unit 7

Balance of payments

Measure of money inflows and outflows between the United States and the rest of the world (ROW) 

• Inflows are referred to as credits
• Outflows are referred to as debits

The balance of payments is divided into 3 accounts

• Current account

• Capital/financial account

• Official reserves account

Double entry bookkeeping

• Every transaction in the balance pf payments is recorded is recorded twice in accordance with standard accounting practice

• Ex. U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland. 

• A credit of $50 million to the current account (- $50 million worth of farm equipment or physical assets)

• A debit of $50 million to the capital/financial account (+$50 million worth of euros or financial assets)

Current account

Balance of trade or net exports

• Exports of goods/services - import of goods/services

• Exports create a credit to the balance of payments

• Imports create a debit to the balance of payments

Net foreign income 

Income earned by U.S. owned foreign assets - income paid to foreign held by U.S. assets

Ex. Interest payments on U.S. owned Brazilian bonds - interest payments on German owned U.S. Treasury bonds

Net transfers (tend to be unilateral) 

Foreign aid > a debit to the current account

Ex. Mexican migrant workers send money to family in Mexico

Capital/financial accounts

The balance of capital ownership

• Includes the purchase of both real and financial assets
• Direct investment in the United States is a credit to the capital account

• Ex. The Toyota factory in San Antonio

• Direct Investment by U.S. firms/individuals in a foreign country are debits to the capital account

• Ex. The Intel factory in San Jose, Costa Rica

• Purchases of foreign financial assets represents a debit to the capital account

• Ex. Warren Buffet buys stock in Petrochina

• Purchases of domestic financial assets by foreigners represents a credit to the capital account
• The United Arab Emirates sovereign wealth fund purchases a stake in the NASDAQ

Relationship between Current and Capital account

Remember double entry bookkeeping?

• The current account and the capital account should zero each other out
• That is...if the current account has a negative balance (deficit), then the capital account should have a positive balance (surplus). 

Official reserves

• The foreign currency holdings of the United States Federal Reserve System
• When there is a balance pf payments surplus the Fed accumulates foreign currency and debits the balance of payments

Active vs passive official reserves

• The united states is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.

• The people's republic of china is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the united states. 

• Foreign exchange (FOREX)

• The buying and selling of currency

• Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their dollars and buy (demand) Euros.

• The exchange rate (e) is determined in the foreign currency markets.

• Simply put. The exchange rate is the price of currency. 

• Do not try to calculate the exact exchange rate. 

Tips

• Always change the demand line on the currency graph, the supply line on the other currency's graph.

• Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer. 

• If D on one graph increases, S on the other graph decrease

• If D moves to the left, S will move to the left on the other graph. 

Changes in Exchange Rates

• Exchange rates (e) are a function of the supply and demand for currency. 

• An increase in the supply of a currency will make it cheaper to buy one unit of that currency. 

• A decrease in supply of a currency will make it more expensive to buy one unit of that currency

• An increase in demand for a currency will make it more expensive to buy one unit of that currency

• A decrease in demand will make it cheaper to buy one unit of that currency. 

• Appreciation of a currency occurs when the exchange rate pf that currency increases (e ^)

• Hypothetical: 100 yen is used to buy $1. Now 200 yen buys $1

• The dollar is "stronger"

• Depreciation of a currency occurs when the exchange rate of that currency decreases (e decreases)

• One hundred yen used to buy one dollar. Now 50 yen buys one dollar

• The dollar is weaker because it takes fewer yen to buy the dollar.

Exchange rate determinants

Consumer tastes

• Ex. A preference for Japanese goods creates an increase in the demand of yen and an increase in the supply of dollars in the currency exchange market.

• The increase in demand of the yen leads to the appreciation of the yen.

• The increase in the supply of dollars leads to the depreciation of the dollar. 

Relative income

• Imports tend to be normal good

• Ex. If Mexico's economy is becoming stronger and the U.S. Economy is in recession, then Mexicans will buy more American goods.

Relative price level

• Ex. If the price level is higher in Canada than in the United States, then American goods are relatively cheaper than Canadian goods. 

• This Canadians will import more american goods causing the us dollar to appreciate. 

Speculation

• Ex. If Us investors expect that Swiss interest rates will climb in the future, then Americans will demand Swiss francs in order to earn the higher rates of return in Switzerland. 

• This will cause the Swiss franc to appreciate as demand for it will increase. 

• Supply of the dollar will increase causing it to depreciate. 

Balance of Payments

Balance of payments

• Measure of money inflows and outflows between the United States and the rest of the world (ROW) 

• Inflows are referred to ad credits

• Outflows are referred to as debits

• The balance of payments is divided into 3 accounts

• Current account

• Capital/financial account

• Official reserves account

Double entry bookkeeping

• Every transaction in the balance pf payments is recorded is recorded twice in accordance with standard accounting practice
• Ex. U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland. 
• A credit of $50 million to the current account (- $50 million worth of farm equipment or physical assets)
• A debit of $50 million to the capital/financial account (+$50 million worth of euros or financial assets)

Current account

Balance of trade or net exports

• Exports of goods/services - import of goods/services
• Exports create a credit to the balance of payments
• Imports create a debit to the balance of payments

Net foreign income

• Income earned by U.S. owned foreign assets - income paid to foreign held by U.S. assets
• Ex. Interest payments on U.S. owned Brazilian bonds - interest payments on German owned U.S. Treasury bonds

Net transfers (tend to be unilateral) 

• Foreign aid > a debit to the current account
• Ex. Mexican migrant workers send money to family in Mexico

Capital/financial accounts

• The balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct investment in the United States is a credit to the capital account

• Ex. The Toyota factory in San Antonio

• Direct Investment by U.S. firms/individuals in a foreign country are debits to the capital account

• Ex. The Intel factory in San Jose, Costa Rica

• Purchases of foreign financial assets represents a debit to the capital account

• Ex. Warren Buffet buys stock in Petrochina

• Purchases of domestic financial assets by foreigners represents a credit to the capital account
• The United Arab Emirates sovereign wealth fund purchases a stake in the NASDAQ

Relationship between Current and Capital account

• Remember double entry bookkeeping?
• The current account and the capital account should zero each other out
• That is...if the current account has a negative balance (deficit), then the capital account should have a positive balance (surplus). 

Official reserves

• The foreign currency holdings of the United States Federal Reserve System
• When there is a balance pf payments surplus the Fed accumulates foreign currency and debits the balance of payments

Active vs passive official reserves

• The united states is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.
• The people's republic of china is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the united states. 

Foreign exchange (FOREX)

• The buying and selling of currency

• Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their dollars and buy (demand) Euros.

• The exchange rate (e) is determined in the foreign currency markets. 
• Simply put. The exchange rate is the price of currency. 
• Do not try to calculate the exact exchange rate. 

Tips

• Always change the demand line on the currency graph, the supply line on the other currency's graph.
• Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer. 
• If D on one graph increases, S on the other graph decreases
• If D moves to the left, S will move to the left on the other graph. 

Changes in Exchange Rates

• Exchange rates (e) are a function of the supply and demand for currency. 
• An increase in the supply of a currency will make it cheaper to buy one unit of that currency. 
• A decrease in supply of a currency will make it more expensive to buy one unit of that currency. 
• An increase in demand for a currency will make it more expensive to buy one unit of that currency.
• A decrease in demand will make it cheaper to buy one unit of that currency. 

Appreciation of a currency occurs when the exchange rate pf that currency increases (e ^)

• Hypothetical: 100 yen is used to buy $1. Now 200 yen buys $1. 
• The dollar is "stronger". 

Depreciation of a currency occurs when the exchange rate of that currency decreases (e decreases)

• One hundred yen used to buy one dollar. Now 50 yen buys one dollar.
• The dollar is weaker because it takes fewer yen to buy the dollar.

Exchange rate determinants

• Consumer tastes

Ex. A preference for Japanese goods creates an increase in the demand of yen and an increase in the supply of dollars in the currency exchange market.

The increase in demand of the yen leads to the appreciation of the yen.

The increase in the supply of dollars leads to the depreciation of the dollar. 

• Relative income

Imports tend to be normal goods

Ex. If Mexico's economy is becoming stronger and the U.S. Economy is in recession, then Mexicans will buy more American goods.

• Relative price level

Ex. If the price level is higher in Canada than in the United States, then American goods are relatively cheaper than Canadian goods. 

This Canadians will import more american goods causing the us dollar to appreciate. 

• Speculation

Ex. If Us investors expect that Swiss interest rates will climb in the future, then Americans will demand Swiss francs in order to earn the higher rates of return in Switzerland. 

This will cause the Swiss franc to appreciate as demand for it will increase. 

Supply of the dollar will increase causing it to depreciate. 

Phillips Curve

Phillip's curve

Short run

• Represents the relationship between employment and inflation
• Trade off between inflation and unemployment that only occurs in the short run 
• There is an inverse relationship between unemployment and inflation 
• Has relevance to Okun's law. 
• Since wages are sticky, inflation changes, move the points on the SRPC
• If inflation persists and the expected rate of inflation rises, then the entire SRPC moves upward due to stagflation 
• If inflation expectations drop, due to new technology or economic growth, then the SRPC moves downward 

Long run

• Long run Phillips curve occurs at the natural rate of unemployment  
• Represented by a vertical line
• No trade off between unemployment and inflation in the long run, which means that the economy produces at the full employment level 
• Will only shift if the LRAS curve shifts
• Structural, seasonal, and frictional unemployment 
• Full employment is around 4-5% 
• Major LRAC assumption is that more worker benefit create higher natural rates. Fewer worker benefits create lower natural rates. 
• Whatever shifts PPC, will shift LRAS

• Aggregate supply shocks cause both the rate of inflation and the rate of unemployment to increase (rapid and significant increase in resource cost)

The long-run Phillips curve (LRPC)

• Because the long-run Phillips curve exists at the natural rate of unemployment (Un), structural changes in the economy that affect Un will also affect cause the LRPC to shift.
• Increases in Un will shift LRPC >
• Decreases in Un will shift LRPC <
• Increase in AD = up/left movement along SRPC
• Decrease in AD = down/right along SRPC
• SRAS > = SRPC < 
• SRAS < = SRPC > (stagflation) 

Stagflation 

• When inflation and unemployment increase simultaneously
• Baby boom 1946-1964
• Women's movement 
• Civil rights movement
• Vietnam war ends
• All embargo of 1973 and 1979

Disinflation

• Reduction in the inflation rate from year to year 
• Occurs when aggregate demand declines

Deflation

• General drop in the price level

Misery index 

• Combination of inflation and unemployment in any given year single digit misery is good

Supply side economics

• Belief that the AS curve will determine levels of inflation, unemployment, and economic growth 
• To increase the economy the AS curve will have to shift to the right which will benefit the company first
• Supply side economists focus on marginal tax rates 
• Amount paid on the last dollar earned, or on each additional dollar earned
• Lower taxes are incentives for businesses to invest in our economy
• Lower taxes are incentives for workers to work more and harder, thereby becoming more productive 
• Lower taxes are incentives for people to increase savings and therefore create lower interest rates which will increase business investment
• Supply side economists support policies that promote GDP growth by arguing that high marginal tax rates along with our current system pf transfer payments such as unemployment compensation or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneur ventures 

Reaganomics 

• Lowered the marginal tax rate to get the U.S. out of a recession 
• Deficit

Laffer curve

• Trade off between tax rates and government revenue
• Used to support the supply side argument 
• As tax rates increase from 0, tax revenues increase from 0 to some maximum level and then decline 

Progressive tax rate

• Increases per year
• 37% breakoff point
• No point in working if there are more taxes

3 criticisms

1. Research suggests that the impact of tax rates on incentives to work, invest, and to save are small

2. Tax cuts also increase demand which can fuel inflation and it causes demand to exceed supply

3. Where the economy is actually located on the curve is yet to be determined

Revisiting AD and AS

Revisiting AD/AS 

Short run aggregate supply 

• Time is too short for wages to adjust to the price level 
• Workers may not be aware of changes in their real wages due to inflation and have adjusted their labor supply decisions and wage demands accordingly 
• Fixed contract, no pay increase

Ranges

• Horizontal/Keynesian
• Intermediate
• Vertical/classical 

Wages

• Nominal wage
• Amount of money received per hour per day or per year
• Sticky wages
• Where the nominal wage level is set according to an initial price level, and it does not vary

Levels

Keynesian

• Price level is fixed
• Wage level is fixed
• unemployment level is flexible
• (Output depends on changes in employment)

Intermediate

• Price level is flexible
• Wage level is fixed
• Employment level is flexible
• (Output depends upon changes in price level and employment) 

Classical

• Price level is flexible
• Wage level is foxed
• Employment level is fixed
• (Output depends on changes in proce level) 

Long run aggregate supply

• Flexible wage and price level 
• They offset each other
• Shifts are connected to the PPC graph
• Time is long enough for wages to adjust to the price level
• Growth in some format, technological change, capital stock gains (shifts) 

Demand pull inflation

• Pulling something towards you
• AD will increase

Cost push inflation

• Pushing something away
• Decrease production 

Recession

• Not going to be spending
• AD is decreasing 

Economic growth

• Prices are going to be going up
• AD is decreasing

AP ECONOMICS VIDEO

Video 6

http://www.youtube.com/watch?v=k37Y6BKcpsY&feature=bf_next&list=PL2CB281D126F65E26&lf=results_video

         In the 6th video, the discussed about money market, loanable funds, and the AD-AD graphs. They should all be side by side in order to see the change in demand or supply. The MV should always be equal to PQ. Increasing interest rate drives an increase in price level, they call this the fisher effect. The walker effect explains how for every cookie you eat, thats one less cookie.

Video 5

http://www.youtube.com/watch?v=1tUC59pz95I&feature=bf_next&list=PL2CB281D126F65E26&lf=results_video

         In the 5th video , they discussed about the Money Creation Process. The way banks create money is by making loans. Multiplier and multiplier desposit expansion both fall under the creating process. Reserve Ratio is the percentage of banks total requirments. The process of the multiple deposits is to add up all the potential loans. But this is only an assumption, from all the banks thats have no excess reserves.

Video 4

http://www.youtube.com/watch?v=rdM44CC0ELY&feature=bf_next&list=PL2CB281D126F65E26&lf=results_video

          In video 4, they discussed about loan-able funds. When the interest rate is low, people demand more money. The DLF line is always down ward sloping. When the interest rate is higher, people have an instinct to borrow, this discourages the government.
         The SLF- is the amount of money people have in the bank, it is dependent on savings. The more money people save, the more money banks have available to make loans. Who would they loan the money to? The answer is future businesses, and customers etc...

Video 3

http://www.youtube.com/watch?v=XJFrPI8lLzQ&feature=bf_next&list=PL2CB281D126F65E26&lf=results_video

 

          In video 3 they explain the FED: Tools of Money Policy. It can be divided into three part but they have 2 options which are expansionary and contractionary money policies.  Expansionary has easy money, the Reserve Requirement and Discount Rate decreases, while in contractionary they both increase. To expand the money supply the FED buys bonds, when trying to contract the money supply the FED will sell bonds

Video 2

http://www.youtube.com/watch?v=gzFdeM6lUno&feature=bf_prev&list=PL2CB281D126F65E26&lf=results_video

 

In video 2, they explain the different parents in the money market graph. The DM is downward sloping because when the price is high the quantity of demand is low. The relationships with quantity and interest are inverse. The supply of money does not vary on interest rate. Demand for money is fixed, it is set by the FED. Increasing the money supply, stabilize interest rates.

Video 1

http://www.youtube.com/watch?v=YLsrkvHo_HA&feature=results_video&playnext=1&list=PL2CB281D126F65E26

 

        In the first video on the list, they explain how there is three different types of money. Commodity,  representative, and fiat money are all forms of exchange for goods. Commodity is a good that has ither purposes such as salt or a cow. Representative money is whatever we are using as currency represented by a precious metal, such as gold or silver. Fiat money is different because it is not backed by a precious metal, but it is still accepted by transactions. Fiat money is only money because the government says it has value.
        There are only 3 functions of money, the first function is that it's a medium of exchange.  The second function is that is can store for value, by saving or putting it away in a bank. The third function is to be the unit of account, which is that the price of an object has the ability to us judge what is the worth of value or quality.
        These are the main idea's spoken in video 1.

Demand for Money

Demand for Money had an inverse relationship between nominal interest rate and the quantity of money demanded

1. What happens to the quantity demand of money when interest rates increase, it DECREASES
2. What happens to the quantity demand when interest rates decreases, it INCREASE

Fiscal 

• Congress, the president
• tax or spend

Monetary 

• The FED (Federal Reserve Bank)
• OMO
• Discount Rate
• Federal Fund Rate
• Reserve Requirement 

Changes In The Supply of Loan-able Funds

• Remember that supply of borrowing of loan-able funds = savings (liw demand for bonds)
• more savings= more supply of loan-able funds (->)
• less savings = less supply of loan-able funds (->)
• EX - 
• -- Government budget surplus = more savings= more supply Loan-able funds .: Slf -> .: v
• -- decrease in consumers MPS = less saving = less supply of loan-able funds .: slf <- .:r ^

Final Thoughts on Loan-able Funds

• loanable funds market determines the real interst rate
• when government does fiscal policy it will affect the loan-able funds market
• changes in the real interst rate (r%) will affect Gross Private investment. 

Federal Fund Rate- the interest rate that commercial bank, change other commercial banks for over night

- discount rate- loans form FED 

- Sister banks- federal fund rate

Prime Rate- the interest rate that is given to a banks most credit worthy consumers

o-4%

Ms. Mac AP Macroeconomics, The Loan-able Funds Market

The Loan-able Funds Market

• The Market where savers and borrowers exchange funds (Qlf) at the real rate of interest (r%)
• the demand for loadable funds, or borrowing comes from households, firms, gov't and foreign sector. The demand for loan-able funds is in a fact the supply of bands.
• The supply of loan-able funds of saving comes from households, firms government and the foreign sector. The supply of loan-able funds is also the demand for bonds.

Changes in the Demand for Loan-able Funds

• Remember that demand for loan-able funds = borrowing (i.e supplying bonds)
• more borrowing = demand for loan-able funds (->)
• Less borrowing  = less demand for loan-able funds (<-) 
• examples
• - government deficit spending = more borrowing = more demand for loan-able finds .: Dlf -> .: r % ^
• - less investment demand =less borrowing = less demand for loan-able funds. 

Key Principles

- A single bank can create money (through loans) by the amount of excess reserves
- the banking system as a whole can create money by a multiple (deposit on a money multiplier) of the initial excess reserves

• Banks loan out all of the excess reserves
• loans are redeposited in checking accounts rather that taken in cash 

money that was created by the banking system. 

Factors That Weaken the Effectiveness Of the Multiplier

1. If the Banks fail to loan out all of their excess reserves, FED weak has to change money multiplier
2. If Bank customers take loans in cash rather new checking deposits creates cash or currency drain.  

Functions of the FED

1. It issues paper currency
2. sets reserve requirements and holds reserves of banks
3. lends money to banks and charges them interest
4. they are a check clearing service for banks
5. It acts as personal bank for the Government
6. supervises member banks
7. Controls the money supply in the economy 

Time Value of Money

Is a dollar today worth more than a dollar tomorrow?
- yes

but....
WHY????
-opportunity cost, and inflation
- this is the reason charging and paying interest

Let V= future VALUE of prices
P= PRESENT VALUE of prices
R= REAL INTEREST RATE (Nominal rate- inflation rate)
n= YEARS
K= Number of times interest is credited per year

Simple Interest Formula

V=( 1+ R)^n x P

Compound Interest Formula
V=(1+R/K)^nk x P

R% = 1 % - pie%

Monetary Equation of Exchange
MV=PQ
-M= Money supply (M1 or M2)
-V Money's Velocity (M1 or M2)
-PL= Price Level (PL on the AS/AD diagram)
-Q= Real GDP ( sometimes labeled Y on the AS/AD diagram)

Investment

Investment- We are redirecting resources, that you would consume now for the future.


Financial Asset- claims on property and income of the borrower

Financial Intermediaries- institution that channels funds from savers to borrowers.

Interest in relationship savers, saver is me, and institution is a bank, the bank invests.

3 Purposes for Financial Intermediaries
1. Share risk
-- Diversification- spreading out investment to reduce risk

2. Providing Information
--Stock-broker to advise you what to do to see

3. Liquidity
--Easily to convert to cash
--Returns- the money and inverses above and beyond the sum of money that was intentionally invested.

The higher the risk, the higher the investment bond.

Bonds
3 Components of a Bond

1. Coupon rate
2. Maturity
3. Par Value

Bonds are Loans or IOUs that represent debt that the Gov't or a cooperation must repay to an invester

-Bonds are generally low risk investments

1. Coupon Rate

- the interest rate that a bond issuer will pay to a bond holder

2. Maturity

- the time at which payment to a bond holder is due

3. Par Value

- the amount that an investor pays to purchase a bond and that will be re payed to an investor at maturity

Yield- Annual rate of return on a bond of the bond were held to maturity 

Bond you LOAN

Stocks you OWN

Money

Money- is any asset that can be easily used to purchase goods and services.

3 uses

•  As a medium of exchange

- Used to determine value

• Unit of Account

- You need something to compare cost to

• Store Value

- When you hide money (shoe box, under mattress)

- In a bank it earns interest, at home its the same value

1. Commodity Money

- value within its self

• Salt
• olive oil
• gold

     2.  Representative Money

- Represents something of value

• IOU - pay back worthless paper

   3.  Fiat Money

- Money because government says so 

• Paper currency
• coins

Currency is not the same as money

All money is not currency

6 Characteristics of Money

1. Durability (last long)
2. Portability ( take it everywhere)
3. Divisibility (Broken down) ex(1 dollar is 10 dimes)
4. Uniformity (looks the same, updates)
5. Limited supply
6. Acceptability 

Money Supply

- All the available money in the economy 

M1

• Consists of LIQUID ASSETS

- easily can convert to cash
-Currency (paper)

-coin

-check-able deposits  (checks)

-Travelers Checks

M2

• Consists of M1 Money + Savings Accounts + money market accounts. 

3 Purposes for financial Institutions

1. Store Money
2. Save Money
3. Loan Money- Credit card/Mortgage 

4 Ways to Save Money

1. Savings Account
2. Checking Account
3. Money Market Account
4. CD certificate of Deposit

3+4 Higher interest rate. 

Loans
Banks operate on fractional reserve bank system
which means - they keep a fraction of the funds, and they loan out the rest

Interest Rate
Principal- amount of money borrowed
Interest- price paid for the use of borrowed money
- simple interest- paid on the principal
- compound interest- paid on the principal + the accumulated Interest

Formulas

P- Principal
R- rate of interest
T- time

Simple Interest
I= P x R x T/ 100

Time
T= I x 100/ P x R

Principal
P = I x 100/ R x T

Interest Rate
R = I x 100/ P x T

Types of financial Institutions

1. Commercial banks
2. loans and saving institutions
3. mutual savings banks
4. credit unions
5. financial companies   

Fiscal Policy

• Changes in the expenditures or tax revenues of fiscal gov't
• - 2 Tools of fiscal policy

• Taxes - government can increase or decrease taxes
• Spending- government can increases or decreases spending
• Fiscal- is enacted to promote our nation's economic good: full employment, price stability, economic growth

Deficits, Surplus and Debt

• Balance budget
• - revenues =Expenditures

• Budget deficit
• - Revenue < expenditures

• Budget Surplus
• - revenues > expenditures

Government debt
- sums of all deficits - sums of all surpluses

Government must borrow money when it runs a budget deficit

Government borrows from
- individuals
- corporations
-financial institutions
-foreign entities or foreign government

Fiscal Policy Two options

• Discretionary Fiscal Policy-think deficit
• Contractionary Fiscal Policy-think surplus

- Non-Discretionary Fiscal Policy (action)
Discretionary v automatic fiscal policies

• discretionary

-increasing or decreasing government spending and/or taxes in order to return the economy to full employment
-discretionary policy involves policy makers doing fiscal policy in response to an economic problem

• Automatic

-unemployment + compensation & marginal tax rates are examples of automatic policies that help mitigate the effect of recession and inflation. Automatic fiscal policy takes places with out policy makers having to respond to current economic problems

Contractionary VS Expansionary
Fiscal Policy

• contractionary fiscal policy- policy designed to decreased aggregate demand
• - strategy for controlling inflation

Expansionary fiscal policy - policy designed to increase aggregate demand

• strategy for increasing GDP, combatting a recessionary &reducing unemployment

Expansionary Fiscal policy
-increase government spending (G ^)
- decrease  taxes (Tv)
* notice that the PL increase

Contractionary Fiscal Policy

• decrease government spending
• Increase

Automatic or Built- In stabilizers.
* anything that increases the government increases its budget deficit during a recession and increases its budget surplus
Without requirement explicit action by policy makers

Economic Importance
- taxes reduces spending and AD
- reductions in spending are desirable when the economy is moving toward inflation
- increases in spending are desirable toward recession

Transfer payment
a. welfare check
b. food stamping
c. unemployment checks
d. corporate dividends
e. social security
f. veteran benefits

Progressive Tax system
*  Average tax rate ( tax revenue/ GDP)

Proportionary Tax System
* Average Tax rate remains constant as GDP changes

Regressive Tax System
* Average tax rate falls

The Spending Multiplier Effect

• An inital change in spending (C,Ig,G,Xn) causes a larger change in Aggregate Spending or Aggregate demand
• Multiplier =CHnage in AD/ Change in spending
• multiplier = Change in Aggregate Demand/ Change in C,Ig,G,Xn

The Spending Multiplier effect

• why does this happen?
• -expenditures and income flow continuously which sets off a spending increase in the economy

Calculating the Spending Multiplier

• The spending multiplier can be calculated from the MPC or the MPS.
• Multiplier = 1/1 -MPC or 1/MPS
• Multipliers are (+) when there is an increase in spending and (-) when there is a decrease in spending

Calculating Tax Multiplier

• When the government taxes the multiplier it works inverse
• why?
• - because how money is leaving the circular flow
• Tax Multiplier (Note : It's Negative)
• -- = -MPC/1-MPS or -MPC/MPS
• If there is a tax-cut, then the multiplier is +, because there is now more money in the circular flow

Consumption and Saving

Disposable Income

• Income after taxes or net income
• DI = Gross Income - Taxes

2 choices

* with disposable income, household

- consume (spend money on goods, and services )

- save (not spend money on goods & services)

Consumption

• Household spending 
• the ability to consume is constrained by the amount of disposable income
• the propensity to save

* Do households consume if DI = O

- Autonomous consumption

-Dis-saving

• APC = C/ DI = DI that is Spent saving
• house hold NOT spending
• the ability to save is constrained by the amount of disposable income
• the propensity to consume

Do house holds save if DI + O

- NO

• APS = S/DI=%DI that is not spent

APC and APS

• APC+APS=1
• 1-APC = APS
• 1-APS =APC
• APC > 1.: dis-saving
• -APS.: Dis-saving

MPS and MPC

*Marginal Propensity to consume 

- change in C/ change in DI

-% of every extra dollar earned that is spend

* Marginal Propensity to save

- change in S/ change in DI

-% of every extra dollar earned that is save 

- MPC + MPS = 1

-1-MPC=MPS

-1-MPS=MPC

Three Schools of Economics

Classical
The main People

• John B. Say
• Adam Smith
• David Ricardo
• Alfred Marshall

What Classical Economics believe in

• Competition is good
• Invisible-Hand Market will take care of it's self
• Say's law supplies creates its own demand 
• AS- Determines output
• economy is always close to or always at full employment
• in the long run the economy will balance at full employment
• Trickle down effect will help the rich first then help everyone else later
• savings(leakage)= investment considered an (injection) because we invest
• prices and wages are flexible downward 
• no involuntary unemployment
• no reason you shouldn't be employed 
• what ever output is produced will be demanded no government intervention 

Keynesian

The Main Person

• John Mainer Keynes

What Keynesian Economics believe in

• Competition
• AD is key and not AS
• leaks cause constant recession 
• savings cause recessions 
• believed in ratchet effects and sticky wages Block Say's laws
• In the long run we are all dead
• demand creates its own supply there fore
• savers =/ Investment and save for different reasons
• the economy is not always close to or at full employment
• prices and wages are inflexible downward
• mono-plastic competition 
• there is government intervention
• fiscal or monetary policy 

Monetary 

The main people

• Allen Green's Span
• Ben Bernanke

What Monetary believed in

• Congress can time policy options
• government best control the health of the economy, by regulating banks and interest rates
• easy money- recession
• tight money- inflation
• change required reserves if needed
• Use bands through open market operation
• use interest rate to change the discount rate, the discount rate, federal fund rate. 

LRAS

Long Run Aggregate Supply (LRAS)

• Represents a point on an economies production possibility curve
• Any time LR, vertical, always stable at full employment 
• LRAS, doesnt change as the Price level changes

What causes shifts?

1. Change in resources
2. Change in technology
3. Economic Growth

Investment Demand Curve (ID)

Investment Demand Curve (ID)

what is the shape of the investment down curve?
- downward sloping

why?
- when interest rates are high, fewer investments are profitable;when interest rates are low more investments are profitable

• changes ink r% causes changes in Ig. Factors other than r% may shift the entire 

Shifts in Investment Demand (ID)

- cost of production 

• lower cost shift ID->
• high cost shift ID <-

- business taxes

• lower business taxes shift ID ->
• higher business taxes shift ID<-

- Technological change

• new technology shift ID->
• lack of technology change shift ID<-

-Stock of Capital 

• If an economy is low on capital, then ID ->
• If an economy has much capital then ID <-

-Expectations

• positive expectations shift ID ->
• Negative expectations shift ID <-

Full Employment

• Full employment equilibrium exists where AD intersects SRAS & LRAS at the same point

Recessionary GAP

• A recessionary gap exists when equilibrium occurs below full employment out put

Recessionary GAP <- AD decreases

• The Gap that exists whenever equilibrium real
• GDP year is less than full-employment real GDP as shown

inflationary GA

•  An inflationary GAP exists when equilibrium occurs beyond full employment output

Investment Demand
Interest Rate

what is investment

• money spent of expenditures on:
• - new plant (factories)
• - capital equipment (machinery)
• - technology (hardware software)
• - new homes
• - Inventories (goods sold by produces

Expected Rate of Return

• How does business determine the benefits?
• - how does business count the cost
• - Interest Cost
• How does business determine the amount of investment my undertake
• - compare expected rate of return to interest cost
• if expected return> interest cost
• if expected return< interest cost then do not interest.

Real (r%) v. Nominal (I%)

• what's the difference?
• -Nominal is the observable rate of interest. real subtract out inflation (pie%) and is only known ex post factor
• how do you complete the real interest rate (r%)
• r%= I%- pie%
• what then determine the cost of an investment decision?
• - the real interest rate (r%)

Aggregate Supply

Aggregate Supply

• The level of real GDP (GDPr) that firms will produce at each price level (PL)
• Real GDP= Out put

Long run v Short run

Long Run

• period of time where input prices are completely flexible and adjustments to change in the price level
• in the Long run, the level of real GDP supplied is independent of the price level

Short Run

• period of time when input prices are sticky and do not adjust to changes in the price level
• in the Short-run, the level of real GDP supplied is directly related to the price level

Long Run Aggregate Supply (LRAS)

• the long run aggregate supply or in the economy (analogous to ppc)
• Because input prices are completly flexible in the long-run changes in the price level do not change firm's real profits and therefore. do NOT Change firms level of full employment

Long Run

Short Run

• Because input prices are sticky in the shrt run, in the SRAS is upward sloping
• an increase in  GDPr, a decrease goes to the right and left
• The key to understand shifts in SRAS is per unit cost of production.

Per unit cost of production
total input/ total output = per unit cost of production

Changes in SRAS (decreases)

• Determinants of SRAS (all following affect production cost
• input prices
• productivity
• legal-institution environment

Input Prices

Domestic Resource Prices

• - wages (75% of all business cost)
• - cost of capital
• -raw material (commodity prices)

Foreign Resource Prices

• -Strong $ = lower foreign resources prices
• - weak $ = higher foreign resources pries

Market Power

• -Monopoly and cartels that control resources
• Increases in resource prices in= SRAS <-
• Decreases in resource prices= SRAS ->

Productivity
productivity = total out put/ total input

• more productivity= lower unit production cost = SRAS ->
• lower productivity = higher unit production cost= SRAS <-

Legal- Institutional Enviornment

• Taxes ($ to gov't) on business increase per unit production cost = SRAS <-
• Subsides ($ form gov't) to business reduce per unit productivity cost = SRAS ->

Government Regulation

• - government regulation creates a cost of compliance = SRAS <-
• - deregulation reduces compliance cost- SRAS-> 

Consumption

Household spending is affected by
-consumer wealth

• more wealth = more spending (AD shifts ->)
• less wealth = less spending (AD shifts <-)

-consumer expectations

• Positive expectations = more spending (AD shifts ->)
• Negative expectations = less spending (AD shifts <-)

-Household Indebtedness

• Less debt= more spending (AD shifts ->)
• more debt= less spending (AD shifts <-)

-Taxes

• less taxed = more spending (AD shifts ->)
• more taxes= less spending (AD shifts <-)

Gross Private Investment
- Investment spending sensitive to

The Real Interest Rate

• Lower Real Interest Rate =more investment (AD shifts ->)
• Higher Real Interest Rate = less investment (AD shifts <-)

Expected Returns

• High Expected returns =more investment (AD shifts ->)
• Lower expected returns = less investment (AD shifts <-)

- Expected returns are influenced by

• Expectations of future profitability
•  Technology
• Degree of excess capacity (existing stock of capital)

Government Spending

• More Gov't spending (AD ->)
• Less Gov't spending (AD <-)

Net Exports

• Net exports are sensitive to:
• - exchange rates (international value of a $)
• strong $ = more imports and fewer exports (AD<-)
• Weak $= fewer imports and more exports=(AD ->)

- Relative income

• strong foreign economies= more exports =(AD ->)
• weak foreign economies = less exports= (AD <-)

Aggregate Demand (AD)

Aggregate Demand

• Shows the amount of real GDP that the private public and foreign sector collectively desire to purchase at each possible price level
• The relationship between the price level and the level of real GDP is inverse

Aggregate Demand Curve




Three Reasons AD is downward sloping

Real-Balance Effect

• When the Price-level is high household and businesses cannot afford to purchase as much out put.
• when the price-level is low households and businesses can afford to purchase more output

Interest Rate Effect

• A higher price level increases that interest rate which tends to discourage investment
• a lower price level decreases the interest rate which tends to encourage investment

Foreign-Purchase Effect

• A higher price level increases the demand for relatively cheaper imports
• A lower price level increases the foreign demand for relatively cheaper U.S exports

Shifts in Aggregate Demand (AD)

• There are 2 parts to shirts in AD
• - change in C, Ig, G, and/or Xn
• - multiplier effect that produces a greater change than the 4 components
• -- increases in AD= AD ->
• -- decreases in AD= AD <-

Increases in Aggregate Demand

Decreases in Aggregate Demand

Unemployment

Unemployment - is the percentage of people who don't have jobs, but are in the labor force

Labor Force - is the number of people in a country that are classified as either employed or unemployed.

Not in The Labor Force

1. kids
2. military personnel
3. mentally insane
4. prison
5. retired
6. stay at home parents
7. discouraged (homeless, lazy, try to get a job but are either under or over qualified, people who stopped looking for jobs)

Unemployment Rate Equation

# of unemployed

-------------------------------------- x 100

# Of unemployed + employed 

Labor force = # of unemployed + of employed


Types Of Unemployed

Frictional

• Between Jobs
• Quit Job for a better job
• Graduated from college and looking for one
• actively looking for a job

Structural 

• associated with a lack of skills of a declining industry
• Ex: High School drop out cant read or write 
• Technology changes

Seasonal 

• School bus drivers
• Santa, Easter Bunny
• Construction Workers
• Jobs that are done during a certain season of a year

Cyclical

• associated with down terms in the business cycle, had for society and individuals
• trough, then cyclical plays

What is full employment ???

Occurs when there is no cyclical employment in the economy

(Natural rate of unemployment -NRU) 4%-5%

Why is Unemployment bad?

"There is not enough consumption" GDP

"it creates to much poverty"

" too much government assistance"

why is Unemployment good?

less pressure to raise waged

more workers available for future expansion

OKUN'S Law

For every 1 percent of unemployment above the NRU (Natural Rate of Unemployment) causes a 2% decline in Real GDP