Macroeconomics Review

Draw a PPF for guns and butter and show the following concepts:

- opportunity cost- actual output- potential output - point of efficiency- point of inefficiency- unattainable point

Also draw a PPF to represent GROWTH with and without DEVELOPMENT.

Macroeconomics Review

• What does ceteris paribus mean?

• Define economics.

• Why is economics a social science?

• Define microeconomics and macroeconomics.

The social science that deals with the production, distribution, and consumption of goods and services

All else equal

Micro: the branch of economics that studies the economy of consumers or households or individual firms

Macro: the study of economics in terms of whole systems, especially with reference to general levels of output and income and to the

Macroeconomics Review

• People have been unemployed for so long that they are willing to work below the minimum wage, but businesses cannot hire them because of the minimum wage law.

• What type of unemployment is this, and represent it with a graph.

• Also, what could a government do to eliminate this type of unemployment?

The Laffer Curve: Illustrates the supply-siders' view that higher taxes could lead to lower tax revenue

·Originally sketched on a napkin by Arthur Laffer to help a reporter understand his theory.

·Shows that 100% tax rate, nothing would get produced so there's ZERO tax revenue.

·As the marginal tax rate declines, there is more of an incentive for firms to produce and workers to seek employment since they now get to keep more of their income. As a result, lower taxes cause incomes and tax revenue to rise.

·At some point, further decreases in taxes will cause tax revenue to decline as firms and workers keep more and more of their income.

·At 0% taxes, clearly tax revenue = $0

Read and discuss the following articles on supply-side economics:

Blog post: "Hey, what are you Laffing at? The relationship between tax rate and tax revenue"

Blog post: "Supply - side economists: lower taxes, more growth, more tax revenue!"

Distribution of IncomeEvaluating Taxes and Income Re-Distribution

Inflati

on (

ΔPL)

Unemployment

8%

2%

2%

8%

PC

Pfe

NRU

·In the short-run, there is an inverse relationship between the price level and the unemployment rate

·When AD is weak, unemployment will increase and there is downward pressure on prices.

·When AD is strong, unemployment falls and there is upward pressure on prices as the economy approached full-employment.

·When economy is at equlibrium, UE will be stable at the Natural Rate of Unemployment

Inflation and Unemploymentthe Phillips Curve (HL only)

Graphing the inflation/unemployment relationship: the Phillips Curve

Inflati

on

(Δ

PL)

Unemployment

5%

4%

3%

6%

PC

NRU

1%

A

B

C

PL

read GDP

ASsr

AD

AD1

ASlr

Yfe

Pc

Pa

Y1

AD1

Pb

Inflation increases as Unemployment decreases!

AD/AS and the Phillips Curve: Assume the economy is at full employment, with an inflation rate of 3% and an unemployment rate of 5% (NRU). The economy is at point A on its Phillips Curve.

When aggregate demand increases, price levels rise, output increases, causing unemployment to fall, and the country moves from point A to point B on the PC.

When AD falls, there is downward pressure on the price level and the fall in output means fewer workers are needed. Inflation falls and unemployment increases, moving from point A to C on the PC. In the short-run, there is a trade-off between unemployment and inflation!

Inflation and Unemploymentthe Phillips Curve (HL)

Answer: Stagflation

·A leftward shift of the SR Aggregate Supply curve will cause both unemployment and inflation to increase simultaneously.

·The Phillips Curve will shift to the right

·The economy will experience UE greater than the NRU and higher than desired rates of inflation.

Factors that could cause stagflation:

·sharp increases in fuel costs·rising food prices·weak currency

Inflati

on

(Δ

PL)

Unemployment

Ife

NRU

PC

PC1

>NRU

I1

Question: What could cause the PC to shift out from PC to PC1 ? In other words, what could cause an increase in both unemployment AND inflation?

Inflation and Unemploymentthe Phillips Curve (HL)

Inflati

on (

ΔPL)

Unemployment

Ife

NRU

PC

PC1

>NRU

I1

AD/AS and the Phillips Curve: Assume the economy starts at full employment.When aggregate supply decreases, price levels rise and output falls causing unemployment to increase.

When AS falls, there are upward pressures on the price level and on unemployment. This is shown in an outward shift of the Phillips Curve, and known as STAGFLATION (stagnant grown combined with inflation)

Inflation and Unemploymentthe Phillips Curve (HL)

PL

read GDP

ASsr

AD1

ASlr

Yfe

Pa

Y1

Pb

ASsr1

A

B

What happens to the Phillips Curve when there is an increase in spending and AD shifts out?

Inflati

on (

ΔPL)

Unemployment

Pfe

NRU

PC

PC1

P1

<NRU

P2

PC2

·Unemployment will decrease below NRU, ·Price level will increase

Phillips Curve moves from A to B

·With rising inflation, workers will begin demanding higher wages.·Wages are a resource cost, so when they increase AS will shift to the left·Leftward shift of AS restores full-employment output·Higher resource costs cause the price level to increase

Phillips Curve moves from B to C

If AD increases again, the process will repeat itself: Rising prices lead to higher wages which leads to AS shifting in, UE returning to NRU, and price level increasing ever higher

Inflation and Unemploymentthe Phillips Curve - SR to LR (HL)

A

BC

D E

Inflati

on (

ΔPL)

Unemployment

Pfe

NRU

PC

PC1

P1

<NRU

P2

PC2

PClr

Understanding the LR PC:

As AD increases, UE will decrease in the short-run, when wages are fixed.

In the log-run, wages and other resource costs are variable, and will adjust to the higher price level, causing AS to shift left

Output will always return to the full-employment level, and unemployment to the NRU.

Consequently, in the long-run, there is no tradeoff between unemployment and inflation!

the Long-run Phillips Curve: In the long-run, there is NO tradeoff between inflation and unemployment.

Inflation and Unemploymentthe Long-run Phillips Curve

The Long-run Phillips Curve is vertical at the Natural Rate of Unemployment.

Inflation and UnemploymentEvaluating the Phillips Curve

Does unemployment always return to the NRU (or Non-accelerating inflation rate of unemployment: NAIRU)? The neo-classical economists led by Miltion Friedmen argued that there was no long-run tradeoff between unemployment and inflation. Just as the long-run AS curve is vertical at full-employment GDP, the Phillips Curve is correspondingly vertical at the NAIRU (NRU).

Is an economy's unemployment doomed to always return to some set level? NO! The implication of the LR PC is not that UE will always be at the same NRU, rather that demand-side policies are ineffective at decreasing UE in the long-run. SUPPLY-SIDE policies, however, can lower the UE in the long-run. More productive, lower cost resources will shift LRAS out, and the LR PC to the left.

Inflation and UnemploymentEvaluating the Phillips Curve

Inflati

on (

ΔPL)

UnemploymentNRUNRU1

PClrPClr1PL

read GDP(employment)

ASsr

AD

ASlr

Yfe

P1

P2

Y1

ASlr1

ASsr1

Supply-side expansion and the Phillips Curve: Expansionary supply-side policies lead to a more productive workforce, more efficient resources, and lower costs to firms and an outward shift of the LRAS, which is consistent with a lower natural rate of unemployment. An outward shift of LRAS results in a leftward shift of the LRPC.

Macroeconomics Review

During a recession, most governments will rely on fiscal policy to some extent and increase government spending. But how much should they spend?

The Spending Multiplier: Any increase in spending in the economy (C, I, G, Xn) will multiply itself through further rounds of new spending, resulting in a larger increase in GDP than the initial change in spending.

The size of the spending multiplier depends on society's Marginal Propensity to Consume

Spending Multiplier = 1

1 - MPCor

1MPS

Macroeconomic ModelsSpending Multiplier (HL only)

Marginal Propensity to Consume: The proportion of any change in income used to consume domestically produced output

MPC = ∆Consumption / ∆Income

Marginal Propensity to Save: The proportion of any change in income saved, used to pay off debts, or to purchase imports

MPS = 1-MPC

MPC + MPS = 1

Macroeconomic ModelsSpending Multiplier (HL only)

Pri

ce level

real Output or Income (Y)

Aggregate Demand

AD1

G increases

Example of the spending multiplier effect:

The Swiss government wishes to stimulate spending in the economy. To do so, it increases government spending on infrastructure projects by SFR 10b

Assume Swiss household tend to spend 40% of new income on Swiss goods and services, while 60% goes towards savings, debt repayment and purchase of imports

Multiplier =1.6 = 1.67

An initial change in spending of SFR 10b will result in an increase in Switzerland's GDP of SFR 16.7b

Blog posts: "The Multiplier Effect"

Demand and Supply-Side Policies the Crowding-out Effect

Crowding-out effect: when a deficit-financed increase in government spending drives up interest rates, thereby directing productive resources away from the private sector towards the public sector

Question: How do governments get money to finance their budgets if they lower taxes at the same time that they increase spending (expansionary fiscal policy)?

Answer: they borrow from the public by issuing new government bonds

BOND (definition): The general term for a long-term loan in which a borrower agrees to pay a lender an interest rate (usually fixed) over the length of the loan and then repay the principal at the date of maturity. Bond maturities are usually 10 years or more, with 30 years quite common. Bonds are used by corporations and federal, state, and local governments to raise funds. (source: www.amosweb.com/)

What causes crowding out?

·When the government issues new bonds to finance its budget deficits, the supply of bonds increases in the bond market, lowering the bond price and increasing the interest rates on bonds·The higher return on government bonds directs savings away from commercial banks, decreasing the supply of loanable funds for the private sector to invest with, driving up commercial interest rates·The increase in borrowing by the government may lead to a decline in private investment, thus "crowding-out" private enterprise in the economy·Crowding-out can also refer to the re-allocation of physical resources (labor, land and capital) away from the private sector towards the public sector as the government embarks on projects requiring large inputs of productive resources.

Demand and Supply-Side Policies the Crowding-out Effect

Demand and Supply-Side Policies the Crowding-out Effect

Crowding-out effect: Graphical representation

Two ways to illustrate crowding-out:·The impact on the Money Market

Crowding-out in the Money Market

Inte

rest

rate

S

D2

Q1

5%

Money Market

7%

Dmoney

Inte

rest

rate

DI

Investment Demand

Q1Q2

Quantity of money Quantity of Investment

Interpretation: The government's "transaction demand" for money increases as it must finance its budget deficit, shifting money demand out, driving up interest rates

Private investment is "crowded-out" due to increased

government borrowing

Supply of money: Money supply is established by the Central Bank, it is perfectly inelastic since it is based on policy goals

·Money supply can increase: If a central bank wishes to lower interest rates, it can increase the supply of money in the economy by buying bonds from the public

·Money supply can decrease: If a central bank wishes to increase interest rates, it can decrease the supply of money in the economy by selling bonds to the public

Inte

rest

rate

Quantity of money

S

Dmoney

Q1

5%

Expansionary Monetary Policy

S1

Q2

4%In

tere

st r

ate

Quantity of money

S

Dmoney

Q1

5%

Contractoinary Monetary Policy

S1

Q2

6%

Demand and Supply-Side Policies Monetary Policy (IB and AP)

The Money Market: an introduction

Expansionary Monetary Policy - how it works:

Demand and Supply-Side Policies Monetary Policy

CB buys bondsfrom public and

banks

checkable deposits and

bank reserves

Excess reserves, money supply

Interest rates

C, I ADGDP,

employment, price level

CB sells bondsto public and

banks

checkable deposits and

bank reserves

Excess reserves, money supply

Interest rates

C, I ADGDP,

employment, price level

Contractionary Monetary Policy - how it works:

B

$

Central Bank

Commercial Banks

$$

$B

B B$$$ $

B

the Public

$

$B

B

B

$

$

$

Central Bank buys bonds from banks,

injecting liquidity to excess reserves

Central Bank buys bonds from public,

increasing amount of checkable deposits