ECO 154/254ECO 154/254

Prof. Michael B. McElroy

Multimedia by: Mannig J. Simidian

IntermediateIntermediateMacroeconomicsMacroeconomics

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• The Scarcity Story• The Production Function• The Production Possibilities Frontier• Opportunity Cost• Dymamics of the PPF: Economic Growth• Choice: Investment or Consumption?• Public vs. Private Spending• Summary & Exercises

• The Scarcity Story• The Production Function• The Production Possibilities Frontier• Opportunity Cost• Dymamics of the PPF: Economic Growth• Choice: Investment or Consumption?• Public vs. Private Spending• Summary & Exercises

The Scarcity Story...“Scarcityman” (as he’s nicknamed) loves pondering the economic phenomenon, scarcity. He claims that scarcity is simply an inherent condition in nature, that we all must endure. He implies that we can’t just have or produce everything. Opportunity costs exist and we must constantly make choices. Decisions will always be about “this or that”, not “this and that” and “now or later” not “now and later.”

Scarcity Scarcity Rules!Rules!

Scarcityman won’t have to remind us to take our bitter pill, scarcity, we will constantly run into it as we further our study of Macroeconomics. We will come to realize that scarcity exists for everyone, rich or poor.

For the richer country, scarcity forces people to work instead of play. If resources were not scarce, the people would pursue

more leisure activities like vacation.

For the richer country, scarcity forces people to work instead of play. If resources were not scarce, the people would pursue

more leisure activities like vacation.

For the poorer country, poverty and appalling living conditions make scarcity a matter of life and death.

For the poorer country, poverty and appalling living conditions make scarcity a matter of life and death.

The Production Function

The production function is a process of transforming inputs (labor (n), capital (k), institutional structure (inst) ) into outputs (final goods and services for a certain time period).

The algebraic representation is: y = F ( n, k, inst)

outputoutput isis some function ofsome function of our given inputsour given inputs

The Production The Production Possibilities FrontierPossibilities Frontier

(The PPF)(The PPF)• Our goal in working with the PPF is to see the most output Our goal in working with the PPF is to see the most output that can be produced given a certain amount of inputs.that can be produced given a certain amount of inputs.• So, first assume that as a nation, our inputs (n,k,iSo, first assume that as a nation, our inputs (n,k,instnst) are fixed ) are fixed and we produce 2 goods, xand we produce 2 goods, x11 and x and x22. In other words, right now, . In other words, right now, we only have a certain amount of workers, and capital to work we only have a certain amount of workers, and capital to work with and a certain level of institutional efficiency within our with and a certain level of institutional efficiency within our society.society.• Next, we’d like to determine what combinations of our 2 Next, we’d like to determine what combinations of our 2 goods we could produce…so here we go. goods we could produce…so here we go.

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Let’s say you decide toLet’s say you decide to produce this amount of goods xproduce this amount of goods x22 and x and x11..

Or you could cut back on xOr you could cut back on x2 2 and and increase your production of xincrease your production of x11..

Remember that Remember that pointspoints

that lie outside that lie outside the PPF, the PPF,

are unattainable.are unattainable.

RememberRememberthat points that points

that lie that lie inside theinside thePPF arePPF are

attainable, attainable, but notbut not

desirable.desirable.

Opportunity CostThe downward slope of the PPF depicts that the opportunity cost of producing more of one good is the amount of the other good that

must be sacrificed.

Suddenly you decide to produce some of good xSuddenly you decide to produce some of good x11 without withoutreducing the production of good xreducing the production of good x22..

Let’s say you are at point A, producing only good xLet’s say you are at point A, producing only good x22. .

BBUh oh…this is outside theUh oh…this is outside thePPF, so you must reduce PPF, so you must reduce

production of xproduction of x2.2.

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AA10 10 unitsunits

7 7 unitsunits

0 units0 units 8 units8 units

Notice that in order to gain 8 Notice that in order to gain 8 units of xunits of x11, you had to give up , you had to give up

3 units (10-7) of good x3 units (10-7) of good x22..

OPPORTUNITY COST

OPPORTUNITY COST

PPFPPF

Dynamics of the PPF: Economic Growth

Now, let’s suppose we can increase Now, let’s suppose we can increase ourour inputs inputs (n,k,i (n,k,instnst). This will shift out ). This will shift out

our PPF, making it possible to our PPF, making it possible to produce at a higher PPF.produce at a higher PPF.xx22

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PPFPPF

Remember that any points Remember that any points that lie beyond even the higher that lie beyond even the higher PPF...PPF...

are still unattainable!!!are still unattainable!!!

This action is calledThis action is called

ConsumptionConsumptionmeasured in millions of dollarsmeasured in millions of dollars

Invest

men

tIn

vest

men

tm

easu

red

in

mill

ion

s of

dolla

rsm

easu

red

in

mill

ion

s of

dolla

rsChoice:

Consumption or Investment?

AA

A nation at point A is choosing “zero-growth”, that is, they would rather

consume right now, than invest and consume more later.

A nation at point A is choosing “zero-growth”, that is, they would rather

consume right now, than invest and consume more later.

00 1010

BB

A nation choosing point B shows more willingness to invest.

By investing more, the nation can increase its capital stock

and therefore experience an increase in their PPF in the future.

A nation choosing point B shows more willingness to invest.

By investing more, the nation can increase its capital stock

and therefore experience an increase in their PPF in the future.

88

66

A nation choosing point C is investing even more and will see an even larger increase in their PPF.

A nation choosing point C is investing even more and will see an even larger increase in their PPF.

99

55

CC

ConsumptionConsumptionmeasured in millions of dollarsmeasured in millions of dollars

Invest

men

tIn

vest

men

tm

easu

red

in

mill

ion

s of

dolla

rsm

easu

red

in

mill

ion

s of

dolla

rs

BB

88

66

99

55

CC A nation choosing point C, is said to have aLow Rate of Time Preference.

A nation choosing point C, is said to have aLow Rate of Time Preference.

A nation choosing point B, is said to have a High Rate of Time Preference.

A nation choosing point B, is said to have a High Rate of Time Preference.

Consumption or investment? Consumption or investment? There is no “better” choice, it just depends on whether one places a higher value on current consumption, than on growth. Keep in mind that investment implies future consumption, so the decision is really

about when to consume.

Public vs. Private Spending

The issue of Public and Private spending must also run into the boundaries set by scarcity. There is an opportunity cost whereby

more government output means less private output.

Pu

blic

Ou

tpu

tPu

blic

Ou

tpu

t

Private OutputPrivate Output

++gg

--(c+i)(c+i)

AA

(c+i)(c+i)AA

ggAA

(c+i)(c+i)BB

BBggBB

Starting at point A, if the government decidesStarting at point A, if the government decidesto increase public spending...to increase public spending...

It It mustmust diminish private spending diminish private spendingand land at point B.and land at point B.

This is known asThis is known as

Copyright 1997 Dead Economists Society

• Historical Background• A Glimpse of Adam Smith• Market Clearing• Quantity Theory of Money• Classical AS* Curve• Classical AD Curve• Conclusions on the Classical

Model

Historical BackgroundHistorical BackgroundThe Classical model of economics relates the standard supply-demand analysis to the macroeconomy. It holds that wages and prices will be “flexible” as opposed to “sticky.” Adam Smith’s Wealth of Nations (1776) suggested that the economy was controlled by the “invisible hand” whereby the market system, instead of government would be the best mechanism for a healthy economy.

A Glimpse of A Glimpse of Adam SmithAdam Smith

The central thesis of The Wealth of Nations is that capital is best employed for the production and distribution of wealth under conditions of governmental noninterference, or laissez-faire, and free trade. In Smith's view, the production and exchange of goods can be stimulated, and a consequent rise in the general standard of living attained, only through the efficient operations of private industrial and commercial entrepreneurs acting with a minimum of regulation and control by governments. To explain this concept of government maintaining a laissez-faire attitude toward commercial endeavors, Smith proclaimed the principle of the “invisible hand”: Every individual in pursuing his or her own good is led, as if by an invisible hand, to achieve the best good for all. Therefore any interference with free competition by government is almost certain to be injurious.

"Smith, Adam," Microsoft® Encarta® 96 Encyclopedia. © 1993-1995 Microsoft Corporation. All rights reserved. © Funk & Wagnalls Corporation. All rights reserved.

Market ClearingMarket clearing is an alignment process whereby decisions between suppliers

and demanders reach an equilibrium.

Here’s how it works...Here’s how it works...Here’s how it works...Here’s how it works...

Remember that the demand curve slopes downward meaning that as you increase the Remember that the demand curve slopes downward meaning that as you increase the price (by moving along the demand curve), the quantity demanded decreases. price (by moving along the demand curve), the quantity demanded decreases.

Conversely, the supply curve slopes upward implying that as the price increases (by Conversely, the supply curve slopes upward implying that as the price increases (by moving along the supply curve), the amount supplied will increase.moving along the supply curve), the amount supplied will increase.

Let’s say you begin with an initial Let’s say you begin with an initial demanddemand and and supplysupply curve for CDs. curve for CDs.

PP

QQ

DD SS

Now, suppose that there is a sudden Now, suppose that there is a sudden increase in the demand for CDs.increase in the demand for CDs.

Demand will shift from Demand will shift from DD to to D´D´..

The center point A is the place where The center point A is the place where market decisions reach an market decisions reach an equilibriumequilibrium..

Q*Q*

P*P* AA

D´D´

Q´Q´

P´P´BB

The increase in demand places The increase in demand places upward pressure upward pressure

on the price to point Bon the price to point Bsince the original price, since the original price,

P* no longer clears the market.P* no longer clears the market.

Shortage

Module 4: Dymanics of IS-LM

LMp0IS

ADAD’

ASLR

r

py

y

LMp1

c

c

ro

rlongrun

rshortrun

plongrun

Steps to doing the “IS-LM”• Step 1:Determine which term will be changedfor example, +X0 (increase in autonomous net exports)• Step 2: Determine which equation (IS or LM) will be affected.• Step 3: Preform the neccisary movements within the IS-LM framework.• Step 4: Determine the affects on the other variables by either reading it directly off the diagram, or using equations 1-10.

Given theseEquations...

1) Y= c + i + x + g2) c= co + ci (y-t)3) t= to + ti y4) i= io - i2 r5) x = xo - xiy -x2 r 6) g = go

7) L/P=M/P 8) L/P=j0+j1y-j2r 9) M=M010SR) P=P010LR) y*=F(n*,K0,I0nst)

IS

LM

Aggregate

Demand(Equ. 1-

9)

AggregateSupply

What happens if there is a

+ x0?

What happens if there is a

+ x0?

What is the impact on other variables in the economy: y,p,r,c,i,x,b?

Steps to the “IS-LM”• Since we want to examine how++xx will affect

other variables in the economy.. we must see which equation, IS or LM will be affected.

• Then we must determine if the variable causes a movement along, or an entire shift of the appropriate line.

yM P j

j

j

j r

( / )0 0 0

1

2

1

y z g c t i x r

c c t x

z c i x

0 0 1 0 2 2

1 1 1 1

0 0 0 0

1 1

) ( )

/ ( )ISIS

LMLM

y= (M0/P0) - j0 + j2 r

LMp0rr

yypp

yy

IS1) +x causes IScurve to shift rightto IS’.

AD

ASSR

IS

’

2) This leads to arightward shift in AD to AD’.

p0

AD’

Short Run: Move from A to B.

Long Run:Market clears at p0 to p2

from B to C.

p2 C

3) +p causes LMp0

to shift leftward to LMp2.

ASLR

LMp2

C

ASSR

Short Run:

y +p 0r +c +I -x ?b -

Long Run:

0+

++0--+0

IS

’ LMp0rr

yypp

yy

IS

AD

p0

AD’

p2 C

ASLR

LMp2

C

Module 5:A Look at the Depression

i

Unemployment Lines, 1930sThe Wall Street stock-market crash of 1929 precipitated the Great Depression, the worst economic downturn in

the history of the United States. The depression lasted over a decade, with hundreds of thousands of Americans losing their jobs, businesses failing, and financial institutions collapsing. Of the 6000 people hoping to get jobs on this day in New York, 135 were hired.

Module 6: Module 6: Fiscal PolicyFiscal Policy

What is Fiscal Policy?• Choices about public spending and how

to finance that spending.• It is a system for transfering reserces

from the private to public sector.

““Private vs. Public Choice”Private vs. Public Choice”

“It DependsIt Depends” Questions

• What is the impact of a +g on the macroeconomy?

• What is the size of the national debt and the deficit?

• What is the impact of continued b on y,p,r,c,i,x etc..?

• Are continued gov’t defecits sistainable?

What is the impact of a +g on the

macroeconomy?

• “It depends” on how the government finances its spending.

• It has three options:

(+(+g= +g= +tt00)) Theft (taxes: coercion now), (+(+g= +g= +b)b) Borrowing (bonds: coersion later), (+(+g= +g= +MM00)) Counterfeiting (Printing money).

Tax-Financed Increase in Tax-Financed Increase in Government Spending Government Spending

(+(+gg00=+=+tt00))

1040

U.S. Tax$$

ASSR

LMp0

rr

yypp

yy

IS

AD

p0

Given our IS equation:y=(z+g-ct)-(i+x)r +g shifts IS to IS’.

+g

But, +t shifts IS back to the left (to

IS ’’). Note: the shift leftward from IS’ to IS ’’ is less than the original rightward shift because the

tax-multiplier (-c1t0) is less than the

expenditure multiplier ().

-c

+t 0

AD’

ASLR

pE E

IS’IS’’Tax-Financed Tax-Financed

Increase in Increase in Government Government

Spending Spending (+(+gg00=+=+tt00))

LMp0

E Result:Result: A small rightward shift in both IS (IS to IS’) and AD (AD to AD’’) and a movement along ASSR . As the market clears, the rising price level contracts LM and the economy moves to E.

Bond-Financed Increase in Bond-Financed Increase in Government Spending Government Spending

(+(+gg00=+=+b)b)

The bearer o

f the United

States

Treasury bon

d is hereby

promised

the repaymen

t of the pri

nciple

value plus t

he interest

which it

incurs throu

gh the terms

stated

thereof.

The United S

tates will j

ustly repay

its bearers

in its entir

ety and

will not def

ault under a

ny

circumstance

s.

Signature of

the Preside

nt

____________

_______

US. Treasury Bond

ASSR

LMp0

rr

yypp

yy

IS

AD

p0

AD’

ASLR

pE E

IS’IS’’Bond-Financed Bond-Financed

Increase in Increase in Government Government

Spending Spending (+(+gg00=+=+b)b)

+g

Given our IS equation:

y=(z+g-ct)-(i+x)r

+g shifts IS to IS’. But, +t shifts IS

back to the left (to IS ’’). Note: the shift leftward from IS’ to IS ’’ is less than the original rightward shift because the

tax-multiplier (-c1t0) is less than the

expenditure multiplier ().

LMp0

-c

+t 0

E Result:Result: A small rightward shift in both IS (IS to IS’) and AD (AD to AD’’) and a movement along ASSR . As the market clears, the rising price level contracts LM and the economy moves to E.

Money-Financed Increase Money-Financed Increase in in

Government Spending Government Spending (+(+gg0 0 =+=+MM00))

What is the size of the national debt and the deficit?

National

Debt

?

Annual Deficit (1997)Annual Deficit (1996)Annual Deficit (1995)

…….…...

A meaningful deficit...

• Exclude funds borrowed from federal agencies.

• Include the deficits of local and stage governments.

• Modify the real value of outstanding public debt. to reflect current inflation.

• Include hidden liabilities that currently escape detection in accounting system.

The Cyclical Deficit• Changes in the cash flow

deficit arise purely from fluctuations of real output (y) around its full employment level.

• For example: A recession causes a lower tax base and therefore decreases the government collections.

t=t0+t1y b=g-t

Structural Deficit• Reflects one or more changes in the

fiscal policy instruments g0, t0, or t1 and results in a shift in the IS and AD curves. g0, t0, or t1

Myopic Consumers

• Short-sighted consumers see a decrease in taxes in such a way that their current consumption might increase because of this new “wealth.”

Their response according to Their response according to our IS equation isour IS equation is ( z( z00 + g + g00 - c - c11 t t00) -) -(x(x2 2 + + ii22) r) rThis tThis t00 induces them to increase Z induces them to increase Z00..

Tax-discounters• Tax-discounters’ perceive that lower tax cuts now, means higher future taxes later, leaving consumption

unchanged. “Tax cuts are tax postponements.”

• Previously, we looked at (+(+gg00=+=+b)b)

we measured the effect of +g only, because the variable b was not in any of our 10 equations. • Tax discounters treat deficits just the same as taxes when making consumption decisions.

They see (+(+gg00=+=+b)b) as (+(+gg00=+=+tt00)) !!!

Government Deficits and Current Economic Activity

• Measurement discrepancies

• Impact of fiscal policy (expansionary, contractionary or nuetrat) depends on the CHANGE in the deficit from the precious year.

• Cyclical vs. Structural Deficits

• Tax-discounting view

Module 7: Monetary Policy

MoneyCommodityCommodity

SymbolSymbol

InventionInvention

Without Money

Self-suffiencySelf-suffiency

BarterBarter

Functions of Money

• Make Transactions• Store Purchasing

Power• Measure Economic

Performance• Measure fullfillment of

contracts

Here’s what Money Does...Monetezation brings effeciency...

PPF1

PPF2

inst)

The better the money, the farther out the PPF.

How does money do this?

Fiat moneyFiat money: A declaration of legal tender.

Back to Classical Model: Quantity Theory of Money

d ln M dt

+ d ln V

dt-

d ln ydt

=d ln P

dt

• MV=Py• Take the logs:

• Next solve for ln P:

• Then, take the derivative of the logs to get the percent changes:

ln M + ln V = ln P + ln y

ln M +ln V - ln y = ln P

Growth of Money Supply + Growth of Money Demand - Growth of output =

Inflation ()

%%M + %M + %V - %V - %y* = %y* = %P = P =

%%M = %M = %y* - %y* - %VV

Non-inflationary conditionfor Monetary Policy.

How does the Fed Control the Money Supply?

• To expand the Money Supply: They buy ___________ and pay for it with new money.

• To reduce the Money Supply: They sell ___________ and receive the existing dollars and then destroy it.

But this is difficult to do…The criteria for choosing__________.1. Storage Cost2. Equity

U.S. Treasury U.S. Treasury BondsBonds

•To expand the Money Supply: They buy U.S. Treasury BondsU.S. Treasury Bonds and

pay for it with new money.•To reduce the Money Supply:

They sell U.S. Treasury BondsU.S. Treasury Bonds and receive the existing dollars and then destroy it.

The bearer o

f the United

States

Treasury bon

d is hereby

promised

the repaymen

t of the pri

nciple

value plus t

he interest

which it

incurs throu

gh the terms

stated

thereof.

The United S

tates will j

ustly repay

its bearers

in its entir

ety and

will not def

ault under a

ny

circumstance

s.

Signature of

the Preside

nt

____________

_______

US. Treasury Bond

The Fed Controls the Money Supply through...

1) Open Market Operations (buying and selling U.S. Treasury bonds).

2) Reserve Requirements (never really used).

3) Discount rate which member banks can borrow from the Fed (not meeting the reserave requirements).

The bearer o

f the United

States

Treasury bon

d is hereby

promised

the repaymen

t of the pri

nciple

value plus t

he interest

which it

incurs throu

gh the terms

stated

thereof.

The United S

tates will j

ustly repay

its bearers

in its entir

ety and

will not def

ault under a

ny

circumstance

s.

Signature of

the Preside

nt

____________

_______

US. Treasury Bond

What impact does M have on y, p, r….?

“It depends.”• Whether y=y*, or

yy*.• Whether SR or LR.• Continued +M or

one shot +M.• Depends on Interest

Rates (nominal or real).

Fisher Equation: R = r + Fisher Equation: R = r + ee

Actual Actual (Market)(Market)

Nominal rate Nominal rate ofof

interestinterest

Real rateReal rateof interestof interest

InflationInflation

One shot +One shot +MM+M

IS LMrr

yyPP

AD

yy

+LM, +AD LM’

AD’

In the short-runshort-run, prices are stickey, so inflation is zero. (Point A to B.)

.A

.A

.B

.B

Plug in the latter effects of the AD/AS diagram into the fisher equation to see the effect on the Nomonal interest rate (R).

R= r+ e 0

SR -r +y -R

In the long-runlong-run, prices will adjust so quickly to point c, that the market will not incur anyinflation, despite the new price level P1.

.CP1

LR r =R =y=0

P0

Continuous +Continuous +M M (Increasing rate of gr wth of the money

suppy)

++MMSR:SR: The AD/AS diagramtells us....-r +y

LR:LR: Prices adjust, shifting LM back leftward, r =0, but with + The fisher equation tells us

+e+R (R=0r+e)

In the LR, prices will adjust and the Nominal In the LR, prices will adjust and the Nominal Interest Rate (R) will rise. Any attempts to -Interest Rate (R) will rise. Any attempts to -r, at y* will only increase the price level and r, at y* will only increase the price level and R.R.

Money Neutrality: Money Neutrality: “You can’t print your way to

prosperity.”

Changes in Monetary Policies have no lasting effect on r, but

changes in Fiscal Policies do.

Distinction between Short-term and Long-term Interest

Rates on Bonds

(3 mos.) RST= r + e

(10 yr.) RLT= r + e

How will the bond market react to a sudden +M,

what happens to R?

+MSR -r RST

LR r =0 + DPe

You would be quite rich if you predict interest rates.

Effecient Market Effecient Market HypthesisHypthesis• Good Prediction

• Unique

Random Walk HypthesisRandom Walk Hypthesis• Given that there are so

many people in the market, you select the stocks randomly.

Why doesn’t the central bank do a better job of

stabilizing the economy?

• What’s the goal?• Policy Lag: Long

&Variable lag between +M and y?

• Which money supply?

Module 8:Suppose you were

Chairman...

Module 9: International Module 9: International TradeTrade

World Trade Center, New York CityManhattan, one of the boroughs of New York City, is the headquarters for much of the world’s foreign trade. The twin towers of the 110-story World Trade Center are seen in this photograph, with the Statue of Liberty in the foreground.

New York Conv. & Vis. Bureau

Scarcity: A bitter pill for rich or poor nations

For the richer country, scarcity rears its ugly head by forcing people to work instead of play. If resources were not scarce, the people would pursue more leisure activities like vacation.

For the poorer country, poverty andappalling living conditions make scarcity a matter of life and dealth.

The PPF

• Our goal in working with the PPF is to see the most output that can be produced given a certain amount of inputs.

• So, first assume that as a nation, our inputs (n,k,inst) are fixed and we produce 2 goods, x1 and x2. In other words, right now, we only have a certain amount of workers, and capital to work with and a certain level of institutional efficiency to work with.

• Next, we’d like to determine what combinations of our 2 goods we could produce…so here we go.