIC GROWTH AND PUBLIC POLICY Next, we look at the ways public policy can affect long-run growth in productivity and living standards. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Saving and Investment ▪We can boost productivity by increasing K, which requires investment. ▪Since resources scarce, producing more capital requires producing fewer consumption goods. ▪Reducing consumption = increasing saving. This extra saving funds the production of investment goods. (More details in the next chapter.) ▪Hence, a tradeoff between current and future consumption. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Diminishing Returns and the Catch-Up Effect ▪The govt can implement policies that raise saving and investment. (Details in next chapter.) Then K will rise, causing productivity and living standards to rise. ▪But this faster growth is temporary, due to diminishing returns to capital: As K rises, the extra output from an additional unit of K falls…. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Output per worker (productivity) The Production Function & Diminishing Returns K/L Y/L Capital per worker If workers have little K, giving them more increases their productivity a lot. If workers already have a lot of K, giving them more increases productivity fairly little. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. the property whereby poor countries tend to grow more rapidly than rich ones The catch-up effect: K/L Y/L Poor country starts here Rich country starts here Poor country’s growth Rich country’s growth © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Example of the Catch-Up Effect ▪Over 1960–1990, the U.S. and S. Korea devoted a similar share of GDP to investment, so you might expect they would have similar growth performance. ▪But growth was >6% in Korea and only 2% in the U.S. ▪Explanation: the catch-up effect. In 1960, K/L was far smaller in Korea than in the U.S., hence Korea grew faster.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Investment from Abroad ▪To raise K/L and hence productivity, wages, and living standards, the govt can also encourage ▪foreign direct investment: a capital investment (e.g., a factory) that is owned & operated by a foreign entity ▪foreign portfolio investment: a capital investment financed with foreign money but operated by domestic residents ▪Some of the returns from these investments flow back to the foreign countries that supplied the funds.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Investment from Abroad ▪Especially beneficial in poor countries that cannot generate enough saving to fund investment projects themselves. ▪Also helps poor countries learn state-of-the-art technologies developed in other countries.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Education ▪Govt can increase productivity by promoting education–investment in human capital (H). ▪Public schools, subsidized loans for college ▪Education has significant effects: In the U.S., each year of schooling raises a worker’s wage by 10%. ▪But investing in H also involves a tradeoff between the present & future: Spending a year in school requires sacrificing a year’s wages now to have higher wages later.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Health and Nutrition ▪
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Property Rights and Political Stability ▪Recall: Markets are usually a good way to organize economic activity. The price system allocates resources to their most efficient uses. ▪This requires respect for property rights, the ability of people to exercise authority over the resources they own.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Property Rights and Political Stability ▪In many poor countries, the justice system doesn’t work very well: ▪Contracts aren’t always enforced ▪Fraud, corruption often go unpunished ▪In some, firms must bribe govt officials for permits ▪Political instability (e.g., frequent coups) creates uncertainty over whether property rights will be protected in the future.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Property Rights and Political Stability ▪When people fear their capital may be stolen by criminals or confiscated by a corrupt govt, there is less investment, including from abroad, and the economy functions less efficiently. Result: lower living standards. ▪Economic stability, efficiency, and healthy growth require law enforcement, effective courts, a stable constitution, and honest govt officials.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Free Trade ▪Inward-oriented policies (e.g., tariffs, limits on investment from abroad) aim to raise living standards by avoiding interaction with other countries. ▪Outward-oriented policies (e.g., the elimination of restrictions on trade or foreign investment) promote integration with the world economy.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Free Trade ▪Recall: Trade can make everyone better off. ▪Trade has similar effects as discovering new technologies—it improves productivity and living standards. ▪Countries with inward-oriented policies have generally failed to create growth. ▪e.g., Argentina during the 20th century. ▪Countries with outward-oriented policies have often succeeded. ▪e.g., South Korea, Singapore, Taiwan after 1960.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Research and Development ▪Technological progress is the main reason why living standards rise over the long run. ▪One reason is that knowledge is a public good: Ideas can be shared freely, increasing the productivity of many. ▪Policies to promote tech. progress: ▪Patent laws ▪Tax incentives or direct support for private sector R&D ▪Grants for basic research at universities
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Population Growth …may affect living standards in 3 different ways: 1. Stretching natural resources ▪200 years ago, Malthus argued that pop. growth would strain society’s ability to provide for itself. ▪Since then, the world population has increased sixfold. If Malthus was right, living standards would have fallen. Instead, they’ve risen. ▪Malthus failed to account for technological progress and productivity growth.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Population Growth 2. Diluting the capital stock ▪Bigger population = higher L = lower K/L = lower productivity & living standards. ▪This applies to H as well as K: fast pop. growth = more children = greater strain on educational system. ▪Countries with fast pop. growth tend to have lower educational attainment.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Population Growth To combat this, many developing countries use policy to control population growth. ▪China’s one child per family laws ▪Contraception education & availability ▪Promote female literacy to raise opportunity cost of having babies 2. Diluting the capital stock
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Population Growth 3. Promoting tech. progress ▪More people = more scientists, inventors, engineers = more frequent discoveries = faster tech. progress & economic growth ▪Evidence from Michael Kremer: Over the course of human history, ▪growth rates increased as the world’s population increased ▪more populated regions grew faster than less populated ones
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Review productivity concepts ▪List the determinants of productivity. ▪List three policies that attempt to raise living standards by increasing one of the determinants of productivity. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Determinants of productivity: K/L, physical capital per worker H/L, human capital per worker N/L, natural resources per worker A, technological knowledge Policies to boost productivity: ▪Encourage saving and investment, to raise K/L ▪Encourage investment from abroad, to raise K/L ▪Provide public education, to raise H/L
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Determinants of productivity: K/L, physical capital per worker H/L, human capital per worker N/L, natural resources per worker A, technological knowledge Policies to boost productivity: ▪Patent laws or grants, to increase A ▪Control population growth, to increase K/L
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Are Natural Resources a Limit to Growth? ▪Some argue that population growth is depleting the Earth’s non-renewable resources, and thus will limit growth in living standards. ▪But technological progress often yields ways to avoid these limits: ▪Hybrid cars use less gas. ▪Better insulation in homes reduces the energy required to heat or cool them. ▪As a resource becomes scarcer, its market price rises, which increases the incentive to conserve it and develop alternatives.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪In the long run, living standards are determined by productivity. ▪Policies that affect the determinants of productivity will therefore affect the next generation’s living standards. ▪One of these determinants is saving and investment. ▪In the next chapter, we will learn how saving and investment are determined, and how policies can affect them.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •There are great differences across countries in living standards and growth rates. •Productivity (output per unit of labor) is the main determinant of living standards in the long run. •Productivity depends on physical and human capital per worker, natural resources per worker, and technological knowledge. •Growth in these factors—especially technological progress—causes growth in living standards over the long run. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Policies can affect the following, each of which has important effects on growth: •Saving and investment •International trade •Education, health & nutrition •Property rights and political stability •Research and development •Population growth •Because of diminishing returns to capital, growth from investment eventually slows down, and poor countries may ―catch up‖ to rich ones. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Saving, Investment, and the Financial System Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 13
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What are the main types of financial institutions in the U.S. economy, and what is their function? •What are the three kinds of saving? •What’s the difference between saving and investment? •How does the financial system coordinate saving and investment? •How do govt policies affect saving, investment, and the interest rate?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Institutions ▪The financial system: the group of institutions that helps match the saving of one person with the investment of another. ▪Financial markets: institutions through which savers can directly provide funds to borrowers. Examples: ▪The Bond Market. A bond is a certificate of indebtedness. ▪The Stock Market. A stock is a claim to partial ownership in a firm.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Institutions ▪Financial intermediaries: institutions through which savers can indirectly provide funds to borrowers. Examples: ▪Banks ▪Mutual funds – institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Financial Crisis of 2008–2009 ▪A financial crisis led to a deep recession in the U.S. and around the world. A few unemployment rates:
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: Elements of Financial Crises ▪Large decline in some asset prices ▪2008–2009: Housing prices fell 30%. ▪Insolvencies at financial institutions ▪2008–2009: Banks and other institutions failed when many homeowners stopped paying their mortgages. ▪Decline in confidence in financial institutions ▪2008–2009: Customers with uninsured deposits began pulling their funds out of financial institutions.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: Elements of Financial Crises ▪Credit crunch ▪2008–2009: Borrowers unable to get loans because troubled lenders not confident in borrowers’ credit-worthiness. ▪Economic downturn ▪2008–2009: Failing financial institutions and a fall in investment caused GDP to fall and unemployment to rise. ▪Vicious circle ▪2008–2009: The downturn reduced profits and asset values, which worsened the crisis.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Different Kinds of Saving Private saving = The portion of households’ income that is not used for consumption or paying taxes = Y – T – C Public saving = Tax revenue less government spending = T – G
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Saving National saving = private saving + public saving = (Y – T – C) + (T – G) = Y – C – G = the portion of national income that is not used for consumption or government purchases
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Saving and Investment Recall the national income accounting identity: Y = C + I + G + NX For the rest of this chapter, focus on the closed economy case: Y = C + I + G Solve for I: I = Y – C – G = (Y – T – C) + (T – G) Saving = investment in a closed economy national saving
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Budget Deficits and Surpluses Budget surplus = an excess of tax revenue over govt spending = T – G = public saving Budget deficit = a shortfall of tax revenue from govt spending = G – T = – (public saving)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 A. Calculations ▪Suppose GDP equals $10 trillion, consumption equals $6.5 trillion, the government spends $2 trillion and has a budget deficit of $300 billion. ▪Find public saving, taxes, private saving, national saving, and investment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers, part A Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3 Public saving = T – G = – 0.3 Taxes: T = G – 0.3 = 1.7 Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8 National saving = Y – C – G = 10 – 6.5 = 2 = 1.5 Investment = national saving = 1.5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 B. How a tax cut affects saving ▪Use the numbers from the preceding exercise, but suppose now that the government cuts taxes by $200 billion. ▪In each of the following two scenarios, determine what happens to public saving, private saving, national saving, and investment. 1. Consumers save the full proceeds of the tax cut. 2. Consumers save 1/4 of the tax cut and spend the other 3/4. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers, part B In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion to $500 billion. 1. If consumers save the full $200 billion, national saving is unchanged, so investment is unchanged. 2. If consumers save $50 billion and spend $150 billion, then national saving and investment each fall by $150 billion. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 C. Discussion questions The two scenarios from this exercise were: 1. Consumers save the full proceeds of the tax cut. 2. Consumers save 1/4 of the tax cut and spend the other 3/4. ▪Which of these two scenarios do you think is more realistic? ▪Why is this question important? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Meaning of Saving and Investment ▪Private saving is the income remaining after households pay their taxes and pay for consumption. ▪Examples of what households do with saving: ▪Buy corporate bonds or equities ▪Purchase a certificate of deposit at the bank ▪Buy shares of a mutual fund ▪Let accumulate in saving or checking accounts
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Meaning of Saving and Investment ▪Investment is the purchase of new capital. ▪Examples of investment: ▪General Motors spends $250 million to build a new factory in Flint, Michigan. ▪You buy $5000 worth of computer equipment for your business. ▪Your parents spend $300,000 to have a new house built. Remember: In economics, investment is NOT the purchase of stocks and bonds!
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds ▪A supply–demand model of the financial system ▪Helps us understand ▪how the financial system coordinates saving & investment ▪how govt policies and other factors affect saving, investment, the interest rate
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds Assume: only one financial market ▪All savers deposit their saving in this market. ▪All borrowers take out loans from this market. ▪There is one interest rate, which is both the return to saving and the cost of borrowing.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds The supply of loanable funds comes from saving: ▪Households with extra income can loan it out and earn interest. ▪Public saving, if positive, adds to national saving and the supply of loanable funds. If negative, it reduces national saving and the supply of loanable funds.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Slope of the Supply Curve Interest Rate Loanable Funds ($billions) Supply An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied. 60 3% 80 6%
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds The demand for loanable funds comes from investment: ▪Firms borrow the funds they need to pay for new equipment, factories, etc. ▪Households borrow the funds they need to purchase new houses.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Slope of the Demand Curve Interest Rate Loanable Funds ($billions) Demand A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded. 50 7% 4% 80
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Equilibrium Interest Rate Loanable Funds ($billions) Demand The interest rate adjusts to equate supply and demand. Supply The eq’m quantity of L.F. equals eq’m investment and eq’m saving. 5% 60
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Policy 1: Saving Incentives Interest Rate Loanable Funds ($billions) D1 Tax incentives for saving increase the supply of L.F. S1 5% 60 S2 …which reduces the eq’m interest rate and increases the eq’m quantity of L.F. 4% 70
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Policy 2: Investment Incentives Interest Rate Loanable Funds ($billions) D1 An investment tax credit increases the demand for L.F. S1 5% 60 …which raises the eq’m interest rate and increases the eq’m quantity of L.F. 6% 70 D2
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Budget deficits ▪Use the loanable funds model to analyze the effects of a government budget deficit: ▪Draw the diagram showing the initial equilibrium. ▪Determine which curve shifts when the government runs a budget deficit. ▪Draw the new curve on your diagram. ▪What happens to the equilibrium values of the interest rate and investment? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Rate Loanable Funds ($billions) D1 A budget deficit reduces national saving and the supply of L.F. S1 5% 60 S2 …which increases the eq’m interest rate and decreases the eq’m quantity of L.F. and investment. 6% 50
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Budget Deficits, Crowding Out, and Long-Run Growth ▪Our analysis: Increase in budget deficit causes fall in investment. The govt borrows to finance its deficit, leaving less funds available for investment. ▪This is called crowding out. ▪Recall from the preceding chapter: Investment is important for long-run economic growth. Hence, budget deficits reduce the economy’s growth rate and future standard of living.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The U.S. Government Debt ▪The government finances deficits by borrowing (selling government bonds). ▪Persistent deficits lead to a rising govt debt. ▪The ratio of govt debt to GDP is a useful measure of the government’s indebtedness relative to its ability to raise tax revenue. ▪Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime—until the early 1980s.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. U.S. Government Debt as a Percentage of GDP, 1970–2010 Revolutionary War Civil War WW1 WW2 63.6% in 2010
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪Like many other markets, financial markets are governed by the forces of supply and demand. ▪One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. Financial markets help allocate the economy’s scarce resources to their most efficient uses. ▪Financial markets also link the present to the future: They enable savers to convert current income into future purchasing power, and borrowers to acquire capital to produce goods and services in the future.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The U.S. financial system is made up of many types of financial institutions, like the stock and bond markets, banks, and mutual funds. •National saving equals private saving plus public saving. •In a closed economy, national saving equals investment. The financial system makes this happen. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The supply of loanable funds comes from saving. The demand for funds comes from investment. The interest rate adjusts to balance supply and demand in the loanable funds market. •A government budget deficit is negative public saving, so it reduces national saving, the supply of funds available to finance investment. •When a budget deficit crowds out investment, it reduces the growth of productivity and GDP. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Policy 3: Govt Budget Deficits Interest Rate Loanable Funds ($billions) D1 A budget deficit reduces national saving and the supply of L.F. S1 5% 60 S2 …which increases the eq’m interest rate and decreases the eq’m quantity of L.F. 6% 50
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Basic Tools of Finance Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 14
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What is ―present value‖? How can we use it to compare sums of money from different times? •Why are people risk averse? How can risk-averse people use insurance and diversification to manage risk? •What determines the value of an asset? What is the ―efficient markets hypothesis‖? Why is beating the market nearly impossible?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction ▪The financial system coordinates saving and investment. ▪Participants in the financial system make decisions regarding the allocation of resources over time and the handling of risk. ▪Finance is the field that studies such decision making.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Present Value: The Time Value of Money ▪To compare sums from different times, we use the concept of present value. ▪The present value of a future sum: the amount that would be needed today to yield that future sum at prevailing interest rates ▪Related concept: The future value of a sum: the amount the sum will be worth at a given future date, when allowed to earn interest at the prevailing rate
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE 1: A Simple Deposit ▪Deposit $100 in the bank at 5% interest. What is the future value (FV) of this amount? ▪In N years, FV = $100(1 + 0.05)N ▪In three years, FV = $100(1 + 0.05)3 = $115.76 ▪In two years, FV = $100(1 + 0.05)2 = $110.25 ▪In one year, FV = $100(1 + 0.05) = $105.00
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE 1: A Simple Deposit ▪Deposit $100 in the bank at 5% interest. What is the future value (FV) of this amount? ▪In N years, FV = $100(1 + 0.05)N ▪In this example, $100 is the present value (PV). ▪In general, FV = PV(1 + r )N where r denotes the interest rate (in decimal form). ▪Solve for PV to get: PV = FV/(1 + r )N
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE 2: Investment Decision ▪Suppose r = 0.06. Should General Motors spend $100 million to build a factory that will yield $200 million in ten years? Solution: Find present value of $200 million in 10 years: PV = ($200 million)/(1.06)10 = $112 million Since PV > cost of factory, GM should build it. Present value formula: PV = FV/(1 + r )N
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EXAMPLE 2: Investment Decision ▪Instead, suppose r = 0.09. Should General Motors spend $100 million to build a factory that will yield $200 million in ten years? Solution: Find present value of $200 million in 10 years: PV = ($200 million)/(1.09)10 = $84 million Since PV < cost of factory, GM should not build it. Present value helps explain why investment falls when the interest rate rises. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Present value You are thinking of buying a six-acre lot for $70,000. The lot will be worth $100,000 in five years. A. Should you buy the lot if r = 0.05? B. Should you buy it if r = 0.10? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers You are thinking of buying a six-acre lot for $70,000. The lot will be worth $100,000 in five years. A. Should you buy the lot if r = 0.05? PV = $100,000/(1.05)5 = $78,350. PV of lot > price of lot. Yes, buy it. B. Should you buy it if r = 0.10? PV = $100,000/(1.1)5 = $62,090. PV of lot < price of lot. No, do not buy it. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Compounding ▪Compounding: the accumulation of a sum of money where the interest earned on the sum earns additional interest ▪Because of compounding, small differences in interest rates lead to big differences over time. ▪Example: Buy $1000 worth of Microsoft stock, hold for 30 years. If rate of return = 0.08, FV = $10,063 If rate of return = 0.10, FV = $17,450 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Rule of 70 ▪The Rule of 70: If a variable grows at a rate of x percent per year, that variable will double in about 70/x years. ▪Example: ▪If interest rate is 5%, a deposit will double in about 14 years. ▪If interest rate is 7%, a deposit will double in about 10 years. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Risk Aversion ▪Most people are risk averse—they dislike uncertainty. ▪Example: You are offered the following gamble. Toss a fair coin. ▪If heads, you win $1000. ▪If tails, you lose $1000. Should you take this gamble? ▪If you are risk averse, the pain of losing $1000 would exceed the pleasure of winning $1000, and both outcomes are equally likely, so you should not take this gamble. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Utility Function Wealth Utility Current wealth Current utility Utility is a subjective measure of well-being that depends on wealth. As wealth rises, the curve becomes flatter due to diminishing marginal utility: the more wealth a person has, the less extra utility he would get from an extra dollar. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Utility Function and Risk Aversion Because of diminishing marginal utility, a $1000 loss reduces utility more than a $1000 gain increases it. Wealth Utility –1000 +1000 Utility loss from losing $1000 Utility gain from winning $1000 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Managing Risk With Insurance ▪How insurance works: A person facing a risk pays a fee to the insurance company, which in return accepts part or all of the risk. ▪Insurance allows risks to be pooled, and can make risk averse people better off: E.g., it is easier for 10,000 people to each bear 1/10,000 of the risk of a house burning down than for one person to bear the entire risk alone. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Two Problems in Insurance Markets 1. Adverse selection: A high-risk person benefits more from insurance, so is more likely to purchase it. 2. Moral hazard: People with insurance have less incentive to avoid risky behavior. Insurance companies cannot fully guard against these problems, so they must charge higher prices. As a result, low-risk people sometimes forego insurance and lose the benefits of risk-pooling. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Adverse selection or moral hazard? Identify whether each of the following is an example of adverse selection or moral hazard. A. Joe begins smoking in bed after buying fire insurance. B. Both of Susan’s parents lost their teeth to gum disease, so Susan buys dental insurance. C. When Gertrude parks her Corvette convertible, she doesn’t bother putting the top up, because her insurance covers theft of any items left in the car. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers A. Joe begins smoking in bed after buying fire insurance. moral hazard B. Both of Susan’s parents lost their teeth to gum disease, so Susan buys dental insurance. adverse selection C. When Gertrude parks her Corvette convertible, she doesn’t bother putting the top up, because her insurance covers theft of any items left in the car. moral hazard © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Measuring Risk ▪We can measure risk of an asset with the standard deviation, a statistic that measures a variable’s volatility—how likely it is to fluctuate. ▪The higher the standard deviation of the asset’s return, the greater the risk. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reducing Risk Through Diversification ▪Diversification reduces risk by replacing a single risk with a large number of smaller, unrelated risks. ▪A diversified portfolio contains assets whose returns are not strongly related: ▪Some assets will realize high returns, others low returns. ▪The high and low returns average out, so the portfolio is likely to earn an intermediate return more consistently than any of the assets it contains. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reducing Risk Through Diversification ▪Diversification can reduce firm-specific risk, which affects only a single company. ▪Diversification cannot reduce market risk, which affects all companies in the stock market. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reducing Risk Through Diversification Increasing the number of stocks reduces firm-specific risk. Standard dev of portfolio return # of stocks in portfolio 0 10 20 30 40 50 0 10 20 30 40 But market risk remains. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Tradeoff Between Risk and Return ▪Tradeoff: Riskier assets pay a higher return, on average, to compensate for the extra risk of holding them. ▪E.g., over past 200 years, average real return on stocks, 8%. On short-term govt bonds, 3%. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Tradeoff Between Risk and Return ▪Example: Suppose you are dividing your portfolio between two asset classes. ▪A diversified group of risky stocks: average return = 8%, standard dev. = 20% ▪A safe asset: return = 3%, standard dev. = 0% ▪The risk and return on the portfolio depends on the percentage of each asset class in the portfolio… © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Tradeoff Between Risk and Return Increasing the share of stocks in the portfolio increases the average return but also the risk. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Asset Valuation ▪When deciding whether to buy a company’s stock, you compare the price of the shares to the value of the company. ▪If share price > value, the stock is overvalued. ▪If price < value, the stock is undervalued. ▪If price = value, the stock is fairly valued. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Valuing a share of stock If you buy a share of AT&T stock today, ▪you will be able to sell it in 3 years for $30. ▪you will receive a $1 dividend at the end of each of those 3 years. If the prevailing interest rate is 10%, what is the value of a share of AT&T stock today? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. $30/(1.1)3 = $22.54 in 3 years $30 $1/(1.1)3 = $ .75 in 3 years $1 $1/(1.1)2 = $ .83 in 2 years $1 $1/(1.1) = $ .91 in 1 year $1 present value of the amount when you will receive it amount you will receive The value of a share of AT&T stock equals the sum of the numbers in the last column: $25.03 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Asset Valuation ▪Value of a share = PV of any dividends the stock will pay + PV of the price you get when you sell the share ▪Problem: When you buy the share, you don’t know what future dividends or prices will be. ▪One way to value a stock: fundamental analysis, the study of a company’s accounting statements and future prospects to determine its value © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 4 Show of hands survey You have a brokerage account with Merrill Lynch. Your broker calls you with a hot tip about a stock: new information suggests that the company will be highly profitable. Should you buy stock in the company? A. Yes B. No C. Not until you read the prospectus. D. What’s a prospectus? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Efficient Markets Hypothesis ▪Efficient Markets Hypothesis (EMH): the theory that each asset price reflects all publicly available information about the value of the asset © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Implications of EMH 1. Stock market is informationally efficient: Each stock price reflects all available information about the value of the company. 2. Stock prices follow a random walk: A stock price only changes in response to new information (―news‖) about the company’s value. News cannot be predicted, so stock price movements should be impossible to predict. 3. It is impossible to systematically beat the market. By the time the news reaches you, mutual fund managers will have already acted on it. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Index Funds vs. Managed Funds ▪An index fund is a mutual fund that buys all the stocks in a given stock index. ▪An actively managed mutual fund aims to buy only the best stocks. ▪Actively managed funds have higher expenses than index funds. ▪EMH implies that returns on actively managed funds should not consistently exceed the returns on index funds. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Index Funds vs. Managed Funds .550 1.272 12.5 10.3 S&P SmallCap 600 (index fund) Managed mid cap funds .535 1.458 10.9 8.1 S&P MidCap 400 (index fund) Managed mid cap funds .351 1.020 6.2% 5.9 S&P 500 (index fund) Managed large cap funds 2006 expense ratio 2001–2006 annualized return © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Market Irrationality ▪Many believe that stock price movements are partly psychological: ▪J.M. Keynes: stock prices driven by ―animal spirits,‖ ―waves of pessimism and optimism‖ ▪Alan Greenspan: 1990s stock market boom due to ―irrational exuberance‖ ▪Bubbles occur when speculators buy overvalued assets expecting prices to rise further. ▪The importance of departures from rational pricing is not known. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪This chapter has introduced some of the basic tools people use when they make financial decisions. ▪The efficient markets hypothesis teaches that a stock price should reflect the company’s expected future profitability. ▪Fluctuations in the stock market have important macroeconomic implications, which we will study later in this course. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce that future sum. •Because of diminishing marginal utility of wealth, most people are risk-averse. Risk-averse people can manage risk with insurance, through diversification, and by choosing a portfolio with a lower risk and lower return. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The value of an asset equals the present value of all payments its owner will receive. For a share of stock, these payments include dividends plus the final sale price. •According to the efficient markets hypothesis, financial markets are informationally efficient, a stock price always equals the market’s best guess of the firm’s value, and stock prices follow a random walk as new information becomes available. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Some economists question the efficient markets hypothesis, and believe that irrational psychological factors also influence asset prices. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Unemployment Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •How is unemployment measured? •What is the “natural rate of unemployment”? •Why are there always some people unemployed? •How is unemployment affected by unions and minimum wage laws? •What is the theory of efficiency wages, and how does it help explain unemployment? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Labor Force Statistics ▪Produced by Bureau of Labor Statistics (BLS), in the U.S. Dept. of Labor ▪Based on regular survey of 60,000 households ▪Based on “adult population” (16 yrs or older) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Labor Force Statistics BLS divides population into 3 groups: ▪Employed: paid employees, self-employed, and unpaid workers in a family business ▪Unemployed: people not working who have looked for work during previous 4 weeks ▪Not in the labor force: everyone else The labor force is the total # of workers, including the employed and unemployed. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. labor force participation rate labor force adult population = 100 x Labor Force Statistics Labor force participation rate: % of the adult population that is in the labor force Unemployment rate (“u-rate”): % of the labor force that is unemployed u-rate # of unemployed labor force = 100 x © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Calculate labor force statistics Compute the labor force, u-rate, adult population, and labor force participation rate using this data: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adult population of the U.S. by group, April 2011 # of employed 139.7 million # of unemployed 13.7 million not in labor force 85.7 million © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers Labor force = employed + unemployed = 139.7 + 13.7 = 153.4 million U-rate = 100 x (unemployed)/(labor force) = 100 x 13.7/153.4 = 8.9% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers Population = labor force + not in labor force = 153.4 + 85.7 = 239.1 LF partic. rate = 100 x (labor force)/(population) = 100 x 153.4/239.1 = 64.2% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Labor Force Statistics for Different Groups ▪The BLS publishes these statistics for demographic groups within the population. ▪These data reveal widely different labor market experiences for different groups. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Labor Force Statistics for Whites & Blacks, April 2011 Adults (20 yrs & older) u-rate LF part. rate White, male 7.9% 73.9% White, female 7.0 59.8 Black, male 17.0 68.6 Black, female 13.4 62.0 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Labor Force Statistics for Whites & Blacks, April 2011 Teens (16–19 yrs) u-rate LF part. rate White 22.3% 36.2% Black 41.6% 26.2% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Labor Force Statistics for Other Groups, April 2011 All ages u-rate LF part. rate Asian 6.4% 64.1% Hispanic 11.8 66.6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Labor Force Statistics by Education Level, April 2011 Adults (25 yrs & older) u-rate LF part. rate less than h.s. 14.6% 45.5% h.s. diploma 9.7 60.4 some college or assoc degree 7.5 69.7 bachelor’s degree or more 4.5 77.0 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LF Participation Rates by Sex, 1950–2009 Men Women percent male female © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Limitations of the u-rate © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In each of the following, what happens to the u-rate? Does the u-rate give an accurate impression of what’s happening in the labor market? A. Sue lost her job and begins looking for a new one. B. Jon, a steelworker who has been out of work since his mill closed last year, becomes discouraged and gives up looking for work. C. Sam, the sole earner in his family of 5, just lost his $80,000 job as a research scientist. Immediately, he takes a part-time job at McDonald’s until he can find another job in his field. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A. Sue lost her job and begins looking for a new one. u-rate rises A rising u-rate gives the impression that the labor market is worsening, and it is. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. B. Jon has been out of work since last year, becomes discouraged, stops looking for work. Discouraged workers ▪would like to work but have given up looking for jobs ▪classified as “not in the labor force” rather than “unemployed” U-rate falls because Jon is no longer counted as unemployed. A falling u-rate gives the impression that the labor market is improving, but it is not. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. C. Sam lost his $80,000 job, and takes a part-time job at McDonald’s until he finds a better one. U-rate unchanged because a person is “employed” whether they work full or part time. Things are worse, but the u-rate fails to show it. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What Does the U-Rate Really Measure? ▪The u-rate is not a perfect indicator of joblessness or the health of the labor market: ▪It excludes discouraged workers. ▪It does not distinguish between full-time and part-time work, or people working part time because full-time jobs not available. ▪Some people misreport their work status in the BLS survey. ▪Despite these issues, the u-rate is still a very useful barometer of the labor market & economy. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Duration of Unemployment Most spells of unemployment are short: ▪Typically 1/3 of the unemployed have been unemployed under 5 weeks, 2/3 have been unemployed under 14 weeks. ▪Only 20% have been unemployed over 6 months. Yet, most observed unemployment is long term. ▪The small group of long-term unemployed persons has fairly little turnover, so it accounts for most of the unemployment observed over time. Knowing these facts helps policymakers design better policies to help the unemployed. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cyclical Unemployment vs. the Natural Rate There’s always some unemployment, though the u-rate fluctuates from year to year. Natural rate of unemployment ▪the normal rate of unemployment around which the actual unemployment rate fluctuates Cyclical unemployment ▪the deviation of unemployment from its natural rate ▪associated with business cycles, which we’ll study in later chapters © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. U.S. Unemployment, 1960–2011 Natural rate of unemployment Unemployment rate percentage of labor force © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Explaining the Natural Rate: An Overview Even when the economy is doing well, there is always some unemployment, including: Frictional unemployment ▪occurs when workers spend time searching for the jobs that best suit their skills and tastes ▪short-term for most workers Structural unemployment ▪occurs when there are fewer jobs than workers ▪usually longer-term © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Job Search ▪Workers have different tastes & skills, and jobs have different requirements. ▪Job search is the process of matching workers with appropriate jobs. ▪Sectoral shifts are changes in the composition of demand across industries or regions of the country. ▪Such shifts displace some workers, who must search for new jobs appropriate for their skills & tastes. ▪The economy is always changing, so some frictional unemployment is inevitable. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Public Policy and Job Search ▪Govt employment agencies provide information about job vacancies to speed up the matching of workers with jobs. ▪Public training programs aim to equip workers displaced from declining industries with the skills needed in growing industries. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Unemployment Insurance ▪Unemployment insurance (UI): a govt program that partially protects workers’ incomes when they become unemployed ▪UI increases frictional unemployment. To see why, recall one of the Ten Principles of Economics: People respond to incentives. UI benefits end when a worker takes a job, so workers have less incentive to search or take jobs while eligible to receive benefits. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Unemployment Insurance Benefits of UI: ▪Reduces uncertainty over incomes ▪Gives the unemployed more time to search, resulting in better job matches and thus higher productivity © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Explaining Structural Unemployment Structural unemployment occurs when not enough jobs to go around. W L D S WE actual wage W1 unemp-loyment Occurs when wage is kept above eq’m. There are three reasons for this… © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1. Minimum-Wage Laws ▪The min. wage may exceed the eq’m wage for the least skilled or experienced workers, causing structural unemployment. ▪But this group is a small part of the labor force, so the min. wage can’t explain most unemployment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. Unions ▪Union: a worker association that bargains with employers over wages, benefits, and working conditions ▪Unions exert their market power to negotiate higher wages for workers. ▪The typical union worker earns 20% higher wages and gets more benefits than a nonunion worker for the same type of work. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. Unions ▪When unions raise the wage above eq’m, quantity of labor demanded falls and unemployment results. ▪“Insiders” – workers who remain employed, are better off ▪“Outsiders” – workers who lose their jobs, are worse off ▪Some outsiders go to non-unionized labor markets, which increases labor supply and reduces wages in those markets. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. Unions Are unions good or bad? Economists disagree. ▪Critics: Unions are cartels. They raise wages above eq’m, which causes unemployment and/or depresses wages in non-union labor markets. ▪Advocates: Unions counter the market power of large firms, make firms more responsive to workers’ concerns. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3. Efficiency Wages ▪The theory of efficiency wages: Firms voluntarily pay above-equilibrium wages to boost worker productivity. ▪Different versions of efficiency wage theory suggest different reasons why firms pay high wages. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3. Efficiency Wages 1. Worker health In less developed countries, poor nutrition is a common problem. Paying higher wages allows workers to eat better, makes them healthier, more productive. 2. Worker turnover Hiring & training new workers is costly. Paying high wages gives workers more incentive to stay, reduces turnover. Four reasons why firms might pay efficiency wages: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3. Efficiency Wages 3. Worker quality Offering higher wages attracts better job applicants, increases quality of the firm’s workforce. 4. Worker effort Workers can work hard or shirk. Shirkers are fired if caught. Is being fired a good deterrent? Depends on how hard it is to find another job. If market wage is above eq’m wage, there aren’t enough jobs to go around, so workers have more incentive to work not shirk. Four reasons why firms might pay efficiency wages: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Applying the concepts © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Which of the following would be most likely to reduce frictional unemployment? A. The govt eliminates the minimum wage. B. The govt increases unemployment insurance benefits. C. A new law bans labor unions. D. More workers post their resumes at Monster.com, and more employers use Monster.com to find suitable workers to hire. E. Sectoral shifts become more frequent. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A. The govt eliminates the minimum wage. C. A new law bans labor unions. These are likely to reduce structural unemployment, not frictional unemployment. Which of the following would be most likely to reduce frictional unemployment? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Which of the following would be most likely to reduce frictional unemployment? B. The govt increases unemployment insurance benefits. E. Sectoral shifts become more frequent. These are likely to increase frictional unemployment, not reduce it. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Which of the following would be most likely to reduce frictional unemployment? D. More workers post their resumes at Monster.com, and more employers use Monster.com to find suitable workers to hire. Likely to speed up the process of matching workers & jobs, which would reduce frictional unemployment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Explaining the Natural Rate of Unemployment: A Summary The natural rate of unemployment consists of ▪ frictional unemployment ▪It takes time to search for the right jobs ▪Occurs even if there are enough jobs to go around ▪ structural unemployment ▪When wage is above eq’m, not enough jobs ▪Due to min. wages, labor unions, efficiency wages In later chapters, we will learn about cyclical unemployment, the short-term fluctuations in unemployment associated with business cycles. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The unemployment rate is the percentage of those who would like to work who do not have jobs. •Unemployment and labor force participation vary widely across demographic groups. •The natural rate of unemployment is the normal rate of unemployment around which the actual rate fluctuates. Cyclical unemployment is the deviation of unemployment from its natural rate and is connected to short-term economic fluctuations. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The natural rate includes frictional unemployment and structural unemployment. •Frictional unemployment occurs when workers take time to search for the right jobs. •Structural unemployment occurs when above- equilibrium wages result in a surplus of labor. •Three reasons for above-equilibrium wages include minimum wage laws, unions, and efficiency wages. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Monetary System Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What assets are considered ―money‖? What are the functions of money? The types of money? •What is the Federal Reserve? •What role do banks play in the monetary system? How do banks ―create money‖? •How does the Federal Reserve control the money supply? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What Money Is and Why It’s Important ▪Without money, trade would require barter, the exchange of one good or service for another. ▪Every transaction would require a double coincidence of wants—the unlikely occurrence that two people each have a good the other wants. ▪Most people would have to spend time searching for others to trade with—a huge waste of resources. ▪This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The 3 Functions of Money ▪Medium of exchange: an item buyers give to sellers when they want to purchase g&s ▪Unit of account: the yardstick people use to post prices and record debts ▪Store of value: an item people can use to transfer purchasing power from the present to the future © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The 2 Kinds of Money Commodity money: takes the form of a commodity with intrinsic value Examples: gold coins, cigarettes in POW camps Fiat money: money without intrinsic value, used as money because of govt decree Example: the U.S. dollar © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Money Supply ▪The money supply (or money stock): the quantity of money available in the economy ▪What assets should be considered part of the money supply? Two candidates: ▪Currency: the paper bills and coins in the hands of the (non-bank) public ▪Demand deposits: balances in bank accounts that depositors can access on demand by writing a check © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Measures of the U.S. Money Supply ▪M1: currency, demand deposits, traveler’s checks, and other checkable deposits. M1 = $1.9 trillion (February 2011) ▪M2: everything in M1 plus savings deposits, small time deposits, money market mutual funds, and a few minor categories. M2 = $8.9 trillion (February 2011) The distinction between M1 and M2 will often not matter when we talk about ―the money supply‖ in this course. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Central Banks & Monetary Policy ▪Central bank: an institution that oversees the banking system and regulates the money supply ▪Monetary policy: the setting of the money supply by policymakers in the central bank ▪Federal Reserve (Fed): the central bank of the U.S. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Structure of the Fed The Federal Reserve System consists of: ▪Board of Governors (7 members), located in Washington, DC ▪12 regional Fed banks, located around the U.S. ▪Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy. Ben S. Bernanke Chair of FOMC, Feb 2006 – present © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank Reserves ▪In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans. ▪The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits. ▪Banks may hold more than this minimum amount if they choose. ▪The reserve ratio, R = fraction of deposits that banks hold as reserves = total reserves as a percentage of total deposits © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank T-Account ▪T-account: a simplified accounting statement that shows a bank’s assets & liabilities. ▪Example: FIRST NATIONAL BANK Assets Liabilities Reserves $ 10 Loans $ 90 Deposits $100 ▪Banks’ liabilities include deposits, assets include loans & reserves. ▪In this example, notice that R = $10/$100 = 10%. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Banks and the Money Supply: An Example Suppose $100 of currency is in circulation. To determine banks’ impact on money supply, we calculate the money supply in 3 different cases: 1. No banking system 2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans 3. Fractional reserve banking system © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Banks and the Money Supply: An Example CASE 1: No banking system Public holds the $100 as currency. Money supply = $100. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Banks and the Money Supply: An Example CASE 2: 100% reserve banking system Public deposits the $100 at First National Bank (FNB). FIRST NATIONAL BANK Assets Liabilities Reserves $100 Loans $ 0 Deposits $100 FNB holds 100% of deposit as reserves: Money supply = currency + deposits = $0 + $100 = $100 In a 100% reserve banking system, banks do not affect size of money supply. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system Depositors have $100 in deposits, borrowers have $90 in currency. Money supply = C + D = $90 + $100 = $190 (!!!) FIRST NATIONAL BANK Assets Liabilities Reserves $100 Loans $ 0 Deposits $100 Suppose R = 10%. FNB loans all but 10% of the deposit: 10 90 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Banks and the Money Supply: An Example How did the money supply suddenly grow? When banks make loans, they create money. The borrower gets ▪$90 in currency—an asset counted in the money supply ▪$90 in new debt—a liability that does not have an offsetting effect on the money supply CASE 3: Fractional reserve banking system A fractional reserve banking system creates money, but not wealth. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system If R = 10% for SNB, it will loan all but 10% of the deposit. SECOND NATIONAL BANK Assets Liabilities Reserves $ 90 Loans $ 0 Deposits $ 90 Borrower deposits the $90 at Second National Bank. Initially, SNB’s T-account looks like this: 9 81 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system If R = 10% for TNB, it will loan all but 10% of the deposit. THIRD NATIONAL BANK Assets Liabilities Reserves $ 81 Loans $ 0 Deposits $ 81 SNB’s borrower deposits the $81 at Third National Bank. Initially, TNB’s T-account looks like this: $ 8.10 $72.90 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system The process continues, and money is created with each new loan. Original deposit = FNB lending = SNB lending = TNB lending = . . . $ 100.00 $ 90.00 $ 81.00 $ 72.90 . . . Total money supply = $ 1000.00 In this example, $100 of reserves generates $1000 of money. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Money Multiplier ▪Money multiplier: the amount of money the banking system generates with each dollar of reserves ▪The money multiplier equals 1/R. ▪In our example, R = 10% money multiplier = 1/R = 10 $100 of reserves creates $1000 of money © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Banks and the money supply © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. While cleaning your apartment, you look under the sofa cushion and find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account. The Fed’s reserve requirement is 20% of deposits. A. What is the maximum amount that the money supply could increase? B. What is the minimum amount that the money supply could increase? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. If banks hold no excess reserves, then money multiplier = 1/R = 1/0.2 = 5 The maximum possible increase in deposits is 5 x $50 = $250 But money supply also includes currency, which falls by $50. Hence, max increase in money supply = $200. You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Answer: $0 If your bank makes no loans from your deposit, currency falls by $50, deposits increase by $50, money supply does not change. You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase? Answer: $200 B. What is the minimum amount that the money supply could increase? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A More Realistic Balance Sheet ▪Assets: Besides reserves and loans, banks also hold securities. ▪Liabilities: Besides deposits, banks also obtain funds from issuing debt and equity. ▪Bank capital: the resources a bank obtains by issuing equity to its owners ▪Also: bank assets minus bank liabilities ▪Leverage: the use of borrowed funds to supplement existing funds for investment purposes © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A More Realistic Balance Sheet MORE REALISTIC NATIONAL BANK Assets Liabilities Reserves $ 200 Loans $ 700 Securities $ 100 Deposits $ 800 Debt $ 150 Capital $ 50 Leverage ratio: the ratio of assets to bank capital In this example, the leverage ratio = $1000/$50 = 20 Interpretation: for every $20 in assets, $ 1 is from the bank’s owners, $19 is financed with borrowed money. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Leverage Amplifies Profits and Losses ▪In our example, suppose bank assets appreciate by 5%, from $1000 to $1050. This increases bank capital from $50 to $100, doubling owners’ equity. ▪Instead, if bank assets decrease by 5%, bank capital falls from $50 to $0. ▪If bank assets decrease more than 5%, bank capital is negative and bank is insolvent. ▪Capital requirement: a govt regulation that specifies a minimum amount of capital, intended to ensure banks will be able to pay off depositors and debts. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Leverage and the Financial Crisis ▪In the financial crisis of 2008–2009, banks suffered losses on mortgage loans and mortgage-backed securities due to widespread defaults. ▪Many banks became insolvent: In the U.S., 27 banks failed during 2000–2007, 166 during 2008–2009. ▪Many other banks found themselves with too little capital, responded by reducing lending, causing a credit crunch. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Government’s Response ▪To ease the credit crunch, the Federal Reserve and U.S. Treasury injected hundreds of billions of dollars’ worth of capital into the banking system. ▪This unusual policy temporarily made U.S. taxpayers part-owners of many banks. ▪The policy succeeded in recapitalizing the banking system and helped restore lending to normal levels in 2009. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Fed’s Tools of Monetary Control ▪Earlier, we learned money supply = money multiplier × bank reserves ▪The Fed can change the money supply by changing bank reserves or changing the money multiplier. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How the Fed Influences Reserves ▪Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed. ▪If the Fed buys a government bond from a bank, it pays by depositing new reserves in that bank’s reserve account. With more reserves, the bank can make more loans, increasing the money supply. ▪To decrease bank reserves and the money supply, the Fed sells government bonds. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How the Fed Influences Reserves ▪The Fed makes loans to banks, increasing their reserves. ▪Traditional method: adjusting the discount rate—the interest rate on loans the Fed makes to banks—to influence the amount of reserves banks borrow ▪New method: Term Auction Facility—the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans. ▪The more banks borrow, the more reserves they have for funding new loans and increasing the money supply. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How the Fed Influences the Reserve Ratio ▪Recall: reserve ratio = reserves/deposits, which inversely affects the money multiplier. ▪The Fed sets reserve requirements: regulations on the minimum amount of reserves banks must hold against deposits. Reducing reserve requirements would lower the reserve ratio and increase the money multiplier. ▪Since 10/2008, the Fed has paid interest on reserves banks keep in accounts at the Fed. Raising this interest rate would increase the reserve ratio and lower the money multiplier. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Problems Controlling the Money Supply ▪If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls. ▪If banks hold more reserves than required, they make fewer loans, and money supply falls. ▪Yet, Fed can compensate for household and bank behavior to retain fairly precise control over the money supply. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank Runs and the Money Supply ▪A run on banks: When people suspect their banks are in trouble, they may ―run‖ to the bank to withdraw their funds, holding more currency and less deposits. ▪Under fractional-reserve banking, banks don’t have enough reserves to pay off ALL depositors, hence banks may have to close. ▪Also, banks may make fewer loans and hold more reserves to satisfy depositors. ▪These events increase R, reverse the process of money creation, cause money supply to fall. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank Runs and the Money Supply ▪During 1929–1933, a wave of bank runs and bank closings caused money supply to fall 28%. ▪Many economists believe this contributed to the severity of the Great Depression. ▪Since then, federal deposit insurance has helped prevent bank runs in the U.S. ▪In the U.K., though, Northern Rock bank experienced a classic bank run in 2007 and was eventually taken over by the British government. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Federal Funds Rate ▪On any given day, banks with insufficient reserves can borrow from banks with excess reserves. ▪The interest rate on these loans is the federal funds rate. ▪The FOMC uses OMOs to target the fed funds rate. ▪Changes in the fed funds rate cause changes in other rates and have a big impact on the economy. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Fed Funds rate and other rates, 1970–2011 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Monetary Policy and the Fed Funds Rate To raise fed funds rate, Fed sells govt bonds (OMO). This removes reserves from the banking system, reduces supply of federal funds, causes rf to rise. rf F D1 S2 3.75% F2 S1 F1 3.50% The Federal Funds market Federal funds rate Quantity of federal funds © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Money serves three functions: medium of exchange, unit of account, and store of value. •There are two types of money: commodity money has intrinsic value; fiat money does not. •The U.S. uses fiat money, which includes currency and various types of bank deposits. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •In a fractional reserve banking system, banks create money when they make loans. Bank reserves have a multiplier effect on the money supply. •Because banks are highly leveraged, a small change in the value of a bank’s assets causes a large change in bank capital. To protect depositors from bank insolvency, regulators impose minimum capital requirements. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The Federal Reserve is the central bank of the U.S., is responsible for regulating the monetary system. •The Fed controls the money supply mainly through open-market operations. Purchasing govt bonds increases the money supply, selling govt bonds decreases it. •In recent years, the Fed has set monetary policy by choosing a target for the federal funds rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Money Growth and Inflation Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •How does the money supply affect inflation and nominal interest rates? •Does the money supply affect real variables like real GDP or the real interest rate? •How is inflation like a tax? •What are the costs of inflation? How serious are they? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction ▪This chapter introduces the quantity theory of money to explain one of the Ten Principles of Economics from Chapter 1: Prices rise when the govt prints too much money. ▪Most economists believe the quantity theory is a good explanation of the long run behavior of inflation. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Value of Money ▪P = the price level (e.g., the CPI or GDP deflator) P is the price of a basket of goods, measured in money. ▪1/P is the value of $1, measured in goods. ▪Example: basket contains one candy bar. ▪If P = $2, value of $1 is 1/2 candy bar ▪If P = $3, value of $1 is 1/3 candy bar ▪Inflation drives up prices and drives down the value of money. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Quantity Theory of Money ▪Developed by 18th century philosopher David Hume and the classical economists ▪Advocated more recently by Nobel Prize Laureate Milton Friedman ▪Asserts that the quantity of money determines the value of money ▪We study this theory using two approaches: 1.A supply-demand diagram 2.An equation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Money Supply (MS) ▪In real world, determined by Federal Reserve, the banking system, consumers. ▪In this model, we assume the Fed precisely controls MS and sets it at some fixed amount. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Money Demand (MD) ▪Refers to how much wealth people want to hold in liquid form. ▪Depends on P: An increase in P reduces the value of money, so more money is required to buy g&s. ▪Thus, quantity of money demanded is negatively related to the value of money and positively related to P, other things equal. (These ―other things‖ include real income, interest rates, availability of ATMs.) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Money Supply-Demand Diagram Value of Money, 1/P Price Level, P Quantity of Money 1 1 ¾ 1.33 ½ 2 ¼ 4 As the value of money rises, the price level falls. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Money Supply-Demand Diagram Value of Money, 1/P Price Level, P Quantity of Money 1 ¾ ½ ¼ 1 1.33 2 4 MS1 $1000 The Fed sets MS at some fixed value, regardless of P. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Money Supply-Demand Diagram Value of Money, 1/P Price Level, P Quantity of Money 1 ¾ ½ ¼ 1 1.33 2 4 MD1 A fall in value of money (or increase in P) increases the quantity of money demanded: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. MS1 $1000 Value of Money, 1/P Price Level, P Quantity of Money 1 ¾ ½ ¼ 1 1.33 2 4 The Money Supply-Demand Diagram MD1 P adjusts to equate quantity of money demanded with money supply. eq’m price level eq’m value of money A © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. MS1 $1000 The Effects of a Monetary Injection Value of Money, 1/P Price Level, P Quantity of Money 1 ¾ ½ ¼ 1 1.33 2 4 MD1 eq’m price level eq’m value of money A MS2 $2000 B Then the value of money falls, and P rises. Suppose the Fed increases the money supply. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Brief Look at the Adjustment Process How does this work? Short version: ▪At the initial P, an increase in MS causes excess supply of money. ▪People get rid of their excess money by spending it on g&s or by loaning it to others, who spend it. Result: increased demand for goods. ▪But supply of goods does not increase, so prices must rise. (Other things happen in the short run, which we will study in later chapters.) Result from graph: Increasing MS causes P to rise. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Real vs. Nominal Variables ▪Nominal variables are measured in monetary units. Examples: nominal GDP, nominal interest rate (rate of return measured in $) nominal wage ($ per hour worked) ▪Real variables are measured in physical units. Examples: real GDP, real interest rate (measured in output) real wage (measured in output) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Real vs. Nominal Variables Prices are normally measured in terms of money. ▪Price of a compact disc: $15/cd ▪Price of a pepperoni pizza: $10/pizza A relative price is the price of one good relative to (divided by) another: ▪Relative price of CDs in terms of pizza: price of cd price of pizza $15/cd $10/pizza = Relative prices are measured in physical units, so they are real variables. = 1.5 pizzas per cd © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Real vs. Nominal Wage An important relative price is the real wage: W = nominal wage = price of labor, e.g., $15/hour P = price level = price of g&s, e.g., $5/unit of output Real wage is the price of labor relative to the price of output: W P = 3 units output per hour $15/hour $5/unit of output = © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Classical Dichotomy ▪Classical dichotomy: the theoretical separation of nominal and real variables ▪Hume and the classical economists suggested that monetary developments affect nominal variables but not real variables. ▪If central bank doubles the money supply, Hume & classical thinkers contend ▪all nominal variables—including prices— will double. ▪all real variables—including relative prices— will remain unchanged. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Neutrality of Money ▪Monetary neutrality: the proposition that changes in the money supply do not affect real variables ▪Doubling money supply causes all nominal prices to double; what happens to relative prices? ▪Initially, relative price of cd in terms of pizza is price of cd price of pizza = 1.5 pizzas per cd $15/cd $10/pizza = ▪After nominal prices double, price of cd price of pizza = 1.5 pizzas per cd $30/cd $20/pizza = The relative price is unchanged. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Neutrality of Money ▪Similarly, the real wage W/P remains unchanged, so ▪quantity of labor supplied does not change ▪quantity of labor demanded does not change ▪total employment of labor does not change ▪The same applies to employment of capital and other resources. ▪Since employment of all resources is unchanged, total output is also unchanged by the money supply. ▪Monetary neutrality: the proposition that changes in the money supply do not affect real variables © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Neutrality of Money ▪Most economists believe the classical dichotomy and neutrality of money describe the economy in the long run. ▪In later chapters, we will see that monetary changes can have important short-run effects on real variables. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Velocity of Money ▪Velocity of money: the rate at which money changes hands ▪Notation: P x Y = nominal GDP = (price level) x (real GDP) M = money supply V = velocity ▪Velocity formula: V = P x Y M © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Velocity of Money Example with one good: pizza. In 2012, Y = real GDP = 3000 pizzas P = price level = price of pizza = $10 P x Y = nominal GDP = value of pizzas = $30,000 M = money supply = $10,000 V = velocity = $30,000/$10,000 = 3 The average dollar was used in 3 transactions. Velocity formula: V = P x Y M © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Exercise One good: corn. The economy has enough labor, capital, and land to produce Y = 800 bushels of corn. V is constant. In 2008, MS = $2000, P = $5/bushel. Compute nominal GDP and velocity in 2008. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Given: Y = 800, V is constant, MS = $2000 and P = $5 in 2005. Compute nominal GDP and velocity in 2008. Nominal GDP = P x Y = $5 x 800 = $4000 V = P x Y M = $4000 $2000 = 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. U.S. Nominal GDP, M2, and Velocity 1960–2011 Nominal GDP M2 Velocity Velocity is fairly stable over the long run. 1960=100 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Quantity Equation ▪Multiply both sides of formula by M: M x V = P x Y ▪Called the quantity equation Velocity formula: V = P x Y M © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Quantity Theory in 5 Steps 1. V is stable. 2. So, a change in M causes nominal GDP (P x Y) to change by the same percentage. 3. A change in M does not affect Y: money is neutral, Y is determined by technology & resources 4. So, P changes by same percentage as P x Y and M. 5. Rapid money supply growth causes rapid inflation. Start with quantity equation: M x V = P x Y © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Exercise © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. One good: corn. The economy has enough labor, capital, and land to produce Y = 800 bushels of corn. V is constant. In 2008, MS = $2000, P = $5/bushel. For 2009, the Fed increases MS by 5%, to $2100. a. Compute the 2009 values of nominal GDP and P. Compute the inflation rate for 2008–2009. b. Suppose tech. progress causes Y to increase to 824 in 2009. Compute 2008–2009 inflation rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Given: Y = 800, V is constant, MS = $2000 and P = $5 in 2008. For 2009, the Fed increases MS by 5%, to $2100. a. Compute the 2009 values of nominal GDP and P. Compute the inflation rate for 2008–2009. Nominal GDP = P x Y = M x V (Quantity Eq’n) P = P x Y Y = $4200 800 = $5.25 = $2100 x 2 = $4200 Inflation rate = $5.25 – 5.00 5.00 = 5% (same as MS!) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Given: Y = 800, V is constant, MS = $2000 and P = $5 in 2005. For 2009, the Fed increases MS by 5%, to $2100. b. Suppose tech. progress causes Y to increase 3% in 2009, to 824. Compute 2008–2009 inflation rate. First, use Quantity Eq’n to compute P in 2009: P = M x V Y = $4200 824 = $5.10 Inflation rate = $5.10 – 5.00 5.00 = 2% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Summary and Lessons about the Quantity Theory of Money ▪If real GDP is constant, then inflation rate = money growth rate. ▪If real GDP is growing, then inflation rate < money growth rate. ▪The bottom line: ▪Economic growth increases # of transactions. ▪Some money growth is needed for these extra transactions. ▪Excessive money growth causes inflation. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Hyperinflation ▪Hyperinflation is generally defined as inflation exceeding 50% per month. ▪Recall one of the Ten Principles from Chapter 1: Prices rise when the government prints too much money. ▪Excessive growth in the money supply always causes hyperinflation. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sign posted in public restroom Hyperinflation in Zimbabwe Large govt budget deficits led to the creation of large quantities of money and high inflation rates. date Zim$ per US$ Aug 2007 245 Apr 2008 29,401 May 2008 207,209,688 June 2008 4,470,828,401 July 2008 26,421,447,043 Feb 2009 37,410,030 Sept 2009 355 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Inflation Tax ▪When tax revenue is inadequate and ability to borrow is limited, govt may print money to pay for its spending. ▪Almost all hyperinflations start this way. ▪The revenue from printing money is the inflation tax: printing money causes inflation, which is like a tax on everyone who holds money. ▪In the U.S., the inflation tax today accounts for less than 3% of total revenue. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Fisher Effect ▪Rearrange the definition of the real interest rate: ▪The real interest rate is determined by saving & investment in the loanable funds market. ▪Money supply growth determines inflation rate. ▪So, this equation shows how the nominal interest rate is determined. Real interest rate Nominal interest rate Inflation rate + = © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Fisher Effect ▪In the long run, money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate. ▪So, the nominal interest rate adjusts one-for-one with changes in the inflation rate. ▪This relationship is called the Fisher effect after Irving Fisher, who studied it. Real interest rate Nominal interest rate Inflation rate + = © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. U.S. Nominal Interest & Inflation Rates, 1960–2011 The close relation between these variables is evidence for the Fisher effect. Inflation rate Nominal interest rate © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Fisher Effect & the Inflation Tax ▪The inflation tax applies to people’s holdings of money, not their holdings of wealth. ▪The Fisher effect: an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged. Real interest rate Nominal interest rate Inflation rate + = © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Costs of Inflation ▪The inflation fallacy: most people think inflation erodes real incomes. ▪But inflation is a general increase in prices of the things people buy and the things they sell (e.g., their labor). ▪In the long run, real incomes are determined by real variables, not the inflation rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. U.S. Average Hourly Earnings & the CPI CPI (left scale) Nominal wage (right scale) Inflation causes the CPI and nominal wages to rise together over the long run. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Costs of Inflation ▪Shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings ▪Includes the time and transactions costs of more frequent bank withdrawals ▪Menu costs: the costs of changing prices ▪Printing new menus, mailing new catalogs, etc. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Costs of Inflation ▪Misallocation of resources from relative-price variability: Firms don’t all raise prices at the same time, so relative prices can vary… which distorts the allocation of resources. ▪Confusion & inconvenience: Inflation changes the yardstick we use to measure transactions. Complicates long-range planning and the comparison of dollar amounts over time. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Costs of Inflation ▪Tax distortions: Inflation makes nominal income grow faster than real income. Taxes are based on nominal income, and some are not adjusted for inflation. So, inflation causes people to pay more taxes even when their real incomes don’t increase. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Tax distortions © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. You deposit $1000 in the bank for one year. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20% a. In which case does the real value of your deposit grow the most? Assume the tax rate is 25%. b. In which case do you pay the most taxes? c. Compute the after-tax nominal interest rate, then subtract inflation to get the after-tax real interest rate for both cases. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. a. In which case does the real value of your deposit grow the most? In both cases, the real interest rate is 10%, so the real value of the deposit grows 10% (before taxes). Deposit = $1000. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. b. In which case do you pay the most taxes? CASE 1: interest income = $100, so you pay $25 in taxes. CASE 2: interest income = $200, so you pay $50 in taxes. Deposit = $1000. Tax rate = 25%. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. c. Compute the after-tax nominal interest rate, then subtract inflation to get the after-tax real interest rate for both cases. CASE 1: nominal = 0.75 x 10% = 7.5% real = 7.5% – 0% = 7.5% CASE 2: nominal = 0.75 x 20% = 15% real = 15% – 10% = 5% Deposit = $1000. Tax rate = 25%. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Summary and lessons © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Inflation… ▪raises nominal interest rates (Fisher effect) but not real interest rates ▪increases savers’ tax burdens ▪lowers the after-tax real interest rate Deposit = $1000. Tax rate = 25%. CASE 1: inflation = 0%, nom. interest rate = 10% CASE 2: inflation = 10%, nom. interest rate = 20% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Special Cost of Unexpected Inflation ▪Arbitrary redistributions of wealth Higher-than-expected inflation transfers purchasing power from creditors to debtors: Debtors get to repay their debt with dollars that aren’t worth as much. Lower-than-expected inflation transfers purchasing power from debtors to creditors. High inflation is more variable and less predictable than low inflation. So, these arbitrary redistributions are frequent when inflation is high. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Costs of Inflation ▪All these costs are quite high for economies experiencing hyperinflation. ▪For economies with low inflation (< 10% per year), these costs are probably much smaller, though their exact size is open to debate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪This chapter explains one of the Ten Principles of economics: Prices rise when the govt prints too much money. ▪We saw that money is neutral in the long run, affecting only nominal variables. ▪In later chapters, we will see that money has important effects in the short run on real variables like output and employment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •To explain inflation in the long run, economists use the quantity theory of money. According to this theory, the price level depends on the quantity of money, and the inflation rate depends on the money growth rate. •The classical dichotomy is the division of variables into real and nominal. The neutrality of money is the idea that changes in the money supply affect nominal variables but not real ones. Most economists believe these ideas describe the economy in the long run. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •The inflation tax is the loss in the real value of people’s money holdings when the government causes inflation by printing money. •The Fisher effect is the one-for-one relation between changes in the inflation rate and changes in the nominal interest rate. •The costs of inflation include menu costs, shoeleather costs, confusion and inconvenience, distortions in relative prices and the allocation of resources, tax distortions, and arbitrary redistributions of wealth. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Open-Economy Macroeconomics: Basic Concepts Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •How are international flows of goods and assets related? •What’s the difference between the real and nominal exchange rate? •What is ―purchasing-power parity,‖ and how does it explain nominal exchange rates? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction ▪One of the Ten Principles of Economics from Chapter 1: Trade can make everyone better off. ▪This chapter introduces basic concepts of international macroeconomics: ▪The trade balance (trade deficits, surpluses) ▪International flows of assets ▪Exchange rates © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Closed vs. Open Economies ▪A closed economy does not interact with other economies in the world. ▪An open economy interacts freely with other economies around the world. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Flow of Goods & Services ▪Exports: domestically-produced g&s sold abroad ▪Imports: foreign-produced g&s sold domestically ▪Net exports (NX), aka the trade balance = value of exports – value of imports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Variables that affect NX What do you think would happen to U.S. net exports if: A. Canada experiences a recession (falling incomes, rising unemployment) B. U.S. consumers decide to be patriotic and buy more products ―Made in the U.S.A.‖ C. Prices of goods produced in Mexico rise faster than prices of goods produced in the U.S. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers A. Canada experiences a recession (falling incomes, rising unemployment) U.S. net exports would fall due to a fall in Canadian consumers’ purchases of U.S. exports B. U.S. consumers decide to be patriotic and buy more products ―Made in the U.S.A.‖ U.S. net exports would rise due to a fall in imports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers C. Prices of Mexican goods rise faster than prices of U.S. goods This makes U.S. goods more attractive relative to Mexico’s goods. Exports to Mexico increase, imports from Mexico decrease, so U.S. net exports increase. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variables that Influence Net Exports ▪Consumers’ preferences for foreign and domestic goods ▪Prices of goods at home and abroad ▪Incomes of consumers at home and abroad ▪The exchange rates at which foreign currency trades for domestic currency ▪Transportation costs ▪Govt policies © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Trade Surpluses & Deficits NX measures the imbalance in a country’s trade in goods and services. ▪Trade deficit: an excess of imports over exports ▪Trade surplus: an excess of exports over imports ▪Balanced trade: when exports = imports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The U.S. Economy’s Increasing Openness Percent of GDP Exports Imports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Flow of Capital ▪Net capital outflow (NCO): domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets ▪NCO is also called net foreign investment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Flow of Capital The flow of capital abroad takes two forms: ▪Foreign direct investment: Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in Moscow. ▪Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying ―loanable funds‖ to a foreign firm. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Flow of Capital NCO measures the imbalance in a country’s trade in assets: ▪When NCO > 0, ―capital outflow‖ Domestic purchases of foreign assets exceed foreign purchases of domestic assets. ▪When NCO < 0, ―capital inflow‖ Foreign purchases of domestic assets exceed domestic purchases of foreign assets. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variables that Influence NCO ▪Real interest rates paid on foreign assets ▪Real interest rates paid on domestic assets ▪Perceived risks of holding foreign assets ▪Govt policies affecting foreign ownership of domestic assets © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Equality of NX and NCO ▪An accounting identity: NCO = NX ▪arises because every transaction that affects NX also affects NCO by the same amount (and vice versa) ▪When a foreigner purchases a good from the U.S., ▪U.S. exports and NX increase ▪the foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Equality of NX and NCO ▪An accounting identity: NCO = NX ▪arises because every transaction that affects NX also affects NCO by the same amount (and vice versa) ▪When a U.S. citizen buys foreign goods, ▪U.S. imports rise, NX falls ▪the U.S. buyer pays with U.S. dollars or assets, so the other country acquires U.S. assets, causing U.S. NCO to fall. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Saving, Investment, and International Flows of Goods & Assets Y = C + I + G + NX accounting identity Y – C – G = I + NX rearranging terms S = I + NX since S = Y – C – G S = I + NCO since NX = NCO ▪When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow. ▪When S < I, foreigners are financing some of the country’s investment, and NCO < 0. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Case Study: The U.S. Trade Deficit ▪The U.S. trade deficit reached record levels in 2006 and remained high in 2007–2008. ▪Recall, NX = S – I = NCO. A trade deficit means I > S, so the nation borrows the difference from foreigners. ▪In 2007, foreign purchases of U.S. assets exceeded U.S. purchases of foreign assets by $775 million. ▪Such deficits have been the norm since 1980…
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. U.S. Saving, Investment, and NCO, 1950–2011 (% of GDP) Investment NCO Saving
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Case Study: The U.S. Trade Deficit Why U.S. saving has been less than investment: ▪In the 1980s and early 2000s, huge govt budget deficits and low private saving depressed national saving. ▪In the 1990s, national saving increased as the economy grew, but domestic investment increased even faster due to the information technology boom.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Case Study: The U.S. Trade Deficit ▪Is the U.S. trade deficit a problem? ▪The extra capital stock from the ’90s investment boom may well yield large returns. ▪The fall in saving of the ’80s and ’00s, while not desirable, at least did not depress domestic investment, since firms could borrow from abroad. ▪A country, like a person, can go into debt for good reasons or bad ones. A trade deficit is not necessarily a problem, but might be a symptom of a problem.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Case Study: The U.S. Trade Deficit as of 12-31-2009 People abroad owned $21.1 trillion in U.S. assets. U.S. residents owned $18.4 trillion in foreign assets. U.S.’ net indebtedness to other countries = $2.7 trillion. Higher than every other country’s net indebtedness: U.S. is ―the world’s biggest debtor nation.‖ ▪So far, the U.S. earns higher interest rates on foreign assets than it pays on its debts to foreigners. ▪But if U.S. debt continues to grow, foreigners may demand higher interest rates, and servicing the debt would become a drain on U.S. income.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Nominal Exchange Rate ▪Nominal exchange rate: the rate at which one country’s currency trades for another ▪We express all exchange rates as foreign currency per unit of domestic currency. ▪Some exchange rates as of 20 May 2011, all per US$ Canadian dollar: 0.97 Euro: 0.71 Japanese yen: 81.67 Mexican peso: 11.65
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Appreciation and Depreciation ▪Appreciation (or ―strengthening‖): an increase in the value of a currency as measured by the amount of foreign currency it can buy ▪Depreciation (or ―weakening‖): a decrease in the value of a currency as measured by the amount of foreign currency it can buy ▪Examples: During 2007, the U.S. dollar… ▪depreciated 9.5% against the Euro ▪appreciated 1.5% against the S. Korean Won
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Real Exchange Rate ▪Real exchange rate: the rate at which the g&s of one country trade for the g&s of another ▪Real exchange rate = where P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, i.e., foreign currency per unit of domestic currency e x P P*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Example With One Good ▪A Big Mac costs $2.50 in U.S., 400 yen in Japan ▪e = 120 yen per $ ▪e x P = price in yen of a U.S. Big Mac = (120 yen per $) x ($2.50 per Big Mac) = 300 yen per U.S. Big Mac ▪Compute the real exchange rate: 300 yen per U.S. Big Mac 400 yen per Japanese Big Mac = e x P P* = 0.75 Japanese Big Macs per U.S. Big Mac
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interpreting the Real Exchange Rate ―The real exchange rate = 0.75 Japanese Big Macs per U.S. Big Mac‖ Correct interpretation: To buy a Big Mac in the U.S., a Japanese citizen must sacrifice an amount that could purchase 0.75 Big Macs in Japan.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Compute a real exchange rate e = 10 pesos per $ price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico A. What is the price of a U.S. latte measured in pesos? B. Calculate the real exchange rate, measured as Mexican lattes per U.S. latte. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. e = 10 pesos per $ price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico A. What is the price of a U.S. latte in pesos? e x P = (10 pesos per $) x (3 $ per U.S. latte) = 30 pesos per U.S. latte B. Calculate the real exchange rate. 30 pesos per U.S. latte 24 pesos per Mexican latte = e x P P* = 1.25 Mexican lattes per U.S. latte
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Real Exchange Rate With Many Goods P = U.S. price level, e.g., Consumer Price Index, measures the price of a basket of goods P* = foreign price level Real exchange rate = (e x P)/P* = price of a domestic basket of goods relative to price of a foreign basket of goods ▪If U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Law of One Price ▪Law of one price: the notion that a good should sell for the same price in all markets ▪Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and can be costlessly transported. ▪There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in Boston. ▪Such arbitrage drives up the price in Seattle and drives down the price in Boston, until the two prices are equal.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Purchasing-Power Parity (PPP) ▪Purchasing-power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries ▪based on the law of one price ▪implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Purchasing-Power Parity (PPP) ▪Example: The ―basket‖ contains a Big Mac. P = price of U.S. Big Mac (in dollars) P* = price of Japanese Big Mac (in yen) e = exchange rate, yen per dollar ▪According to PPP, e x P = P* price of Japanese Big Mac, in yen ▪Solve for e: P* P e = price of U.S. Big Mac, in yen
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PPP and Its Implications ▪PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels. ▪If the two countries have different inflation rates, then e will change over time: ▪If inflation is higher in Mexico than in the U.S., then P* rises faster than P, so e rises— the dollar appreciates against the peso. ▪If inflation is higher in the U.S. than in Japan, then P rises faster than P*, so e falls— the dollar depreciates against the yen. P* P e =
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Limitations of PPP Theory Two reasons why exchange rates do not always adjust to equalize prices across countries: ▪Many goods cannot easily be traded ▪Examples: haircuts, going to the movies ▪Price differences on such goods cannot be arbitraged away ▪Foreign, domestic goods not perfect substitutes ▪E.g., some U.S. consumers prefer Toyotas over Chevys, or vice versa ▪Price differences reflect taste differences
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Limitations of PPP Theory ▪Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends. ▪For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US). ▪The data support this prediction…
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Inflation & Depreciation in a Cross-Section of 31 Countries Avg annual CPI inflation 1993–2003 (log scale) Avg annual depreciation relative to US dollar 1993–2003 (log scale) Ukraine Brazil Japan Canada Mexico Argentina Romania Kenya
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Chapter review questions 1. Which of the following statements about a country with a trade deficit is not true? A. Exports < imports B. Net capital outflow < 0 C. Investment < saving D. Y < C + I + G 2. A Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A trade deficit means NX < 0. Since NX = S – I, a trade deficit implies I > S. 1. Which of the following statements about a country with a trade deficit is not true? A. Exports < imports B. Net capital outflow < 0 C. Investment < saving D. Y < C + I + G not true © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers 2. A Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)? P* = 720,000 rubles P = $24,000 e = P*/P = 720000/24000 = 30 rubles per dollar © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Net exports equal exports minus imports. Net capital outflow equals domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets. •Every international transaction involves the exchange of an asset for a good or service, so net exports equal net capital outflow. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Saving can be used to finance domestic investment or to buy assets abroad. Thus, saving equals domestic investment plus net capital outflow. •The nominal exchange rate is the relative price of the currency of two countries. •The real exchange rate is the relative price of the goods and services of the two countries. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •According to the theory of purchasing-power parity, a unit of any country’s currency should be able to buy the same quantity of goods in all countries. •This theory implies that the nominal exchange rate between two countries should equal the ratio of the price levels in the two countries. •It also implies that countries with high inflation should have depreciating currencies. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Macroeconomic Theory of the Open Economy Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •In an open economy, what determines the real interest rate? The real exchange rate? •How are the markets for loanable funds and foreign-currency exchange connected? •How do government budget deficits affect the exchange rate and trade balance? •How do other policies or events affect the interest rate, exchange rate, and trade balance? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction ▪The previous chapter explained the basic concepts and vocabulary of the open economy: net exports (NX), net capital outflow (NCO), and exchange rates. ▪This chapter ties these concepts together into a theory of the open economy. ▪We will use this theory to see how govt policies and various events affect the trade balance, exchange rate, and capital flows. ▪We start with the loanable funds market… © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds ▪An identity from the preceding chapter: S = I + NCO Saving Domestic investment Net capital outflow ▪Supply of loanable funds = saving. ▪A dollar of saving can be used to finance ▪the purchase of domestic capital ▪the purchase of a foreign asset ▪So, demand for loanable funds = I + NCO © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds ▪Recall: ▪S depends positively on the real interest rate, r. ▪I depends negatively on r. ▪What about NCO? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How NCO Depends on the Real Interest Rate The real interest rate, r, is the real return on domestic assets. A fall in r makes domestic assets less attractive relative to foreign assets. ▪People in the U.S. purchase more foreign assets. ▪People abroad purchase fewer U.S. assets. ▪NCO rises. r NCO NCO r2 Net capital outflow r1 NCO1 NCO2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. D = I + NCO r adjusts to balance supply and demand in the LF market. The Loanable Funds Market Diagram r LF S = saving Loanable funds r1 Both I and NCO depend negatively on r, so the D curve is downward-sloping. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Budget deficits and capital flows ▪Suppose the government runs a budget deficit (previously, the budget was balanced). ▪Use the appropriate diagrams to determine the effects on the real interest rate and net capital outflow. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The higher r makes U.S. bonds more attractive relative to foreign bonds, reduces NCO. A budget deficit reduces saving and the supply of LF, causing r to rise. D1 r NCO NCO1 Net capital outflow r LF S1 Loanable funds r1 S2 r2 r2 r1 When working with this model, keep in mind: the LF market determines r (in left graph), then this value of r determines NCO (in right graph). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Foreign-Currency Exchange ▪Another identity from the preceding chapter: NCO = NX Net exports Net capital outflow ▪In the market for foreign-currency exchange, ▪NX is the demand for dollars: Foreigners need dollars to buy U.S. net exports. ▪NCO is the supply of dollars: U.S. residents sell dollars to obtain the foreign currency they need to buy foreign assets. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Foreign-Currency Exchange ▪Recall: The U.S. real exchange rate (E) measures the quantity of foreign goods & services that trade for one unit of U.S. goods & services. ▪E is the real value of a dollar in the market for foreign-currency exchange. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. S = NCO The Market for Foreign-Currency Exchange E Dollars D = NX E1 An increase in E has no effect on saving or investment, so it does not affect NCO or the supply of dollars. E adjusts to balance supply and demand for dollars in the market for foreign- currency exchange. An increase in E makes U.S. goods more expensive to foreigners, reduces foreign demand for U.S. goods—and U.S. dollars. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: Disentangling Supply and Demand When a U.S. resident buys imported goods, does the transaction affect supply or demand in the foreign exchange market? Two views: 1. The supply of dollars increases. The person needs to sell her dollars to obtain the foreign currency she needs to buy the imports. 2. The demand for dollars decreases. The increase in imports reduces NX, which we think of as the demand for dollars. (So, NX is really the net demand for dollars.) Both views are equivalent. For our purposes, it’s more convenient to use the second. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. FYI: Disentangling Supply and Demand When a foreigner buys a U.S. asset, does the transaction affect supply or demand in the foreign exchange market? Two views: 1. The demand for dollars increases. The foreigner needs dollars in order to purchase the U.S. asset. 2. The supply of dollars falls. The transaction reduces NCO, which we think of as the supply of dollars. (So, NCO is really the net supply of dollars.) Again, both views are equivalent. We will use the second. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Budget deficit, exchange rate, and NX ▪Initially, the government budget is balanced and trade is balanced (NX = 0). ▪Suppose the government runs a budget deficit. As we saw earlier, r rises and NCO falls. ▪How does the budget deficit affect the U.S. real exchange rate? The balance of trade? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The budget deficit reduces NCO and the supply of dollars. The real exchange rate appreciates, reducing net exports. Since NX = 0 initially, the budget deficit causes a trade deficit (NX < 0). S1 = NCO1 E Dollars D = NX E1 S2 = NCO2 E2 Market for foreign-currency exchange © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The “Twin Deficits” Net exports and the budget deficit often move in opposite directions. Percent of GDP U.S. federal budget deficit U.S. net exports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY: The Effects of a Budget Deficit ▪National saving falls ▪The real interest rate rises ▪Domestic investment and net capital outflow both fall ▪The real exchange rate appreciates ▪Net exports fall (or, the trade deficit increases) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY: The Effects of a Budget Deficit ▪One other effect: As foreigners acquire more domestic assets, the country’s debt to the rest of the world increases. ▪Due to many years of budget and trade deficits, the U.S. is now the ―world’s largest debtor nation.‖ International Investment Position of the U.S. 31 December 2009 Value of U.S.-owned foreign assets $18.4 trillion Value of foreign-owned U.S. assets $21.1 trillion U.S.’ net debt to the rest of the world $2.7 trillion © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Connection Between Interest Rates and Exchange Rates r NCO E dollars NCO D = NX S1 = NCO1 S2 E1 E2 r1 r2 Anything that increases r will reduce NCO and the supply of dollars in the foreign exchange market. Result: The real exchange rate appreciates. NCO1 NCO2 NCO1 NCO2 Keep in mind: The LF market (not shown) determines r. This value of r then determines NCO (shown in upper graph). This value of NCO then determines supply of dollars in foreign exchange market (in lower graph). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Investment incentives ▪Suppose the government provides new tax incentives to encourage investment. ▪Use the appropriate diagrams to determine how this policy would affect: ▪the real interest rate ▪net capital outflow ▪the real exchange rate ▪net exports © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. D1 r NCO NCO Net capital outflow r LF S1 Loanable funds r1 r1 r2 D2 r2 r rises, causing NCO to fall. NCO1 NCO2 Investment—and the demand for LF—increase at each value of r. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The fall in NCO reduces the supply of dollars in the foreign exchange market. The real exchange rate appreciates, reducing net exports. S1 = NCO1 E Dollars D = NX E1 S2 = NCO2 E2 Market for foreign-currency exchange © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Budget Deficit vs. Investment Incentives ▪A tax incentive for investment has similar effects as a budget deficit: ▪r rises, NCO falls ▪E rises, NX falls ▪But one important difference: ▪Investment tax incentive increases investment, which increases productivity growth and living standards in the long run. ▪Budget deficit reduces investment, which reduces productivity growth and living standards. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Trade Policy ▪Trade policy: a govt policy that directly influences the quantity of g&s that a country imports or exports ▪Examples: ▪Tariff – a tax on imports ▪Import quota – a limit on the quantity of imports ▪“Voluntary export restrictions” – the govt pressures another country to restrict its exports; essentially the same as an import quota © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Trade Policy ▪Common reasons for policies that restrict imports: ▪Save jobs in a domestic industry that has difficulty competing with imports ▪Reduce the trade deficit ▪Do such trade policies accomplish these goals? ▪Let’s use our model to analyze the effects of an import quota on cars from Japan designed to save jobs in the U.S. auto industry. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. D An import quota does not affect saving or investment, so it does not affect NCO. (Recall: NCO = S – I.) Analysis of a Quota on Cars from Japan r NCO NCO Net capital outflow r LF S Loanable funds r1 r1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analysis of a Quota on Cars from Japan Since NCO unchanged, S curve does not shift. The D curve shifts: At each E, imports of cars fall, so net exports rise, D shifts to the right. At E1, there is excess demand in the foreign exchange market. E rises to restore eq’m. S = NCO E Dollars D1 E1 Market for foreign-currency exchange D2 E2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analysis of a Quota on Cars from Japan What happens to NX? Nothing! ▪If E could remain at E1, NX would rise, and the quantity of dollars demanded would rise. ▪But the import quota does not affect NCO, so the quantity of dollars supplied is fixed. ▪Since NX must equal NCO, E must rise enough to keep NX at its original level. ▪Hence, the policy of restricting imports does not reduce the trade deficit. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analysis of a Quota on Cars from Japan Does the policy save jobs? The quota reduces imports of Japanese autos. ▪U.S. consumers buy more U.S. autos. ▪U.S. automakers hire more workers to produce these extra cars. ▪So the policy saves jobs in the U.S. auto industry. But E rises, reducing foreign demand for U.S. exports. ▪Export industries contract, exporting firms lay off workers. The import quota saves jobs in the auto industry but destroys jobs in U.S. export industries!! © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CASE STUDY: Capital Flows from China ▪In recent years, China has accumulated U.S. assets to reduce its exchange rate and boost its exports. ▪Results in U.S.: ▪Appreciation of $ relative to Chinese renminbi ▪Higher U.S. imports from China ▪Larger U.S. trade deficit ▪Some U.S. politicians want China to stop, argue for restricting trade with China to protect some U.S. industries. ▪Yet, U.S. consumers benefit, and the net effect of China’s currency intervention is probably small. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Political Instability and Capital Flight ▪1994: Political instability in Mexico made world financial markets nervous. ▪People worried about the safety of Mexican assets they owned. ▪People sold many of these assets, pulled their capital out of Mexico. ▪Capital flight: a large and sudden reduction in the demand for assets located in a country ▪We analyze this using our model, but from the perspective of Mexico, not the U.S. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The equilibrium values of r and NCO both increase. As foreign investors sell their assets and pull out their capital, NCO increases at each value of r. Demand for LF = I + NCO. The increase in NCO increases demand for LF. D1 Capital Flight from Mexico r NCO NCO1 r1 Net capital outflow r LF S1 r1 Loanable funds D2 r2 NCO2 r2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Capital Flight from Mexico The increase in NCO causes an increase in the supply of pesos in the foreign exchange market. The real exchange rate value of the peso falls. S2 = NCO2 Market for foreign-currency exchange E Pesos D1 S1 = NCO1 E1 E2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Examples of Capital Flight: Mexico, 1994 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Examples of Capital Flight: S.E. Asia, 1997 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Examples of Capital Flight: Russia, 1998 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Examples of Capital Flight: Argentina, 2002 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪The U.S. economy is becoming increasingly open: ▪Trade in g&s is rising relative to GDP. ▪Increasingly, people hold international assets in their portfolios and firms finance investment with foreign capital. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪Yet, we should be careful not to blame our problems on the international economy. ▪Our trade deficit is not caused by other countries’ ―unfair‖ trade practices, but by our own low saving. ▪Stagnant living standards are not caused by imports, but by low productivity growth. ▪When politicians and commentators discuss international trade and finance, the lessons of this and the preceding chapter can help separate myth from reality. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •In an open economy, the real interest rate adjusts to balance the supply of loanable funds (saving) with the demand for loanable funds (domestic investment and net capital outflow). •In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (net capital outflow) with the demand for dollars (net exports). •Net capital outflow is the variable that connects these markets. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •A budget deficit reduces national saving, drives up interest rates, reduces net capital outflow, reduces the supply of dollars in the foreign exchange market, appreciates the exchange rate, and reduces net exports. •A policy that restricts imports does not affect net capital outflow, so it cannot affect net exports or improve a country’s trade deficit. Instead, it drives up the exchange rate and reduces exports as well as imports. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Political instability may cause capital flight, as nervous investors sell assets and pull their capital out of the country. As a result, interest rates rise and the country’s exchange rate falls. This occurred in Mexico in 1994 and in other countries more recently. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Aggregate Demand and Aggregate Supply Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •What are economic fluctuations? What are their characteristics? •How does the model of aggregate demand and aggregate supply explain economic fluctuations? •Why does the Aggregate-Demand curve slope downward? What shifts the AD curve? •What is the slope of the Aggregate-Supply curve in the short run? In the long run? What shifts the AS curve(s)? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction ▪Over the long run, real GDP grows about 3% per year on average. ▪In the short run, GDP fluctuates around its trend. ▪Recessions: periods of falling real incomes and rising unemployment ▪Depressions: severe recessions (very rare) ▪Short-run economic fluctuations are often called business cycles. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Three Facts About Economic Fluctuations FACT 1: Economic fluctuations are irregular and unpredictable. U.S. real GDP, billions of 2005 dollars The shaded bars are recessions © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Three Facts About Economic Fluctuations FACT 2: Most macroeconomic quantities fluctuate together. Investment spending, billions of 2005 dollars © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Three Facts About Economic Fluctuations FACT 3: As output falls, unemployment rises. Unemployment rate, percent of labor force © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction, continued ▪Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. ▪Most economists use the model of aggregate demand and aggregate supply to study fluctuations. ▪This model differs from the classical economic theories economists use to explain the long run. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Classical Economics—A Recap ▪The previous chapters are based on the ideas of classical economics, especially: ▪The Classical Dichotomy, the separation of variables into two groups: ▪Real – quantities, relative prices ▪Nominal – measured in terms of money ▪The neutrality of money: Changes in the money supply affect nominal but not real variables. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Classical Economics—A Recap ▪Most economists believe classical theory describes the world in the long run, but not the short run. ▪In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate). ▪To study the short run, we use a new model. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Model of Aggregate Demand and Aggregate Supply P Y AD SRAS P1 Y1 The price level Real GDP, the quantity of output The model determines the eq’m price level and eq’m output (real GDP). ―Aggregate Demand‖ ―Short-Run Aggregate Supply‖ © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Aggregate-Demand (AD) Curve The AD curve shows the quantity of all g&s demanded in the economy at any given price level. P Y AD P1 Y1 P2 Y2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the AD Curve Slopes Downward Y = C + I + G + NX Assume G fixed by govt policy. To understand the slope of AD, must determine how a change in P affects C, I, and NX. P Y AD P1 Y1 P2 Y2 Y1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Wealth Effect (P and C ) Suppose P rises. ▪The dollars people hold buy fewer g&s, so real wealth is lower. ▪People feel poorer. Result: C falls. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Interest-Rate Effect (P and I ) Suppose P rises. ▪Buying g&s requires more dollars. ▪To get these dollars, people sell bonds or other assets. ▪This drives up interest rates. Result: I falls. (Recall, I depends negatively on interest rates.) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Exchange-Rate Effect (P and NX ) Suppose P rises. ▪U.S. interest rates rise (the interest-rate effect). ▪Foreign investors desire more U.S. bonds. ▪Higher demand for $ in foreign exchange market. ▪U.S. exchange rate appreciates. ▪U.S. exports more expensive to people abroad, imports cheaper to U.S. residents. Result: NX falls. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Slope of the AD Curve: Summary An increase in P reduces the quantity of g&s demanded because: P Y AD P1 Y1 ▪the wealth effect (C falls) P2 Y2 ▪the interest-rate effect (I falls) ▪the exchange-rate effect (NX falls) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the AD Curve Might Shift Any event that changes C, I, G, or NX—except a change in P—will shift the AD curve. Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right. P Y AD1 AD2 Y2 P1 Y1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the AD Curve Might Shift ▪Changes in C ▪Stock market boom/crash ▪Preferences re: consumption/saving tradeoff ▪Tax hikes/cuts ▪Changes in I ▪Firms buy new computers, equipment, factories ▪Expectations, optimism/pessimism ▪Interest rates, monetary policy ▪Investment Tax Credit or other tax incentives © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the AD Curve Might Shift ▪Changes in G ▪Federal spending, e.g., defense ▪State & local spending, e.g., roads, schools ▪Changes in NX ▪Booms/recessions in countries that buy our exports ▪Appreciation/depreciation resulting from international speculation in foreign exchange market © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 The Aggregate-Demand curve What happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The U.S. exchange rate falls. C. A fall in prices increases the real value of consumers’ wealth. D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left. B. The U.S. exchange rate falls. NX rises, AD curve shifts right. C. A fall in prices increases the real value of consumers’ wealth. Move down along AD curve (wealth-effect). D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains. C rises, AD shifts right. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Aggregate-Supply (AS ) Curves The AS curve shows the total quantity of g&s firms produce and sell at any given price level. P Y SRAS LRAS AS is: ▪upward-sloping in short run ▪vertical in long run © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Long-Run Aggregate-Supply Curve (LRAS) The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate. YN is also called potential output or full-employment output. P Y LRAS YN © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why LRAS Is Vertical YN determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology. An increase in P P Y LRAS P1 does not affect any of these, so it does not affect YN. (Classical dichotomy) P2 YN © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the LRAS Curve Might Shift Any event that changes any of the determinants of YN will shift LRAS. Example: Immigration increases L, causing YN to rise. P Y LRAS1 YN LRAS2 YN ’ © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the LRAS Curve Might Shift ▪Changes in L or natural rate of unemployment ▪Immigration ▪Baby-boomers retire ▪Govt policies reduce natural u-rate ▪Changes in K or H ▪Investment in factories, equipment ▪More people get college degrees ▪Factories destroyed by a hurricane © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the LRAS Curve Might Shift ▪Changes in natural resources ▪Discovery of new mineral deposits ▪Reduction in supply of imported oil ▪Changing weather patterns that affect agricultural production ▪Changes in technology ▪Productivity improvements from technological progress © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LRAS1990 Using AD & AS to Depict Long-Run Growth and Inflation Over the long run, tech. progress shifts LRAS to the right P Y AD2000 LRAS2000 AD1990 Y2000 and growth in the money supply shifts AD to the right. Y1990 AD2010 LRAS2010 Y2010 P1990 Result: ongoing inflation and growth in output. P2000 P2010 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short Run Aggregate Supply (SRAS) The SRAS curve is upward sloping: Over the period of 1–2 years, an increase in P P Y SRAS causes an increase in the quantity of g & s supplied. Y2 P1 Y1 P2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the Slope of SRAS Matters If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment. P Y AD1 SRAS LRAS ADhi ADlo Y1 If AS slopes up, then shifts in AD do affect output and employment. Plo Ylo Phi Yhi Phi Plo © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Three Theories of SRAS In each, ▪some type of market imperfection ▪result: Output deviates from its natural rate when the actual price level deviates from the price level people expected. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1. The Sticky-Wage Theory ▪Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly. ▪Due to labor contracts, social norms ▪Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1. The Sticky-Wage Theory ▪If P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment. ▪Hence, higher P causes higher Y, so the SRAS curve slopes upward.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. The Sticky-Price Theory ▪Imperfection: Many prices are sticky in the short run. ▪Due to menu costs, the costs of adjusting prices. ▪Examples: cost of printing new menus, the time required to change price tags ▪Firms set sticky prices in advance based on PE.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. The Sticky-Price Theory ▪Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise. ▪In the short run, firms without menu costs can raise their prices immediately. ▪Firms with menu costs wait to raise prices. Meanwhile, their prices are relatively low, which increases demand for their products, so they increase output and employment. ▪Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3. The Misperceptions Theory ▪Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell. ▪If P rises above PE, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment. ▪So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What the 3 Theories Have in Common: In all 3 theories, Y deviates from YN when P deviates from PE. Y = YN + a (P – PE) Output Natural rate of output (long-run) a > 0, measures how much Y responds to unexpected changes in P Actual price level Expected price level
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What the 3 Theories Have in Common: P Y SRAS YN When P > PE Y > YN When P < PE Y < YN PE the expected price level Y = YN + a (P – PE) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SRAS and LRAS ▪The imperfections in these theories are temporary. Over time, ▪sticky wages and prices become flexible ▪misperceptions are corrected ▪In the LR, ▪PE = P ▪AS curve is vertical © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LRAS SRAS and LRAS P Y SRAS PE YN In the long run, PE = P and Y = YN. Y = YN + a (P – PE) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why the SRAS Curve Might Shift Everything that shifts LRAS shifts SRAS, too. Also, PE shifts SRAS: If PE rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left. LRAS P Y SRAS PE YN SRAS PE © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Long-Run Equilibrium In the long-run equilibrium, PE = P, Y = YN , and unemployment is at its natural rate. P Y AD SRAS PE LRAS YN © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Economic Fluctuations ▪Caused by events that shift the AD and/or AS curves. ▪Four steps to analyzing economic fluctuations: 1. Determine whether the event shifts AD or AS. 2. Determine whether curve shifts left or right. 3. Use AD–AS diagram to see how the shift changes Y and P in the short run. 4. Use AD–AS diagram to see how economy moves from new SR eq’m to new LR eq’m. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LRAS YN The Effects of a Shift in AD Event: Stock market crash 1. Affects C, AD curve 2. C falls, so AD shifts left 3. SR eq’m at B. P and Y lower, unemp higher 4. Over time, PE falls, SRAS shifts right, until LR eq’m at C. Y and unemp back at initial levels. P Y AD1 SRAS1 AD2 SRAS2 P1 A P2 Y2 B P3 C © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Two Big AD Shifts: 1. The Great Depression From 1929–1933, ▪money supply fell 28% due to problems in banking system ▪stock prices fell 90%, reducing C and I ▪Y fell 27% ▪P fell 22% ▪u-rate rose from 3% to 25% U.S. Real GDP, billions of 2000 dollars © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Two Big AD Shifts: 2. The World War II Boom From 1939–1944, ▪govt outlays rose from $9.1 billion to $91.3 billion ▪Y rose 90% ▪P rose 20% ▪unemp fell from 17% to 1% U.S. Real GDP, billions of 2000 dollars © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Working with the model ▪Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a long-run equilibrium. ▪A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LRAS YN P Y AD2 SRAS2 AD1 SRAS1 P1 P3 C P2 Y2 B A Event: Boom in Canada 1. Affects NX, AD curve 2. Shifts AD right 3. SR eq’m at point B. P and Y higher, unemp lower 4. Over time, PE rises, SRAS shifts left, until LR eq’m at C. Y and unemp back at initial levels. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CASE STUDY: The 2008–2009 Recession ▪From 12/2007 to 6/2009, real GDP fell about 4% ▪Unemployment rose from 4.4% in 5/2007 to 10.1% in 10/2009 ▪The housing market played a central role in this recession… © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CASE STUDY: The 2008–2009 Recession Case-Shiller Home Price Index 2000 = 100 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CASE STUDY: The 2008–2009 Recession Rising house prices during 2002–2006 due to: ▪low interest rates ▪easier credit for ―sub-prime‖ borrowers ▪government policies to increase homeownership ▪securitization of mortgages: ▪Investment banks purchased mortgages from lenders, created securities backed by these mortgages, sold the securities to banks, insurance companies, and other investors. ▪Mortgage-backed securities perceived as safe, since house prices ―never fall‖ © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CASE STUDY: The 2008–2009 Recession Consequences of 2006–2009 housing market crash: ▪Millions of homeowners ―underwater‖—owed more than house was worth ▪Millions of mortgage defaults and foreclosures ▪Banks selling foreclosed houses increased surplus and downward price pressures ▪Housing crash badly damaged construction industry: 2010 unemployment rate was 20.6% in construction vs. 9.6% overall © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CASE STUDY: The 2008–2009 Recession Consequences of 2006–2009 housing market crash: ▪Mortgage-backed securities became ―toxic,‖ heavy losses for institutions that purchased them, widespread failures of banks and other financial institutions ▪Sharply rising unemployment and falling GDP © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CASE STUDY: The 2008–2009 Recession The policy response: ▪Federal Reserve reduced Fed Funds rate target to near zero. ▪Federal Reserve purchased mortgage-backed securities and other private loans. ▪U.S. Treasury injected capital into the banking system, to increase banks’ liquidity and solvency in hopes of staving off a ―credit crunch‖ ▪Fiscal policymakers increased government spending and reduced taxes by $800 billion © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LRAS YN The Effects of a Shift in SRAS Event: Oil prices rise 1. Increases costs, shifts SRAS (assume LRAS constant) 2. SRAS shifts left 3. SR eq’m at point B. P higher, Y lower, unemp higher From A to B, stagflation, a period of falling output and rising prices. P Y AD1 SRAS1 SRAS2 P1 A P2 Y2 B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LRAS YN Accommodating an Adverse Shift in SRAS If policymakers do nothing, 4. Low employment causes wages to fall, SRAS shifts right, until LR eq’m at A. P Y AD1 SRAS1 SRAS2 P1 A P2 Y2 B AD2 P3 C Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift: Y back to YN, but P permanently higher. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The 1970s Oil Shocks and Their Effects # of unemployed persons Real GDP CPI + 1.4 million + 2.9% + 26% + 99% + 3.5 million – 0.7% + 21% + 138% Real oil prices 1978–80 1973–75 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. John Maynard Keynes, 1883–1946 ▪The General Theory of Employment, Interest, and Money, 1936 ▪Argued recessions and depressions can result from inadequate demand; policymakers should shift AD. ▪Famous critique of classical theory: Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat. The long run is a misleading guide to current affairs. In the long run, we are all dead. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪This chapter has introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations. ▪Keep in mind: these fluctuations are deviations from the long-run trends explained by the models we learned in previous chapters. ▪In the next chapter, we will learn how policymakers can affect aggregate demand with fiscal and monetary policy. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Short-run fluctuations in GDP and other macroeconomic quantities are irregular and unpredictable. Recessions are periods of falling real GDP and rising unemployment. •Economists analyze fluctuations using the model of aggregate demand and aggregate supply. •The aggregate demand curve slopes downward because a change in the price level has a wealth effect on consumption, an interest-rate effect on investment, and an exchange-rate effect on net exports. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Anything that changes C, I, G, or NX—except a change in the price level—will shift the aggregate demand curve. •The long-run aggregate supply curve is vertical because changes in the price level do not affect output in the long run. •In the long run, output is determined by labor, capital, natural resources, and technology; changes in any of these will shift the long-run aggregate supply curve. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •In the short run, output deviates from its natural rate when the price level is different than expected, leading to an upward-sloping short-run aggregate supply curve. The three theories proposed to explain this upward slope are the sticky wage theory, the sticky price theory, and the misperceptions theory. •The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run aggregate supply curve. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Economic fluctuations are caused by shifts in aggregate demand and aggregate supply. •When aggregate demand falls, output and the price level fall in the short run. Over time, a change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate supply curve shifts rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •A fall in aggregate supply results in stagflation—falling output and rising prices. Wages, prices, and perceptions adjust over time, and the economy recovers. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Influence of Monetary and Fiscal Policy on Aggregate Demand Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: •How does the interest-rate effect help explain the slope of the aggregate-demand curve? •How can the central bank use monetary policy to shift the AD curve? •In what two ways does fiscal policy affect aggregate demand? •What are the arguments for and against using policy to try to stabilize the economy? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction ▪Earlier chapters covered: ▪the long-run effects of fiscal policy on interest rates, investment, economic growth ▪the long-run effects of monetary policy on the price level and inflation rate ▪This chapter focuses on the short-run effects of fiscal and monetary policy, which work through aggregate demand. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Aggregate Demand ▪Recall, the AD curve slopes downward for three reasons: ▪The wealth effect ▪The interest-rate effect ▪The exchange-rate effect ▪Next: A supply-demand model that helps explain the interest-rate effect and how monetary policy affects aggregate demand. the most important of these effects for the U.S. economy © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Theory of Liquidity Preference ▪A simple theory of the interest rate (denoted r) ▪r adjusts to balance supply and demand for money ▪Money supply: assume fixed by central bank, does not depend on interest rate © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Theory of Liquidity Preference ▪Money demand reflects how much wealth people want to hold in liquid form. ▪For simplicity, suppose household wealth includes only two assets: ▪Money – liquid but pays no interest ▪Bonds – pay interest but not as liquid ▪A household’s ―money demand‖ reflects its preference for liquidity. ▪The variables that influence money demand: Y, r, and P. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Money Demand ▪Suppose real income (Y) rises. Other things equal, what happens to money demand? ▪If Y rises: ▪Households want to buy more g&s, so they need more money. ▪To get this money, they attempt to sell some of their bonds. ▪I.e., an increase in Y causes an increase in money demand, other things equal. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 The determinants of money demand A. Suppose r rises, but Y and P are unchanged. What happens to money demand? B. Suppose P rises, but Y and r are unchanged. What happens to money demand? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers A. Suppose r rises, but Y and P are unchanged. What happens to money demand? r is the opportunity cost of holding money. An increase in r reduces money demand: households attempt to buy bonds to take advantage of the higher interest rate. Hence, an increase in r causes a decrease in money demand, other things equal. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers B. Suppose P rises, but Y and r are unchanged. What happens to money demand? If Y is unchanged, people will want to buy the same amount of g&s. Since P is higher, they will need more money to do so. Hence, an increase in P causes an increase in money demand, other things equal. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How r Is Determined MS curve is vertical: Changes in r do not affect MS, which is fixed by the Fed. MD curve is downward sloping: A fall in r increases money demand. M Interest rate MS MD1 r1 Quantity fixed by the Fed Eq’m interest rate © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How the Interest-Rate Effect Works Y P M Interest rate AD MS MD1 MD2 P2 P1 Y1 Y2 r2 r1 A fall in P reduces money demand, which lowers r. A fall in r increases I and the quantity of g&s demanded. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Monetary Policy and Aggregate Demand ▪To achieve macroeconomic goals, the Fed can use monetary policy to shift the AD curve. ▪The Fed’s policy instrument is MS. ▪The news often reports that the Fed targets the interest rate. ▪More precisely, the federal funds rate, which banks charge each other on short-term loans ▪To change the interest rate and shift the AD curve, the Fed conducts open market operations to change MS. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effects of Reducing the Money Supply Y P M Interest rate AD1 MS1 MD P1 Y1 r1 MS2 r2 AD2 Y2 The Fed can raise r by reducing the money supply. An increase in r reduces the quantity of g&s demanded. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Monetary policy For each of the events below, - determine the short-run effects on output - determine how the Fed should adjust the money supply and interest rates to stabilize output A. Congress tries to balance the budget by cutting govt spending. B. A stock market boom increases household wealth. C. War breaks out in the Middle East, causing oil prices to soar. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers A. Congress tries to balance the budget by cutting govt spending. This event would reduce agg demand and output. To stabilize output, the Fed should increase MS and reduce r to increase agg demand. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers B. A stock market boom increases household wealth. This event would increase agg demand, raising output above its natural rate. To stabilize output, the Fed should reduce MS and increase r to reduce agg demand. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers C. War breaks out in the Middle East, causing oil prices to soar. This event would reduce agg supply, causing output to fall. To stabilize output, the Fed should increase MS and reduce r to increase agg demand. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Liquidity traps ▪Monetary policy stimulates aggregate demand by reducing the interest rate. ▪Liquidity trap: when the interest rate is zero ▪In a liquidity trap, mon. policy may not work, since nominal interest rates cannot be reduced further. ▪However, central bank can make real interest rates negative by raising inflation expectations. ▪Also, central bank can conduct open-market ops using other assets—like mortgages and corporate debt—thereby lowering rates on these kinds of loans. The Fed pursued this option in 2008–2009. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fiscal Policy and Aggregate Demand ▪Fiscal policy: the setting of the level of govt spending and taxation by govt policymakers ▪Expansionary fiscal policy ▪an increase in G and/or decrease in T ▪shifts AD right ▪Contractionary fiscal policy ▪a decrease in G and/or increase in T ▪shifts AD left ▪Fiscal policy has two effects on AD... © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1. The Multiplier Effect ▪If the govt buys $20b of planes from Boeing, Boeing’s revenue increases by $20b. ▪This is distributed to Boeing’s workers (as wages) and owners (as profits or stock dividends). ▪These people are also consumers and will spend a portion of the extra income. ▪This extra consumption causes further increases in aggregate demand. Multiplier effect: the additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1. The Multiplier Effect A $20b increase in G initially shifts AD to the right by $20b. The increase in Y causes C to rise, which shifts AD further to the right. Y P AD1 P1 AD2 AD3 Y1 Y3 Y2 $20 billion © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Marginal Propensity to Consume ▪How big is the multiplier effect? It depends on how much consumers respond to increases in income. ▪Marginal propensity to consume (MPC): the fraction of extra income that households consume rather than save E.g., if MPC = 0.8 and income rises $100, C rises $80. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Notation: ΔG is the change in G, ΔY and ΔC are the ultimate changes in Y and C Y = C + I + G + NX identity ΔY = ΔC + ΔG I and NX do not change ΔY = MPC ΔY + ΔG because ΔC = MPC ΔY solved for ΔY 1 1 – MPC ΔY = ΔG A Formula for the Multiplier The multiplier © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The size of the multiplier depends on MPC. E.g., if MPC = 0.5 multiplier = 2 if MPC = 0.75 multiplier = 4 if MPC = 0.9 multiplier = 10 A Formula for the Multiplier 1 1 – MPC ΔY = ΔG The multiplier A bigger MPC means changes in Y cause bigger changes in C, which in turn cause more changes in Y. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Other Applications of the Multiplier Effect ▪The multiplier effect: Each $1 increase in G can generate more than a $1 increase in agg demand. ▪Also true for the other components of GDP. Example: Suppose a recession overseas reduces demand for U.S. net exports by $10b. Initially, agg demand falls by $10b. The fall in Y causes C to fall, which further reduces agg demand and income. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. The Crowding-Out Effect ▪Fiscal policy has another effect on AD that works in the opposite direction. ▪A fiscal expansion raises r, which reduces investment, which reduces the net increase in agg demand. ▪So, the size of the AD shift may be smaller than the initial fiscal expansion. ▪This is called the crowding-out effect. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. How the Crowding-Out Effect Works Y P M Interest rate AD1 MS MD2 MD1 P1 r1 r2 A $20b increase in G initially shifts AD right by $20b But higher Y increases MD and r, which reduces AD. AD3 AD2 Y1 Y2 $20 billion Y3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Changes in Taxes ▪A tax cut increases households’ take-home pay. ▪Households respond by spending a portion of this extra income, shifting AD to the right. ▪The size of the shift is affected by the multiplier and crowding-out effects. ▪Another factor: whether households perceive the tax cut to be temporary or permanent. ▪A permanent tax cut causes a bigger increase in C—and a bigger shift in the AD curve—than a temporary tax cut. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Fiscal policy effects The economy is in recession. Shifting the AD curve rightward by $200b would end the recession. A. If MPC = .8 and there is no crowding out, how much should Congress increase G to end the recession? B. If there is crowding out, will Congress need to increase G more or less than this amount? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers The economy is in recession. Shifting the AD curve rightward by $200b would end the recession. A. If MPC = .8 and there is no crowding out, how much should Congress increase G to end the recession? Multiplier = 1/(1 – .8) = 5 Increase G by $40b to shift agg demand by 5 x $40b = $200b. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers The economy is in recession. Shifting the AD curve rightward by $200b would end the recession. B. If there is crowding out, will Congress need to increase G more or less than this amount? Crowding out reduces the impact of G on AD. To offset this, Congress should increase G by a larger amount. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fiscal Policy and Aggregate Supply ▪Most economists believe the short-run effects of fiscal policy mainly work through agg demand. ▪But fiscal policy might also affect agg supply. ▪Recall one of the Ten Principles from Chapter 1: People respond to incentives. ▪A cut in the tax rate gives workers incentive to work more, so it might increase the quantity of g&s supplied and shift AS to the right. ▪People who believe this effect is large are called ―Supply-siders.‖ © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fiscal Policy and Aggregate Supply ▪Govt purchases might affect agg supply. Example: ▪Govt increases spending on roads. ▪Better roads may increase business productivity, which increases the quantity of g&s supplied, shifts AS to the right. ▪This effect is probably more relevant in the long run: it takes time to build the new roads and put them into use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Using Policy to Stabilize the Economy ▪Since the Employment Act of 1946, economic stabilization has been a goal of U.S. policy. ▪Economists debate how active a role the govt should take to stabilize the economy. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Case for Active Stabilization Policy ▪Keynes: ―Animal spirits‖ cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment. ▪Also, other factors cause fluctuations, e.g., ▪booms and recessions abroad ▪stock market booms and crashes ▪If policymakers do nothing, these fluctuations are destabilizing to businesses, workers, consumers. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Case for Active Stabilization Policy ▪Proponents of active stabilization policy believe the govt should use policy to reduce these fluctuations: ▪When GDP falls below its natural rate, use expansionary monetary or fiscal policy to prevent or reduce a recession. ▪When GDP rises above its natural rate, use contractionary policy to prevent or reduce an inflationary boom. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Keynesians in the White House 1961: John F Kennedy pushed for a tax cut to stimulate agg demand. Several of his economic advisors were followers of Keynes. 2009: Barack Obama pushed for spending increases and tax cuts to increase agg demand in the face of a deep recession. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Case Against Active Stabilization Policy ▪Monetary policy affects economy with a long lag: ▪Firms make investment plans in advance, so I takes time to respond to changes in r. ▪Most economists believe it takes at least 6 months for mon policy to affect output and employment. ▪Fiscal policy also works with a long lag: ▪Changes in G and T require acts of Congress. ▪The legislative process can take months or years. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Case Against Active Stabilization Policy ▪Due to these long lags, critics of active policy argue that such policies may destabilize the economy rather than help it: By the time the policies affect agg demand, the economy’s condition may have changed. ▪These critics contend that policymakers should focus on long-run goals like economic growth and low inflation. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Automatic Stabilizers ▪Automatic stabilizers: changes in fiscal policy that stimulate agg demand when economy goes into recession, without policymakers having to take any deliberate action © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Automatic Stabilizers: Examples ▪The tax system ▪In recession, taxes fall automatically, which stimulates agg demand. ▪Govt spending ▪In recession, more people apply for public assistance (welfare, unemployment insurance). ▪Govt spending on these programs automatically rises, which stimulates agg demand. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪Policymakers need to consider all the effects of their actions. For example, ▪When Congress cuts taxes, it should consider the short-run effects on agg demand and employment, and the long-run effects on saving and growth. ▪When the Fed reduces the rate of money growth, it must take into account not only the long-run effects on inflation but the short-run effects on output and employment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •In the theory of liquidity preference, the interest rate adjusts to balance the demand for money with the supply of money. •The interest-rate effect helps explain why the aggregate-demand curve slopes downward: an increase in the price level raises money demand, which raises the interest rate, which reduces investment, which reduces the aggregate quantity of goods & services demanded. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •An increase in the money supply causes the interest rate to fall, which stimulates investment and shifts the aggregate demand curve rightward. •Expansionary fiscal policy—a spending increase or tax cut—shifts aggregate demand to the right. Contractionary fiscal policy shifts aggregate demand to the left. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change: •The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. •The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Economists disagree about how actively policymakers should try to stabilize the economy. •Some argue that the government should use fiscal and monetary policy to combat destabilizing fluctuations in output and employment. •Others argue that policy will end up destabilizing the economy because policies work with long lags. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Six Debates over Macroeconomic Policy Premium PowerPoint Slides by Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. N. Gregory Mankiw Macroeconomics Principles of Sixth Edition 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. In this chapter, look for the answers to these questions: What are the arguments on both sides of each of the following debates? •Should policymakers try to stabilize the economy? •Should fiscal policy fight recessions with spending hikes or tax cuts? •Should monetary policy be made by rule or discretion? •Should the central bank aim for zero inflation? •Should the government balance its budget? •Should the tax laws be reformed to encourage saving? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Introduction ▪This course has introduced you to the tools economists use to analyze the behavior of the economy as a whole and the impact of policies on the economy. ▪This final chapter presents both sides in six classic debates over macroeconomic policy. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1. Should Policymakers Try to Stabilize the Economy? Arguments for active stabilization: ▪Left on their own, economies tend to fluctuate. E.g., pessimism of households and firms causes a fall in agg demand, which causes a recession. ▪Policymakers can “lean against the wind,” i.e. use monetary & fiscal policy to stabilize agg demand, output, and employment. ▪A more stable economy benefits everyone. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1. Should Policymakers Try to Stabilize the Economy? Arguments against active stabilization: ▪Monetary & fiscal policy work with long lags, so policy must act in advance of economic changes. ▪But the shocks that cause fluctuations are unpredictable, and forecasting is highly imprecise. ▪If policy takes effect too late, it will worsen fluctuations. ▪So, leave economy to its own devices. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Active stabilization policy ▪Would you be more likely to support active stabilization policy if wages, prices, and expectations adjust quickly in response to economic changes, or if they adjust slowly? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 1 Answers ▪If wages, prices, and expectations adjust slowly, it will take longer for the economy to return to its natural rates of output and employment. ▪In that case, there’s a better chance that expansionary policy will act in time to alleviate the recession, rather than push the economy into an inflationary boom. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. Should the Government Fight Recessions with Spending Hikes or Tax Cuts? Arguments for fighting recessions with spending: ▪Each $ of govt spending adds directly to aggregate demand, but only part of each $ of a tax cut does because consumers save part of it. ▪Since most states must keep balanced budgets, federal spending given to states can prevent states from laying off public workers, saving jobs. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. Should the Government Fight Recessions with Spending Hikes or Tax Cuts? Arguments for fighting recessions with tax cuts: ▪Tax cuts increase households’ disposable income and therefore increase consumption spending. ▪Tax cuts can increase aggregate demand with incentives—like the investment tax credit. ▪Tax cuts can increase aggregate supply by increasing the incentive to work and produce g&s. ▪Rapid spending increases may be wasteful (“bridges to nowhere”) and will require future tax increases. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3. Should Monetary Policy Be Made by Rule or Discretion? ▪The Federal Reserve has almost complete discretion over monetary policy. ▪Some argue that the Fed should be forced to follow a rule, such as ▪constant money growth rate ▪inflation targeting: ▪increase money growth rate if inflation is below target ▪decrease money growth rate if inflation is above target © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3. Should Monetary Policy Be Made by Rule or Discretion? Arguments against discretion: ▪Allowing central bankers discretion could do great harm if they are incompetent. ▪Discretion allows the possibility of abuse. ▪E.g., using monetary policy to affect election outcomes, causing fluctuations called “the political business cycle.” ▪Central bankers who promise price stability may renege if a recession occurs. ▪Time-inconsistency: the discrepancy between actual policy and announced policy © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3. Should Monetary Policy Be Made by Rule or Discretion? Arguments for discretion: ▪Discretion allows flexibility to react to unforeseen events. ▪Political business cycles and time-inconsistency are theoretical possibilities but not that important in practice. ▪It is difficult to specify rules precisely and to determine what the best rule would be. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4. Should the Central Bank Aim for Zero Inflation? ▪Recall two of the Ten Principles of Economics from Chapter 1: Prices rise when the govt prints too much money. Society faces a short-run tradeoff between inflation and unemployment. ▪How much inflation should the central bank accept? Is zero the right target? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4. Should the Central Bank Aim for Zero Inflation? Arguments for a zero inflation target: ▪The costs of inflation (shoeleather, menu, etc.) can be substantial even for low inflation. ▪Achieving zero inflation would have temporary costs (higher unemployment) but permanent benefits. ▪And these costs could be reduced if the commitment to zero inflation is credible (reduces the expected inflation rate). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4. Should the Central Bank Aim for Zero Inflation? Arguments against a zero inflation target: ▪The benefits of moving from moderate to zero inflation are small, but the costs are large: ▪Estimates: must sacrifice 5% of a year’s GDP for each 1% reduction in inflation ▪A disinflation would leave permanent scars: ▪Investment falls, lowering the future capital stock ▪Workers’ skills diminish while unemployed ▪Some of inflation’s costs could be reduced through more widespread indexation. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Another issue in the zero inflation debate Suppose a structural change reduces the demand for university administrators, lowering their equilibrium real wage by 3%. A. If the actual real wage paid to university administrators remains constant, what would be the consequences? B. Would it be easier to achieve the 3% real wage reduction if the inflation rate is 0% or if it is 4%? Why? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers A. If the actual real wage paid to university administrators remains constant, what would be the consequences? Whenever the actual real wage exceeds the equilibrium real wage, there is a surplus of labor, which represents wasted resources. A fall in the wage would alleviate the surplus: ▪it would encourage some administrators to switch to university teaching or private sector employment ▪it would increase the quantity of administrators demanded © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 2 Answers B. Would it be easier to achieve the 3% real wage reduction if the inflation rate is 0% or if it is 4%? Why? To restore labor market equilibrium under 0% inflation, administrators would have to accept a 3% nominal wage cut. Under 4% inflation, they would have to accept a 1% nominal wage increase. The second scenario is more likely, as many people suffer from “money illusion” and focus on nominal variables rather than real ones. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5. Should the Government Balance Its Budget? Arguments for balancing the budget: ▪Govt debt places a burden on future generations. ▪Budget deficits crowd out investment, reducing growth and future living standards. ▪While deficits may be justified during recessions or wars, the surging peacetime debt of recent decades is unsustainable and detrimental. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5. Should the Government Balance Its Budget? Arguments against balancing the budget: ▪The burden of the govt’s debt is exaggerated; it’s only a tiny % of a person’s lifetime income. ▪Cutting the deficit could do more harm than good: ▪Cutting education would reduce human capital accumulation and future living standards ▪Raising taxes reduces incentives to work and save ▪Focusing on the deficit diverts attention from other programs that redistribute income across generations, such as Social Security. ▪Debt/income ratio more relevant than debt itself © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6. Should the Tax Laws Be Reformed to Encourage Saving? Arguments for tax reform to encourage saving: ▪One of the Ten Principles of Economics: A nation’s standard of living depends on its ability to produce g&s. ▪Higher saving provides more funds for capital accumulation, which increases productivity and living standards. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6. Should the Tax Laws Be Reformed to Encourage Saving? Arguments for tax reform to encourage saving: ▪Another of the Ten Principles of Economics: People respond to incentives. ▪The current U.S. tax system discourages saving: ▪High marginal tax rates reduce return on saving ▪Some saving is taxed twice (as corporate income and again as personal income) ▪High tax rates on bequests (up to 55%!!!) ▪Better: replace income tax with a consumption tax to increase the incentive to save © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Switching to a consumption tax ▪Suppose the income tax were replaced with a consumption tax, and the tax rate was chosen carefully to ensure that the average person’s tax burden remains unchanged. ▪Who would benefit? Who would be worse off? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ACTIVE LEARNING 3 Answers ▪People with higher incomes save a bigger percentage of their incomes, so would benefit most from this change. ▪People with low incomes use most or all of their incomes for consumption and would be worse off. (This is why most consumption tax proposals include exemptions for necessities, like groceries, which comprise a larger share of the budgets of low-income persons.) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6. Should the Tax Laws Be Reformed to Encourage Saving? Arguments against tax reform to encourage saving: ▪Such tax reform would mainly benefit the wealthy, who need tax relief the least. ▪Estimates of interest-rate elasticity of saving are low, so tax incentives may not increase saving much. ▪Reducing taxes on capital income may increase the govt’s budget deficit, negating the benefits of higher private saving. ▪Better: increase national saving directly by reducing the budget deficit. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION ▪Economics teaches us “there’s no such thing as a free lunch.” There are few easy answers and many unresolved questions. ▪Crafting the best policy requires knowing the pros and cons of every alternative. ▪Being an informed voter requires the ability to evaluate the candidates’ policy proposals. ▪Knowing the principles of economics helps in these endeavors. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Advocates of active policy argue that the economy is inherently unstable and believe that policy can manage aggregate demand to help stabilize output and employment. Critics of active policy note that policies act with long lags and can end up destabilizing the economy rather than helping it. •Advocates of monetary policy rules argue that discretionary policy can suffer from incompetence, abuse, and time-inconsistency. Critics of rules argue that the flexibility of discretion is important for responding to changing economic circumstances. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Advocates of fighting recessions with spending hikes rather than tax cuts argue that spending has a larger effect on aggregate demand, since households may not spend all of a tax cut. Advocates of fighting recessions with tax cuts argue that hastily implemented spending increases may be wasteful, and that tax cuts have beneficial incentive effects on both demand and supply. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Advocates of zero inflation argue that inflation has many costs and no benefits. The costs of achieving zero inflation are temporary, while the benefits are permanent. Critics claim that the costs of low inflation are small, whereas the recession necessary to reduce inflation is quite costly. •Advocates of balancing the budget note that deficits burden future generations by raising their taxes and lowering their incomes. Critics argue that the deficit is only one part of fiscal policy and should be considered in a broader context. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY •Advocates of reforming the tax laws to encourage saving note that current tax laws discourage saving. Higher saving would increase investment, productivity growth, and future living standards. Critics argue that such reforms would mainly benefit the wealthy, and that such changes may have only a small effect on saving. They feel that reducing the budget deficit would be a more effective and more equitable way to increase national saving. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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