Unit VI

Long-Run Economics Growth, Phillips Curves, and the Laffer Curve

• Focus on Real GDP per Capita
• Last 50 years Real GDP grew by about 3.5% per year
• Last 50 Years Real GDP per Capita grew by about 2.3% per year

The Sources of Long-Run Growth

• Productivity- output per unit input
• Labor Productivity- output per worker

      What leads to higher productivity?

• Stock of Physical Capital- buildings, machines, robots, ect.
• Human Capital- Knowledge, skills, education, ect.
• Technology- technical means for producing goods and services
• Improved Resource Allocation- Trade allows us to shift labor services from low-productive jobs to high productive jobs
• Economies of Scale- reduction in per-unit cost that result from increases in the size of markets and firms

Production Possibilities Curve and LRAS
-Economic Growth= Shift in Production Possibilities Curve outward
-Economic Growth= Shift in the Long-Run Aggregate Supply Curve to the RIGHT

Why Growth Rate Differ among Countries
-Rates of Savings
-Foreign Investments
-Education
-Infrastructure- roads, power lines, ports, and information networks, ect.
-Research and Development
-Political Stability
-Protection of Property Rights
-Economic Freedom versus Excessive Government Intervention

The Phillips Curves- Short and Long Run
-Tradeoff between inflation and unemployment
-Stagflation leads to shifts in the SRPC
-Aggregate Supply Shocks: Oil Embargo, Major Agriculture shortfalls, Depreciating US Dollar, Wake Hikes, Inflationary Expectations
-Long-run Philips Curve (LRPC)
-Vertical line at the natural rate of Unemployment

Supply-side Economics and the Laffer Curve
-Stress that changes in Aggregate Supply are an active force in determining the levels of inflation, employment, and economic growth
-Concentrate on tax levels
-Lower taxes are an incentive for business to invest in our economy
-Lower taxes are an incentive 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 for increases in business investment
-Focus on the marginal tax rates

The Laffer Curve

• Relationship between tax rates and tax revenues
• Used to support the supply-side argument
• Reaganomics= Supply-Side Economics
• Idea = the government could lower tax rates and actually increase tax revenues
• Has been severely criticized

Unit V

Long Run and Short Run Curves

• AS curve doesn’t shift in response to changes in the AD curve in the short run.
• Nominal wages do not respond to price-level changes
• Long Run – period in which nominal wages are fully responsive to previous changes 
• in price level
• When changes occur in the short run they result in either increased or decreased producer profits – not changes in wages paid.
• Nominal wages – money getting paid, Real wages – actual value of money, actual gross pay
• In the long run, increases in AD result in a higher price level, as in the short run, but as workers demand more money the AS curve shifts left to equate production  at the original output level, but now at a higher price.
• In the long run, the AS curve is vertical at the natural rate of unemployment (NRU), or full employment (FE) level of output. Everyone who wants a job has one & no one is tempted into or out of the market.
• Demand-pull inflation will result when an increase in demand shifts the AD 
• curve to the right, temporarily increasing output while raising prices.
• Cost-push inflation results when an increase in input costs that shifts the AS curve to the left. In this case, the price level increase is not in response to the  increase in AD, but instead the cause of price level increasing.

The Philips Curve

• represents the relationship between unemployment and inflation
• The trade-off between the inflation and the unemployment occurs in the short run
• Each point on the Philips curve corresponds to a different level of output
• Long Run Philips Curve
• It occurs at the Natural Rate of Unemployment (NRU)
• It is represented by a vertical line
• There is no trade-off between unemployment and inflation in the long run
• The economy produces at the full-employment output level
• The nominal wages of workers fully incorporate any changes in price level as wages
• adjust to inflation over the long run.

Determinants of the Philips Curve

Increase in AD = Up/left movement along SRPC
Determinants (increase): AD to the right, GDPR up & PL down: u% down & π% up: up/left
along the curve

Decrease in AD = Down/right movement along SRPC
Determinants (decrease): AD to the left, GDPR up & PL down: u% up & π% down: down/right a
long the curve

SRAS down = SRPC to the left
Determinants (Inflationary Expectations, Input Prices, Productivity, Business Taxes, and/or
Deregulation) (decrease): SRAS to the right, GDPR up & PL up: u% down & π% down: SRPC to the left

Supply shock - a rapid and significant increase in resource cost which causes the SRAS curve to shift
Natural Rate of Unemployment (NRU) = frictional + structural + seasonal

The natural rate at fewer worker benefits creates a lower NRU
Misery Index – the combination of inflation and unemployment in any given year

Single digit misery is good
If the inflation rate persists and the expected rate of inflation rises, then the entire SRPC moves
upward. If inflation expectations drop (new technology, efficiencies), then the SRPC moves
downward.
Stagflation occurs when you have high unemployment and high inflation at the same time.
Disinflation – when inflation decreases over time:

Nominal
Business profits fall
Firms reduce employment, thus unemployment increases
Laffer Curve – trade-off between tax rates and government revenue; As tax rates increase from 0,
tax revenues increase from 0 to some maximum level and then decline.

The higher the tax rate you set, the less money you will collect. Laffer Curve is controversial and
debatable.

Criticisms on the Laffer Curve

1. Where the economy is located on the curve is difficult to determine.
2. Tax cuts also increase demand which can fuel inflation
3. Empirical evidence suggests that the impact of tax rates on incentives to work, save,
and invest are small

Supply-side/Reaganomics

They support policies that support GDP growth by arguing that high marginal tax rates
along with the current system of transfer payments (unemployment compensation and
social security) provide disincentives to work, invest, innovative, and undertake entrepreneurial
ventures. They believe that the AS curve will determine levels of inflation, unemployment, and economic growth.

Marginal Tax-Rate: The amount paid on the last dollar earned or on each additional dollar earned.

Supply-side economists believe that if you reduce the marginal tax rate then more people
will be able to work longer thus forgoing leisure time.

Unit VII

 Balance of Payments

• Balance of Payments Defined
• The sum of all the transactions that have taken place between a nation's residents and the residents of all foreign nations.
• Transactions Include:
• Exports and imports of goods
• Exports and imports of services
• Tourist expenditures
• Interest and dividends received or paid abroad
• Purchases and sales of financial or real assets abroad

3 Components

• Current Account
• U.S. trade in currently produced goods and services
• Balance of Current Account is found when all transactions in current account are added.
• Capital Account
• Summarizes the purchase or sale of real or financial assets and the corresponding flows of monetary payments accompanying them.
• Official Reserves Account
• Quantities that central banks of nations hold of foreign currencies
• All three components must equal zero.

Balance of Payments Deficits and Surpluses

• Imbalances between current and capital accounts that cause a drawing down or up a building up of foreign currencies.

Foreign Exchange Market

• Foreign Exchange Market Defined
• A market in which various national currencies are exchanged for one another.
• Exchange Rates
• Equilibrium prices in the markets
• Two Points of Foreign Exchange Markets
• Competitive Market:
• Characterized by large numbers of buyers and sellers dealing in standardized products such as the euro, yen, and the dollar.
• Linkage to All Domestic and Foreign Prices:
• The market price or exchange rate of a nation's currency is an unusual price that links all the domestic prices with all the foreign prices.
• Changes in Foreign Exchange Rates
• Increase in the supply of currency will decrease the exchange rate of a currency.
• Decrease in supply will increase exchange rate.
• Increase in demand, increase in exchange rate.
• Decrease in demand, increase in exchange rate.
• Exchange Rate Determinants / Appreciate & Depreciation
• Buyer's Taste
• Relative Income
• Relative Price Level
• Appreciation: currency increases in value
• Depreciation: exchange rate decreases

Comparative and Absolute Advantage

• Principle of Absolute Advantage
• One country would have an absolute advantage over the other if it is able to produce the same amount of goods with fewer resources.
• Principle of Comparative Advantage
• A nation has the comparative advantage in the production of a product when it can produce the product a lower domestic opportunity cost than it can with a trading partner.
• Terms of Trade
• The rate of exchange of two products that can be determined through negotiation, thus the outcome is the terms of trade.
• Gains from trade are based on comparative advantage.

Specialization and Trade

• Specialization based on comparative advantage improves global resource allocation.
• Specialization and trade also increase the productivity and the standard of living within a nation.
• There will be a larger global output of goods and services due to specialization and trade.

Unit IV

3 Uses of Money

• medium of exchange
• unit of account
• store of value

Types of Money

• Representative Money- paper money backed by a tangible product
• Commodity Money- gold and silver coins
• Fiat Money- it is money b/c the government says it is 

Characteristics of Money 

• Durability - how long is money good for 
• Portability - can carry it anywhere
• Divisibility - can be broken into smaller units
• Scarcity
• Acceptability

M1 Money

• consists of currency in circulation (paper and coins, travelers check)
• Checkable deposits- checking accounts, demand deposits 
• Account for 75% of $ in circulation

M2 Money 

• savings accounts
• money- market accounts
• accounts held by banks outside the U.S

Assets= Liabilities + Net Worth 
Reserve Ratio: commercial banks required reserves/ commercial banks check able deposit liabilities

3 Important Issues

• Excess Reserves = actual reserves - required reserves
• lending ability
• asset or liability to which bank
• M1 money as well
• money market account- accounts interests; large money account
• Banks create money by lending excess reserves and destroy it by loan repayment. Purchasing bonds from the public also creates money
• Monetary Multiplier = 1 / (required reserve ratio)
• Maximum check able deposit creation = excess reserves x monetary multiplier

Reserve Requirement

• The Fed. requires banks to always have some money readily available to meet consumers demand for cash
• The amount set by the Fed.  is the Required Reserve Ratio 
• The required reserve ratio is the % of demand deposits that must not be loaned out 
• Typical Reserve Ratio = 10%

Monetary policy

• Controlled by the federal reserve bank (fed)
• Influencing the economy through changes in reserves which influences the money supply and available credit

4 options

1.       Reserve requirement – percent that is set by the fed of the minimum reserve that the bank must keep

2.       Discount rate – rate of interest that the fed charges for overnight loans to banks  

3.       Federal fund rate – rate that FDIC members charge each other for loans

a.       Decrease = expansionary monetary policy

b.      Increase = contractionary monetary policy

4.       OMO(open market operation)- buy or sell securities (bonds)

a.       Fed buys bonds = expand money supply

b.      Fed sells bonds = decrease money supply

Prime rate – interest rate that banks charge their most credit worthy borrowers 

	Expansionary (easy money)	Contractionary (tight money)
OMO	Buy bonds	Sell bonds
Discount rate	Decrease	Increase
Federal fund	Decrease	Increase
Required reserve	Decrease	Increase

Easy money - dollar depreciates

Tight money - high interest rate 

Single bank- amount of money single bank can create (loan out) = ER

Ar - Rr = Er

Banking system - can create money by a multiple of its initial ER

Deposit multiplier = 1/rr

New money system - deposit multiplier X initial ER

If initial deposit is not new money, the total change in the MS is only the money created by the banking system

Money Market 

Loanable Funds 

Video Notes

Video 1: Types and Functions of Money 

3 types of money 

• Commodity – goods that act as money

• Representative – coins and dollars 

• Flat money – government’s word 

3 main functions 

• Medium of exchange 

• Storage of value 

• Unit of account 

Video 2: Money Market Graphs 

Money supply 

• Constant b/c it is controlled by the interest rates and gov’t. 

• Vertical b/c it’s not based off of interest rates 

• Increase demand = increase interest rates

The law of demand – if the price is high quantity demanded is low, if price is low quantity demanded is high

Video 3: The Fed’s tools of monetary policy 

The gov’t uses two options regarding changes in the money supply

• Contractionary (tight money)

• Expansionary (easy money) 

Contractionary fiscal policy 

• Reserve rate will ↑

• Discount rate will ↑

• Gov’t will sell bonds and securities 

Expansionary fiscal policy 

• Reserve rate will ↓

• Discount rate will ↓

• Gov’t will buy bonds and securities 

Video 4: The Loanable funds Market 

Loadable funds graph 

• Supply curve is completely dependent on saving

• If more people save, then more loans are available 

• If gov’t is in a deficit then demand for loans will increase, which leads to a decrease in supply of loans 

Video 5: Money creation and multiple deposit expansion 

Money is created when banks make loans 

To find how much money a loan creates you must:

• Find the multiplier – (1/RR)

• Multiply by the loan amount = multiple deposit expansion 

Example

• RR = 20% 

• (1/.2)=5

• 5(500) = 2500

Video 6: Relating Money market, Loanable funds Market, AD/AS model

Exchange : MV = PQ

• Increase in demand for money increases price level 

• Increase in demand for money increases interest rate, which causes the demand curve to increase resulting in the price levels to increase as well as GDPr  in AD/AS graphs 

Unit III

Aggregate Demand - shows the amount of RGDP that the private, public and foreign sector collectively desire to purchase at each positive price

• relationship between price and RGDP is inverse
• price of Y
• Quantity of X

Why AD is Downward Sloping

• Real Balancing Effect
•  price is high; businesses and households cannot afford to buy as much output 
• Interest-Rate Effect
• high price level increases interest rate, discourages investment
• Foreign Purchases Effect
•  higher price level increases the demand for relatively cheaper imports

Shifts in AD

• Change in C, Ig, G and Xn
•  a multiplier effect that produces a greater change than the original change in the 4 components
• Consumption
• Affected by:
• consumer wealth
• more wealth, AD increases
• Consumer Expectations
•  positive, AD increases
•  Household indebtedness
• less debt, AD increases
• Taxes
• Less Taxes, AD increases

• Gross Private Investment
• Affected by:
• · The real interest rate
•  low interest rate, AD increases
• Expected Returns
•  Higher Expected Returns, AD increases
•  Influenced by
•  expectations of future profitability
• technology
•  degree of excess capability
• business taxes
• Government Spending
• More, AD increases
• Net Exports
• Affected by:
•  Exchange Rate
•  strong money = more imports fewer exports, AD decreases
• weak money = fewer imports and more exports AD increases
• Relative Income
• Strong Foreign Economy = increase in exports, AD increases
• Weak Foreign Economy = decrease in exports, AD decreases

Aggregate Supply

• Long Run 
• · input prices are completely flexible and adjust to changes in the price level
•  level of RGDP supplied is independent of the Price Level 
• marks the level of full employment in the economy (analogous to PPC) 
• Vertical 
• Short Run
•  input prices are sticky and do not adjust to changes in the PL
•  level of RGDP supplied is directly related to the PL
• Changes in SRAS
• Increase in SRAS seen as shift to right: SRAS →
• Decreases in SRAS shift to left: SRAS ←
• Per unit of production:
• (Per Unit Production Cost = Total Input Cost / Total Output)
• Determinants of SRAS
• Input Prices
• Domestic Resource Prices
• Wages (75% of all business costs)
• Cost of capital
• Raw materials (commodity prices)
• Foreign Resource Prices
• Strong money = Lower Foreign Resource Prices
• Weak money= Higher Foreign Resource Prices
• Productivity
• (Productivity = Total Output / Total Input)
• More Productivity = Lower Unit Production Costs = SRAS shifts right
• Lower Productivity = Higher Unit Production Costs = SRAS shifts left
• Legal-Institutional Environment
• Taxes and Subsidies
• Taxes ($ to government) on businesses increase per unit production costs = SRAS shifts left
• Subsidies ($ from government) on businesses reduce per unit production cost = SRAS shifts right
• Government Regulation
• Government regulation creates a cost of compliance = SRAS shifts left
• Deregulation reduces compliance costs = SRAS shifts right

The AS/AD Model 

• the equilibrium of AS & AD determined where AD intersects SRAS & LRAS at the same point

Recessionary Gap

• exists when equilibrium occurs below Full Employment output

Inflationary Gap

• exists when equilibrium occurs beyond full employment output

3 Ranges

• Horizontal or Keynesian Range
• It includes only levels of real output that are less than the FE output.
• It implies that the economy is in recession.
• Vertical or Classical Range
• The economy reaches its full capacity real output.
• Increase in PL = constant production
• Intermediate
• Expansion of real output and price level

Consumption and Saving

• Disposable Income (▵DI)
• income after taxes, net income
• DI= gross income - taxes
• households cane either consume or save
• Consumption - household spending
• the ability to consume is constrained by:
• the amount of DI
• the propensity to save
• Do household consume if DI=0?
• Yes; autonomous consumption 
• Average Propensity to Consume (APC) = C/DI = % of DI that is spent
• Saving - household NOT spending
• the ability to save is constrained by:
• the amount of DI
• the propensity to consume
• Do household save if DI=0?
• No
• Average Propensity to Save (APS) = S/DI = % of DI that is saved
• Equations
• APC+APS=1
• 1-APC=APS
• 1-APS=APC
• APC>1, dissaving
• -APS, dissavings
• Marginal Propensity to Consume (MPC) = C/DI = % of every extra dollar earned that is spent
• Marginal Propensity to Save (MPS) = S/DI = % of every extra dollar earned that is saved
• MPC+MPS=1
• 1-MPC=MPS
• 1-MPS=MPC

Determinants of C & S

• wealth, expectations, household debt, taxes

Spending Multiplier Effect

• an initial change in spending (C, Ig, G, Xn) causes a larger change in AS or AD
• AD/( C, Ig, G, Xn)
• Why does this happen?
• expectations and income flow continuously which sets off a spending increase in the economy
• = 1/(1-MPC) or 1/MPS
• (+) when increase in spending
• (-) when decrease in spending

Tax Multiplier 

• when the government taxes, the multiplier works in reverse because money is leaving circular flow
• = -MPC/(1-MPC) or -MPC/MPS
• if tax is cut, then multiplier is positive because there is more money in the circular flow

Interest Rates and Investment Demands

Investment

• Money spent on expenditures on:
• New plants or factories
• Capital equipment 
• Technology 
• New homes
• Inventories 
• Expected Rates of Return
• investment decisions
• Cost/Benefit analysis
• determine the benefits
• Expected rate of return
• count the cost
• Interest cost
• determine the amount of investment they undertake
• Compared expected rate of return to interest cost
• If expected return > interest cost, then invest.
• If expected return > interest cost, then do not cost.

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

• Nominal is the observable rate of interest. Real accounts for inflation (π%), only known ex post facto.
• Computing r%: (r% = i% - π%)
• determining the cost of an investment decision
• Real interest rate (r%)

Investment Demand (ID)

• Downward sloping
• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable.

Shifts in ID

• Cost of production
• Business taxes
• Technological change
• Stock of capital
• Expectations

Fiscal Policy

• Fiscal policy is the changes in the expenditures or tax revenues of the federal government
• 2 tools of fiscal policy:
• Taxes: Government can increase or decrease taxes
• Spending: Government can increase or decrease spending
• enacted to promote our nation's economic goals: full employment, price stability, economic growth

Deficits, Surpluses, and Debt

• Balanced budget: Revenues = Budget
• Budget Deficit: Revenues < Budget
• Budget Surplus: Revenues > Budget
• Government Debt: sum of all deficits - sum of all surpluses
• Government must borrow money when it runs a budget deficit from:
• individuals, corporations, financial institutions, and foreign entities/governments

Fiscal Policy : Two Options

• Discretionary (actions)
• Expansionary - deficit
• to increase RGDP, combat recession, and reducing unemployment
• Government Spending increases, Taxes decrease
• creates inflation
• Contractionary  - surplus
• strategy for controlling inflation
• Government Spending decreases, Taxes increase
• Non-Discretionary (no action) - AUTOMATIC
• Discretionary increases or decreases taxes
• Automatic - takes in unemployment compensation, social security, etc, that help eases the effects of recession and inflation

Tax Systems

• Progressive Tax System
• Average tax rate that rises with GDP
• Proportional Tax System
• Average tax rate remains constant as GDP changes
• Regressive Tax System
• Average tax rate falls with GDP

Graphs: 

Unit II Notes

Circular Flow Model

GDP

• Gross Domestic Product; the total value of all final goods and services produces within a countries borders within a given year
• Included:
• final goods and services
• income earned
• interest payments on corporate bonds
• current production of final goods/services
• unsold output (business inventories)
• Excluded:
• intermediate goods
• transfer payments (public/private)
• Ex: scholarship, SS
• purchases of stocks and bonds
• used/secondhand sales
• non-market transactions

§  illegal drugs, prostitution

§  baby sitting

§  own housework/repairs

§  growing own products for person consumption

GNP

• Gross National Product; total value of all final goods and services produces by US within a given year

Calculations

• GDP:
• Expenditure: C + Ig + G + Xn
• C- personal consumption
• Ig- Gross private domestic investment
• G- government spending
• Xn- Net Exports
• Income: W + R + I + P + Statistical Adjustments
• F.O.P
• W- wages/salaries/compensation of employees
• R- rent/rental income
• I- interest income
• P- Payments/ Proprietors income/profit
• Budget
• Deficit - Total amount that the govt. borrows within a year (total govt. spending exceed tax and fee revenue)
• transfer payments + govt. purchases of goods/services - Gov. tax and fee collection
• Neg = Surplus Pos = deficit
• Trade
• Exports - imports
• National Income
• Method 1:
• Compensation of employees + proprietors income + interests income + rental income + corporate income
• Method  2:
• GDP - Indirect business taxes - depreciation - net foreign factor
• Disposable Personal Income
• national income - Household taxes + Govt. Transfer Payments
• Net Domestic Product 
• GDP - depreciation (consumption of fixed income)
• Net National Product 
• GNP – depreciation (consumption of fixed income) 
• GNP
• GDP + Net Foreign Factor Payment

• Nominal GDP (Inflation)
• The value of output produces in current prices (can increase year to year if either output or price increase
• P X Q 

• ·         Real GDP (Economic Growth)

o    Value of output produced in constant or base year prices

o    can only increase if output increases

o    Original Price X Q

o    adjusted for inflation 

• ·         Deflator- NGDP/RGDP * 100

o    Base Yr: Def =100

o    After Base Yr: Def>100

o    Before Base Yr: Def<100

• ·         Consumer Price Index

o    measures the cost of the market basket of goods of a typical urban American family

o    (Cost of market basket in a given year)/(cost of market basket in a base year) * 100

• ·         Inflation - general rise of the price level

• ·         Deflation - fall of the price level

• ·         Rate of Inflation

o    (CPIx - CPIbase)/CPIbase * 100

• ·         Types of Inflation

o    Cost-push inflation - higher production costs which increase prices, results in a supply shock

o    Demand-pull inflation - too much money chasing too few goods; shortage driving up prices, overheated economy w/ excessive spending w/ same amount of goods

• Political Panic - depression/ recession

• Inflation Hurts
• lenders-  loan money at a fixed rate
• people with a fixed income
•  fixed wage
• Inflation Benefits
• debtors
• business where price of the product increases faster than the price of resources

• ·         Unemployment

o    % of people w/o jobs

• ·         Labor force- employed + unemployed

• ·         Not in the labor force:

o    16 or younger

o    military personnel

o     mentally insane

o    jail mates

o     stay at home mom/dads

o     full time students; retires

o    discouraged (16+ years olds who have searched for a job for 2 weeks)

• ·         Calculate Unemployment Rate 

o    (# of unemployed)/(total labor force) * 100

• ·         4 Types of Unemployment 

o    Seasonal- lifeguard/ Santa worker, etc.

o    Frictional- between jobs, quit before you get the other jobs

o    Structural- lack of skill/declining industry

o    Cyclical- bad for society and individuals (you have a recession)

• ·         Full Employment - occurs when there is no cyclical unemployment present in the economy

• ·         Okun's Law - for every one % of unemployment above the NRU occurs a 2% decline in real GDP