Macro August 11 - 31

August 18
REAGAN'S SUPPLY SIDE PLATFORM 1 cut taxes 2 increase tax revenues 3 accelerate growth 4 do it WITHOUT inducing inflation SUPPLY SIDE VS KEYNESIANISM the supply side approach looks similar to the 1960s Keynesian tax cut Supply Siders did not agree that such a tax cut would necessarily cause inflation A BEHAVIORAL DIFFERENCE THEORY: people will work harder and invest more if they were allowed to keep more PRESUMED RESULT: increase amount of goods and services our economy can produce out the supply curve ERGO: SUPPLY SIDE economics THE LAFFER CURVE supply-side philosophy is embodied in one of the few formal theoretical constructs of supply-side economics: the so called Laffer Curve named after Arthur Laffer vertical axis: marginal tax rate horizontal axis: total tax revenues backward bending curve reflects behavioral notion that at some point people will work less the more they are taxed THE REAGAN TAX CUT assumed economy was on the backward bending portion of the Laffer Curve IMPLICATION: a tax cut would increase total tax revenues based on this assumption it moved forward with one of  the largest tax cuts in American history REAGANOMICS IN ACTION corporate tax rate cut 25% top marginal tax rate fell from 50% to 38% deregulation of everything from monopoly and oligopoly to pollution and product safety was designed to shift aggregate supply curve out DID SUPPLY SIDE EXPERIMENT WORK? significant declines in inflation and interest rates a then record-long peacetime expansion full employment BUT budget and trade deficits ballooned THE TWIN DEFICITS AND PRESIDENT BUSH the Twin Deficits deeply concerned Reagan's successor George Bush the budget deficit jumped over 200bn at the midpoint of his term in 1990 the economy began to slide into recession NEW CLASSICAL ECONOMICS IN ACTION to Keynesians the 1990 recession would have called for expansionary fiscal and monetary policy in the Bush White House Ronald Reagan's Supply Side advisors had been supplanted by a new breed of NEW CLASSICAL economists they replaced ADAPTIVE EXPECTATIONS with a new theory of RATIONAL EXPECTATIONS and rejected short-run Keynesian solutions

August 18
AN OBVIOUS POLICY QUESTION this Monetarist-inspired story raises an obvious policy question: how do you stop such an inflationary spiral? THE MONETARIST SOLUTION stop using expansionary Keynesian policies allow the economy to return to the natural rate of unemployment THE BIG PROBLEM: even if we stop an upward inflationary spiral we still have significant inflation because a higher core rate of  inflation has been built into the economy!!!! neither the traditional Keynesian or monetarist approaches to wringing this inflation out of the economy has any political appeal THE TRADITIONAL KEYNESIAN SOLUTION an INCOMES POLICY impose wage and price controls until the inflation dissipates an incomes policy may not work Pres Nixon learned this in the 1970s he watched helplessly as inflation jumped back up to  double digits once controls were lifted an incomes policy is ideologically contrary businesses don't want government holding down their prices workers don't want government holding down their wages THE MONETARISTS' BAD POLITICS it is equally politically unpalatable to wring inflation out of the economy, the actual inflation rate must be below the expected inflation rate to achieve this, the actual unemployment rate must be  above the natural rate that means inducing a recession!! THE FEDERAL RESERVE'S 1979 GAMBIT under chairman Paul Volcker the Federal Reserve adopted a sharply contractionary monetary policy incredibly interest rates soared to over 20% effective but costly the resulting recession was the worst since the Great Depression BUT between 1979 and 1984 inflation fell dramatically but at great human and economic cost THE COMING OF RONAL REAGAN the hard economic times left a bitter taste in the mouths of the American people enter stage right: Supply Side economics

August 18
THE MODIFIED PHILLIPS CURVE the theory grew out of the work of Edmund Phelps and Milton Friedman there is a minimum unemployment rate consistent with steady inflation THE NATURAL RATE OF UNEMPLOYMENT a key concept of monetarist inflation theory aka the LOWEST SUSTAINABLE RATE OF UNEMPLOYMENT MONETARISTS' MAJOR POINT 1 it is impossible to drive unemployment below the natural or lowest sustainable rate in the long run 2 implies long run Phillips Curve is vertical rather than downward sloping THE MONETARISTS' NATURAL RATE THEORY strikes at the heart of Keynesian activism implication1: expansionary fiscal or monetary policy can drive unemployment below the natural rate temporarily implication2: this Keynesian joy ride along the short run Phillips Curve must inevitably come at the price of rising inflation A DEADLY INFLATIONARY SPIRAL if a nation repeatedly uses Keynesian policies to try and keep unemployment below the natural rate an inflationary spiral will result in the long run HOW AN INFLATIONARY SPIRAL HAPPENS the natural rate of unemployment is NOT a constant the natural rate of unemployment CHANGES as the structure of an economy changes example: in the prosperous 1960s the natural rate of unemployment ranged between 4% to 5% but rose in the 1970s supply shocks drive up the rate the natural rate of unemployment climbed to 5% to 6% range in the 1970s because of supply side shocks shocks like energy price shocks raised the real costs of production higher costs in turn lowered potential output FROM THE MONETARIST'S PERSPECTIVE the monetarist perspective on the Phillips Curve helps illustrate how inflation can spiral out of control the trigger: policy makers try to expand the economy below its natural rate of unemployment

August 18
THE CORE OR INERTIAL RATE OF INFLATION tends to persist at the same rate until a demand or supply side shock changes things Key Concepts: INFLATIONARY EXPECTATIONS and a behavioral model known as ADAPTIVE EXPECTATIONS INFLATIONARY EXPECTATIONS the expectation of inflation can significantly contribute to actual inflation inflationary expectations strongly influence the behavior of businesses investors workers and consumers! ADAPTIVE EXPECTATIONS we assume people believe next year's rate of inflation will be the same as last year's historical example: during 1990s prices rose 3% per year and most people came to expect that inflation rate this expected rate was built into the core rate through institutional arrangements like labor contracts HOW INFLATION BECOMES EXPECTED suppose you are a labor negotiator and you believe your auto workers will achieve a 1% productivity increase you will negotiate for at least a 1% increase in  real, inflation adjusted wages QUESTION: assuming last year's inflation rate was 3% what is the percentage increase in nominal wages that you will demand? ANSWER: you will demand a 4% increase in the nominal wage! 1% for the productivity gains 3% to adjust for expected inflation this shows how inflationary expectations get built into an economy! EXPECTATIONS BECOME REALITY the increase in wages caused by your union's inflationary expectations will lead to an actual increase in the auto industry's labor costs this in turn will put upward pressure on auto prices so that the expectation of inflation becomes a self-fulfilling prophecy and the inertial or  core rate of inflation is maintained NEXT QUESTIONS 1 why does the core inflation rate change? 2 how can it spiral out of control? to answer these questions we have to introduce the Phillips Curve ORIGINS OF THE PHILLIPS CURVE A.W. Phillips studied data on unemployment and money wages in the United Kingdom he found wages rose when unemployment was low but fell when unemployment was high reason: workers press less strongly for wage hikes when fewer jobs are available and businesses fight harder against wage demands when profits are low what happens to the unemployment rate as output rises? answer: increase in real output leads to fall in unemployment as prices rise THE PHILLIPS CURVE BECOMES CONVENTIONAL WISDOM most economists came to believe that a stable predictable tradeoff exists between unemployment and inflation POLICY IMPLICATION: you can use expansionary policies to reduce unemployment and the only price will be a bit more inflation THE PHILLIPS CURL MONETARISTS EXPLAIN THE PHILLIPS CURVE the disappearance of the Phillips Curve in the 1970s and the appearance of the Phillips Curl can be explained using the NATURAL RATE OF UNEMPLOYMENT concept monetarists also distinguish between a short run and a long run Phillips Curve

August 18
INFLATION IS THE CRUELEST TAX suppose the inflation rate exceeds the rate of growth in our paycheck that means our real income or purchasing power is declining even though our wages are going up! BUT inflation that is unanticipated can benefit borrowers at the expense of lenders TWO KINDS OF INFLATION 1 demand pull too much money chasing too few goods example: the US tried to finance both the Vietnam War and the Great Society when real output rises far above potential output the price level moves up sharply as well 2 cost push in 1972 Pres Nixon imposed price and wage controls when the controls were lifted in 1973 inflation jumped back up to double digits a new kind of inflation also emerged: COST-PUSH or SUPPLY SIDE inflation cost push inflation results when external shocks drive up production costs supply shocks can include crop failure and oil prices hikes due to war or terrorism (1970s) sharply higher oil, commodity, and labor cost increased the cost of doing business the higher costs shift the AS curve up  output declines, while prices rise this leads to stagflation, the double whammy of both lower output and higher prices PRIOR TO THE 1970s economists didn't believe high inflation and high unemployment could exist at the same time if unemployment went up inflation had to go down the 1970s stagflation proved economists wrong Keynesian economics was incapable of solving the new stagflation problem THE KEYNESIAN DILEMMA using expansionary policy to reduce unemployment creates more inflation using contractionary policy to curb inflation deepens a recession KEY POINT Keynesian tools can solve only half of the stagflation problem and only by making the other half worse MONETARIST PERSPECTIVE stagflation set the stage for a Monetarist challenge to the Keynesian orthodoxy to understand the Keynesian failure we have to understand modern inflation theory and the Phillips Curve

August 18
UNEMPLOYMENT problem that results not only in a waste of valuable labor resources but also the loss of potential output OKUN'S LAW first identified by economist Arthur Okun through data analysis, Okun found an important CO-MOVEMENT between output and unemployment when GDP falls unemployment rises! for every 2% GDP falls, unemployment rises by 1% EXAMPLE Okun's Law says a 2% fall in GDP should result in a 1% rise in unemployment so a 9% GDP shortfall should increase unemployment rate by 4.5% with unemployment rate at 5.8% in 1979 Okun's Law predicts a 10.3% unemployment rate by 1982 actual rate was very close: 9.7% OKUN'S LAW AND POTENTIAL GDP Okun's Law implies actual GDP must grow as rapidly as potential GDP just to keep the unemployment rate from rising GDP has to keep growing just to keep unemployment in the same place if you want to bring the unemployment rate down actual GDP must be growing faster than potential GDP

August 18
TWO IMPORTANT QUESTIONS 1 how is unemployment rate defined? 2 how is it measured? COLLECTING UNEMPLOYMENT DATA statistics on unemployment and the labor force are gathered monthly the procedure used is random sampling of the population about 60000 households are interviewed monthly to get a picture of the entire workforce THE UNEMPLOYMENT RATE FORMULA Unemployed / Labor Force * 100 TEENAGE UNEMPLOYMENT a large frictional component teenagers move in and out of the labor force very frequently teens get jobs quickly and change jobs often UNEMPLOYMENT BY AGE half the unemployed teenagers are NEW ENTRANTS who have never had a paying job before all these factors suggest that teenage unemployment is largely FRICTIONAL that is, it represents the job search and turnover necessary for young people to discover their personal skills and to learn what working is all about THE MINIMUM WAGE & WELFARE STATE Theory 1: a high minimum wage tends to drive low-productivity black teenagers into unemployment Theory 2: conservatives blame high black unemployment on a culture of dependency nurtured by government welfare to the poor

August 18
UNEMPLOYMENT AND INFLATION two important problems in macroeconomics in most cases macroeconomists can solve at least inflation or unemployment when economists solve one problem they usually worsen the other THE INFLATION/UNEMPLOYMENT TRADEOFF expansionary policies stimulate a recessionary economy but cause inflation contractionary policies fight inflation but can trigger unemployment and recession KEYNESIANISM AND STAGFLATION what happens when an economy faces both high unemployment and inflation? are traditional Keynesian-style monetary and fiscal policies still effective in fighting such stagflation? AN INFLATION-UNEMPLOYMENT TRADEOFF? one of the great macroeconomic debates: is there a PHILLIPS CURVE tradeoff between unemployment and inflation? or is the PHILLIPS CURVE simply a dinosaur concept of a failed Keynesianism? KEYNESIANSIM VS MONETARISM compare and contrast the Keynesian and Monetarist views of stagflation illustrate why Supply Side economics emerged in the 1980s as a viable political alternative THREE KINDS OF UNEMPLOYMENT 1 frictional least of the macroeconomist's worries arises because of movement of people between regions and jobs or through different stages of their life cycle reflects normal turnover in labor market examples: students graduate and search for jobs women reenter labor force after giving birth 2 cyclical a much more serious problem occurs when economy dips into recession macroeconomists spend most of their time trying to solve it 3 structural a mismatch between available jobs and worker skills often results when technological change makes someone's job obsolete can result from a mismatch between the location of workers and the location of job openings DISTINCTION BETWEEN 3 TYPES OF UNEMPLOYMENT HELPS WITH DIAGNOSIS KEY POINTS 1 cyclical unemployment due to recession can be cured with expansionary fiscal or monetary policies 2 structural unemployment requires more targeted policies such as job retraining

August 17
MONETARY POLICY IS LESS PRECISE THAN FISCAL POLICY!!! from a mechanistic Keynesian point of view monetary policy is conducted with less precision than fiscal policy with fiscal policy, if we know the size of the recessionary gap and the multiplier we can exactly calculate the increase in G or reduction in taxes needed to close the gap FISCAL VS MONETARY POLICY monetary policy is more of a guessing game than fiscal policy why? because the link between the money supply and shifts in  the AE curve is much more complex while the Fed can raise or lower interest rates it can't know with precision how investment consumption and net exports will respond A MAJOR PARADOX OF THE KEYNESIAN-MONETARIST DEBATE! the Keynesian support an activist role for monetary policy the Monetarists actually oppose an activity role!!!!!!! WHEN MONETARY POLICY IS EFFECTIVE Keynesians believe monetary policy is a FINE TUNING TOOL most effective when the economy is near full employment investment and aggregate expenditures respond swiftly to changes in the interest rate caused by changes in the money supply with an inflationary gap, contractionary moentary policy is like PULLING ON A STRING WHEN MONETARY POLICY IS INEFFECTIVE Keynesians believe monetary policy is ineffective in a recession or depression cutting interest rates in these conditions is like PUSHING ON A STRING investment does not respond as forcefully to easier money and lower interest rates in a severe downturn in the recessionary and depressionary ranges of the economy Keynesians believe expansionary fiscal policy is  more appropriate THE MONETARIST VIEW SUMMARIZED the Monetarist School does not believe in an activist fiscal and monetary policy inflation happens when the government prints too much money recession happens when it prints too little Milton Friedman rejected the Keynesian view of the origins of the Great Depression as well as  the Keynesian fiscal policy cure MONETARISTS BLAME THE GREAT DEPRESSION ON MONETARY POLICY the Great Depression resulted from bad monetary policy by the Federal Reserve - not Keynes' income adjustment mechanism the Fed sharply contracted the money supply at the worst possible time this fall in M plunged a private economy that would otherwise have been stable into a depression IS THE MONETARIST EXPLANATION OF THE GREAT DEPRESSION CORRECT? there is much truth in Friedman's argument in the wake of numerous bank failures people began hoarding cash rather than leaving it in banks the banks themselves dramatically increased reserves in case nervous depositors triggered a bank run MILTON FRIEDMAN BLAMES THE FED this fall in demand deposits coupled with an increase in the bank's own self-imposed reserve requirements led to a sharp contraction of M ultimately Friedman faulted the Fed for not stepping into the monetary policy breach to stabilize the situation FRIEDMAN'S REJECTION OF KEYNESIANISM if the Fed had acted promptly and injected enough currency to stabilize the money supply and activist fiscal policy as embodied in Franklin Delano Roosevelt's New Deal would never have been necessary THE BAD DRIVER FED in their critique of activist monetary policy Monetarists liken the Fed to a bad driver the Fed is always accelerating too fast or breaking too hard on M this analogy actually describes quite well the behavior of the Fed during the 1970s as it tried to cope alternatively with recession and inflation and then both at the same time THE BAD DRIVER FED PLUNGES THE ECONOMY INTO RECESSION in response to a soaring inflation in the early 1970s the Fed stomped on the monetary breaks and interest rates climbed dramatically investment slowed and the economy plunged into a recession in 1975 the Bad Driver Fed stomped back on the accelerator using a Keynesian-style tax cut to stimulate the economy THE BAD DRIVER FED HELPS SPAWNS STAGFLATION to accommodate this tax cut, the Fed reluctantly increased the money supply this monetary stimulus helped spawn a new and ugly macroeconomic phenomenon called STAGFLATION: simultaneous high unemployment and high inflation and it began to tighten its deadly grip on the nation STAGFLATION A NEW PHENOMENON! prior to the 1970s economists didn't believe stagflation was possible if unemployment went up inflation had to go down and vice versa the 1970s proved economists wrong on this point and exposed Keynesian economics as being incapable of solving stagflation THE KEYNESIAN STAGFLATION DILEMMA using expansionary policies to reduce unemployment simply created more inflation using contractionary policies to curb inflation only deepened the recession traditional tools could solve only half of the problem at any one time--and only by making the other half worse!!!!!!! this inability of Keynesian economics to cope with stagflation set the stage for the Monetarist challenge to the Keynesian orthodoxy THE MONETARIST CURE to fight stagflation and prevent the roller coaster ride of economic booms and busts the Monetarist solution is to SET MONETARY GROWTH TARGETS example: for economic growth to proceed at 3% simply increase M by 3% THE FED'S MONETARIST CURE FOR AN INFLATIONARY SPIRAL after almost a decade of fruitless Keynesian failures the Fed embraced the Monetarists' monetary growth targets approach in October 1979 Fed Chairman Paul Volcker announced that the Fed would no longer focus on holding interest rates stable instead the Fed would simply adopt growth targets and stick by them THE FED'S MONETARIST BITTER MEDICINE unfortunately the Fed's Monetarist cure proved to be  almost as bad as the stagflation disease interest rates soared to above 20%!!! inflation remained in the double digits111 and the economy entered into the beginning of a severe three-year recession!!! THE CURE WORKS - AT GREAT COST! Chairman Paul Volcker stuck to his Monetarist guns both tight money and a deep recession eventually helped wring inflation out of the economy the cost in human terms was high ENTER STAGE RIGHT: SUPPLY SIDE ECONOMICS in the summer of 1982 the Fed relaxed its Monetarist rules by late fall the recession had ended this was just in time to try the latest evolution in economic theory: SUPPLY SIDE ECONOMICS

August 17
THE US FED'S PECULIAR STRUCTURE the US Fed is NOT one big bank directly controller by the Federal Government like in Germany or Japan instead the Fed is both decentralized and privately owned consists of 12 regional banks spread throughout the US  and they are owned by the commercial banks in reality the Fed behaves as a government agency structure was originally designed in an age of populism populist goal was to avoid too great a concentration of central banking powers in the hands of eastern establishment bankers or Washington bureaucrats STRUCTURE OF THE FEDERAL RESERVE Regional Reserve Banks and Branches 12 regional Federal Reserve banks 25 branches of Federal Reserve banks Board of Governors of the Federal Reserve System 7 members nominated by the President and confirmed by the Senate to serve overlapping terms of 14 years chairman and vice chairman designated by the president and confirmed by the senate members of the boards are generally bankers or economists Federal Open Mark Committee (FOMC) key policy making body 7 members of the Fed's Board of Governors the president of the New York Federal Reserve District Bank 4 rotating members from the other eleven Federal Reserve District Banks The Federal Reserve Chairman pinnacle of the Federal Reserve second most powerful individual in American government behind the president exerts enormous control over monetary policy MAJOR FUNCTIONS OF THE US FEDERAL RESERVE 1 issue currency 2 lender of last resort 3 regulate financial institutions 4 provide banking services to the Federal government 5 provide financial services to the nation's banks 6 conduct monetary policy THE OBJECTIVES OF MONETARY POLICY 1 promote economic growth in line with the economy's potential to expand 2 provide a high level of employment 3 insure stable prices 4 provide moderate long-term interest rates THE FED'S OPEN MARKET COMMITTEE the Fed conducts monetary policy through its Federal Open Market Committee FOMC the FOMC meets periodically to conduct monetary policy using 3 major policy instruments: 1 Setting The Reserve Requirement 2 Setting The Discount Rate 3 Open Market Operations SETTING THE RESERVE REQUIREMENT the least used of the Fed's monetary policy tools Fed can increase M by lowering the RR or decrease M  by raising the RR Fed rarely uses changes in the RR to conduct monetary policy Fed's primary function is to insure that banks don't fall below a safe level of reserves and thereby undermine the stability of the system SETTING THE DISCOUNT RATE the discount rate is the interest rate the Fed charges to banks when they borrow money lowering the discount rate makes it cheaper for banks to borrow money and expand M raising the discount rate makes ir more expensive for banks to borrow from the Fed and is contractionary OPEN MARKET OPERATIONS the most important instrument of monetary policy involves the buying and selling of government securities to expand or contract M the Fed BUYS government securities to expand the money supply the Fed SELLS government securities to contract the money supply STEP1: FOMC purchases from public, government bonds; pays for bonds with Federal Reseve check STEP2: Bond seller deposits Fed check to a Private Bank STEP3: Private Bank deposits check at a Fed bank, as reserve credit OPEN MARKET OPERATIONS AS POTENT TOOL! by buying or selling bonds the Fed can expand or contract the money supply such open market operations allow the Fed to determine the total supply of money open market operations thereby represent the Fed's most potent traditional monetary policy tool!!! EXAMPLE: THE FED FIGHTS INFLATION suppose the Fed thinks the economy is overheating and starting to generate demand-pull inflation the Keynesian solution is to contract the economy so the FOMC votes to sell 1bn of treasury bills this reduces the money supply and thereby drives up  interest rates and slows the economy WHO ARE THE BONDS SOLD TO? the bonds are sold to the "open market" hence open market operations this open market includes dealers in government bonds who resell them to commercial banks, big corporations other financial institutions and even individuals the purchasers buy bonds by writing checks to the Fed drawn from an account in a commercial bank in this way Fed reduces the money supply MONETARY TRANSMISSION MECHANISM 5-step monetary policy sequence 1 Fed reduces reserves R through open market operations 2 money supply M contracts, and causes interest rates i to rise 3 rise in i not only reduces investment I, it also reduces consumption expenditure C, and net exports X  for example consumers may respond to higher mortgage interest rates by buying a smaller home or    renovating their old home rather than purchasing a new one similarly, in an economy open to international trade higher interest rates may raise the foreign exchange rate of the dollar and this will in turn depress net exports 4 the total effect of a fall in I C and X is to push aggregate expenditures or aggregate demand down. in doing so real GDP and inflation likewise go down thereby achieving the desired policy goal EASY MONEY POLICY problem: unemployment and recession 1 federal reserve buys bonds, lowers reserve ration or lowers discount rate 2 excess reserves increase 3 money supply rises 4 interest rates fall 5 investment spending increases 6 aggregate demand increases 7 real GDP rises by a multiple of the increase in investment TIGHT MONEY POLICY problem: inflation 1 federal reserve sells bonds, increases reserve ratio, or increases the discount rate 2 excess reserves decrease 3 money supply falls 4 interest rate rises 5 investment spending decreases 6 aggregate demand decreases 7 inflation declines

August 17
THE GOLDSMITHS CREATE THE FIRST FORM OF PAPER MONEY get in a time machine and go back several hundred years to England gold is the prevailing medium of exchange the stuff's heavy and can be stolen so people start storing their gold with the goldsmiths the goldsmiths issued paper receipts people would use the receipts to redeem their gold when they needed to make a purchase over time three things happened!!!! THE FIRST PAPER MONEY depositors started trading their gold receipts for goods rather than going back to the goldsmith to redeem the paper every time they needed to make a transaction these receipts functioned as the first paper money!!!! THE FIRST BANK INTEREST depositors also figured out they didn't have to leave their gold with the goldsmith for free after a time the goldsmiths started competing for gold accounts while the goldsmiths didn't offer free toasters or rebates like some banks today they did offer interest on their gold deposits THE FIRST FRACTIONAL RESERVES goldsmiths figured out that they could operate under what is today called the system of fractional reserves for example they might take in 1000 gold deposits and issue receipts for that amount to the depositors however they then might turn around and also issue another 1000 in gold receipts to other people even though they didn't have enough gold deposits to redeem all the receipts that they issued goldsmiths could operate this way because it was highly unlikely that everyone who held the receipts would come in at the same time to demand their gold in this particular example the implicit fractional reserve is 50% or 0.5 at this level the goldsmiths would issue twice as many receipts as they had gold deposits for such system allowed the goldsmiths to expand the supply of money over and above the amount of gold reserves they held in their vaults THE MONEY-SUPPLY MULTIPLIER also MONEY MULTIPLIER very different from the Keynesian expenditure multiplier! THE MONEY MULTIPLIER FORMULA MM = 1/RR MM: the Money Multiplier RR: the Reserve Requirement THE MONEY MULTIPLIER IN ACTION RR = 0.5 MM = 2 if Bank1 receives a new demand deposit of 1000 it lends out 500 Bank2 then lends out 250 and so on until a total of  2000 of new money is in circulation THE MONEY MULTIPLIER POINT MM and RR are inversely related the bigger the RR, the smaller the MM and the less money created by a new dollar of demand deposits! A LINGERING QUESTION where did the original 1000 deposited in Bank1 come from? the Federal Reserve or Fed is the nation's central bank by controlling bank reserves, the Fed sets the level of interest rates by conducting monetary policy the Fed has a major impact on output and employment THE FEDERAL RESERVE the Fed was created in 1913 following the financial panic of 1907 during this panic numerous banks collapsed because of  so-called RUNS ON THE BANKS WHAT'S A BANK RUN? if too many of a bank's depositors demand their money at the same time the bank doesn't have enough cash on hand to pay! WHEN FEAR LEADS TO BANK FAILURES bank runs usually happen when people suddenly believe they may not be able to get their money out of their bank the irony: when everybody tries to get their money at once the bank fails!!!! in such cases, FEAR BECOMES REALITY and a self-fulfilling prophecy A BANKER'S BANK a nation's central bank serves as the LENDER OF LAST RESORT for all the other banks if a bank needs money to pay off its depositors it can always borrow it from the Federal Reserve the Fed is in essence a BANKER'S BANK

August 17
DETERMINANTS OF MONEY DEMAND 1 Transactions Demand 2 Asset Demand TRANSACTIONS DEMAND FOR MONEY both consumers and businesses need money as a medium of exchange households use it to buy products like groceries firms need it to pay their workers and buy materials NOMINAL GDP DETERMINES TRANSACTIONS DEMAND the basic determinant of the amount of money demanded for transactions is the level of nominal GDP the larger the total money value of all goods and services that are exchanged in the economy, the larger the amount of money needed to negotiate these transactions QUESTION: what will happen to the transactions demand for money if prices and nominal GDP double? if prices and nominal GDP double, the transactions demand for money will also double!! THE ASSET DEMAND FOR MONEY also called SPECULATIVE MOTIVE people hold money because they use it as a store of value UNDERSTANDING THE SPECULATIVE NATURE OF ASSET DEMAND suppose you want to buy some stocks or bonds but you think that the prices are too high so you hold on to your money until the prices fall essentially you are SPECULATING that a better investment opportunity will appear INFLATION ERODES THE VALUE OF MONEY money provides no rate of return like other assets like stocks, bonds, and savings accounts if inflation occurs, your money will lose value! THE OPPORTUNITY COST OF HOLDING MONEY 1 the interest rate that could have been earned by lending the money 2 the rate of return that could have been earned by investing the money in stocks 3 the loss in value from holding money during inflation QUESTION: what do you think will happen to the asset demand for money if interest rates rise or the expectations of inflation increases if the interest rate or inflationary expectations rise the opportunity cost of holding money increases therefore the asset demand for money must decrease

August 17
INTEREST RATES ARE CRITICAL when we examine how money affects economic activity we will focus on the impact of the interest rate INTEREST RATE is the amount of interest paid per unit of time expressed as a percentage of the amount borrowed interest is the payment made for the use of money interest rate is often called the PRICE OF MONEY MANY DIFFERENT INTEREST RATES there is a vast array of interest rates there are 3 major reasons why interest rates differ 1 term or maturity of the loan 2 riskless rate 3 liquidity TERM OR MATURITY OF THE LOAN length of time to pay off a loan ranges from overnight loans to 30 year home mortgages in general the longer the term of the loan the higher the interest rate borrowers have to pay lenders must be compensated for the risk of providing a longer term loan THE RISKLESS RATE some loans such as the securities of the US government are virtually riskless the interest rate on US government securities is often called the riskless rate HIGHER RISK INVESTMENTS HAVE HIGHER INTEREST RATES bonds that face a higher risk of non-payment have higher interest rates: 1 the JUNK BONDS of businesses close to bankruptcy 2 the municipal bonds of cities with shrinking tax bases 3 countries with large overseas debt and unstable political systems these riskier investments might pay 1, 2 or even 5% or more per year above the riskless rate THE MORE LIQUID THE LOAD, THE LOWER THE INTEREST RATE a liquid asset can be converted into cash quickly with little loss of value ILLIQUID assets or loans which cannot be readily converted to cash usually command higher interest rates NOMINAL VS REAL INTEREST RATES nominal interest rate measures the yield in dollars per year per dollar of investment as with nominal GDP inflation can make the dollar a distorted yardstick (when inflation rises, dollar value falls) REAL INTEREST RATE corrects for inflation Rreal = Rnominal - Inflation NEGATIVE REAL INTEREST RATES ARE POSSIBLE! it's important to focus on REAL return, not NOMINAL return

August 17
WHAT IS MONEY? money has a much broader definition than the cash in our pockets money is anything that can be widely used and accepted in exchange for other goods and services THREE KINDS OF MONEY 1 Commodity Money gold nuggets, silver, beads, grains 2 Bank Money checkbooks, bank drafts 3 Fiat or Paper money currencies like the US dollar, japanese yen THE THREE FUNCTIONS OF MONEY money is the most "liquid" of assets meaning it is the most readily spendable three major functions: 1 medium of exchange without money we would have to use the barter system 2 standard of value tells the rate at which goods can be exchanged e.g. if a loaf of bread costs 1 and a pound of butter costs 2, the butter will exchange for 2 loaves of bread 3 store of value people can hold on to money and spend it later most methods of holding money do not yield the same monetary returns that you get by storing wealth in the form of less liquid assets like stocks and bonds in the presence of inflation money can rapidly lose its value! in talking about monetary policy macroeconomists distinguish between 4 kinds of money 1 M1  2 M2   3 M3   L M1: currency in circulation outside of bank vaults demand deposits at commercial banks NOW and ATS accounts credit union share drafts demand deposits at mutual savings banks traveler's checks (nonbank) M2: M1 plus savings accounts time deposits of less than 100,000 money-market mutual funds M3: M2 plus time deposits larger than 100,000 repurchase agreements overnight eurodollars L: M3 plus other liquid assets: treasury bills US savings bonds bankers' acceptances term eurodollars commercial paper HOW IS MONEY DEFINED? M1: known as transactions money because it consists of  items that are actually used for transactions M1 = Cash + Checking Accounts + Traveler's Checks M2: known as broad money, includes M1 + NEAR MONEYS M2 = M1 + Savings Accounts + Time Deposits + Money Market Mutual Funds M3 = M1 + M2 + Short Term Fiscal Assets WHY THESE DEFINITIONS MATTER monetary policy uses changes in the money supply to contract or expand the economy to conduct monetary policy effectively we must have a very good idea of what we are changing when we change the money supply

August 17
Monetary or Fiscal Policy? Monetarism or Keynesianism? these became the macroeconomic questions in the 1970s as the nation found itself first fighting a soaring inflation and then a virulent stagflation A DEFINITION MONETARY POLICY involves the use of changes in the money supply to contract or expand the economy FISCAL POLICY PLAYS FIRST FIDDLE monetary policy largely played second fiddle to fiscal policy because of fiscal policy's successes fiscal policy helped lift us out of the Great Depression in the 1930s fiscal policy also worked well to end a more mild recession in 1949-1950 FISCAL POLICY & "FINE TUNING" the Kennedy tax cut of 1964 seemed to provide incontrovertible proof that Keynesian economics could be used to "fine tune" the economy and keep it at or close to full employment with minimum inflation MONETARY POLICY PLAYED AN IMPORTANT SUPPORTING ROLE during four decades of Keynesian triumphs monetary policy played an important supporting role example: Pres Eisenhower relied on a tight monetary policy to keep inflation in check many critics now believe that an overly conservative monetary policy led to a stagnating economy in the late 1950s THE ECONOMY STARTS MOVING TOO FAST by the late 1960s demand-pull inflation began to rear its ugly head by 1969 inflation had crept to over 5% by the early 1970s it had jumped to almost double digits as STAGFLATION began to emerge, monetarism began to challenge the Keynesian orthodoxy

August 16
EXPLAINING THE GREAT DEPRESSION in 1929 the economy was booming and at full employment the stock market crash sent the business community into a panic ANIMAL SPIRITS went from bullish to bearish businesses cut back sharply on investment and production frightened consumers cut back dramatically on consumption and MPS rose! KEYNES' INCOME ADJUSTMENT MECHANISM IN ACTION the reactions of business and consumers led to a sharp and sudden downward shift of the aggregate expenditures curve business people responded by decreasing output further this depressed income and consumption the economy continued its downward spiral and eventually unemployment reached a staggering 25% of  the workforce THE PARADOX OF THRIFT in attempting to save more, many individual households saved less because their incomes fell as  aggregate expenditures fell can be an important contributor to recessionary events FISCAL POLICY (AND WAR) TO THE RESCUE with consumers saving more and spending less, business were also unwilling to invest no matter how low interest rates fell the government stepped in with a massive does of expansionary fiscal policy FDR's New Deal followed by the dramatic spurt of  WWII expenditures triggered increased consumption and investment and the economy reared back to  full employment MECHANISTIC KEYNESIANISM the Keynesian model provides a very mechanistic approach to curing a recession if you know what the actual GDP and full employment GDP are you know the size of the recessionary or inflationary gap if you know the MPC and therefore the multiplier you know how much to increase or decrease G or T to close the gap IT'S NOT THIS SIMPLE if mechanistic Keynesianism worked like the simple model none of us would have to worry about being unemployed any of us after mastering the simple lesson of this lecture would be qualified to serve as the president's top economic advisor! but it's just not this simple -- even if many economists at the height of the 1960s Keynesian era thought it was!!! A KEY CONCEPT: CROWDING OUT a reduction in private sector investment that can be  caused by increased government spending can happen when the government borrows money to finance these expenditures such borrowing or DEFICIT SPENDING can drive up interest rates higher interest rates can in turn reduce private sector investment CROWDING OUT reduces the effect of fiscal policy any fiscal policy stimulus may be partly or fully offset by a reduction in private sector demand because of crowding out therefore the net expansionary effect of fiscal policy might be smaller than intended!! THE ACHILLES HEEL OF THE KEYNESIAN MODEL much broader problem with the mechanistic Keynesian approach: 1 relies on a model that is incomplete 2 ignores the monetary and financial sector 3 assumes a closed economy despite limitations the Keynesian model is a powerful tool for illustrating two particular situations: the first is when the economy is in the Keynesian recessionary or depressionary range in this range the fixed price assumption mirrors reality because increased output brought about by increased aggregate demand does not put upward pressure on prices the second situation where the Keynesian model is useful analytically is for illustrating how a small imbalance between leakages and injections can multiply into a much larger unemployment or inflation problem A KEY WEAKNESS: THE FIXED PRICE ASSUMPTION the Keynesian model assumes away inflation the Keynesian model thereby neglects the crucial influence of monetary factors on interest rates and interest-sensitive components of output such as investment THE KEY STRENGTH OF THE AD/AS MODEL the AS-AD model illustrates both price levels and real output QUESTION: what is the relationship between the Keynesian aggregate expenditures-aggregate production model and the classical aggregate supply-aggregate demand model?

August 16
SUMMARIZING THE KEYNESIAN MODEL consumption function slopes upward slope of consumption function is flatter than the aggregate production curve both investment and government expenditure functions are represented by horizontal lines THE SLOPE OF THE AGGREGATE EXPENDITURES FUNCTION IS THE MPC vertically summing the consumption investment and government expenditure curves yields the AE function the slope of the AE function is the same as the slope of the consumption function because the investment and government expenditure functions are horizontal lines therefore the slope of the AE function is the MPC CLOSING A RECESSIONARY GAP we can demonstrate that expansionary fiscal policy can be used to close a 100bn recessionary gap before we can do this we have to master one more concept: the KEYNESIAN EXPENDITURE MULTIPLIER THE KEYNESIAN MULTIPLIER the number by which a change in aggregate expenditures must be multiplied to determine the resulting change in total output the Keynesian multiplier is GREATER THAN ONE because income is re-spent many times after the initial increase CALCULATING THE MULTIPLIER Keynesian Multiplier = 1/MPS = 1/(1-MPC) HOW THE MULTIPLIER WORKS -- EXAMPLE suppose the US permanently increases defense spending by 100bn in response to a thread to the oil fields in the Mideast what will be the effect of this increase in G on the GDP? such expenditures trigger increased investment and consumption and the total expansionary effect is  far larger than the initial stimulus USING THE MULTIPLIER TO CLOSE A RECESSIONARY GAP we have to know the multipier to calculate exactly how much to raise government expenditures or cut taxes to close a recessionary gap!!!! USING TAX CUTS TO CLOSE A RECESSIONARY GAP we can also use a tax cut to close a recessionary gap example: The Kennedy Tax Cut of 1964 the tax cut multiplier is a bit more complicated than the government spending multiplier!! Tax Cut Multiplier = Expenditure Multiplier * MPC THE LOGIC OF THE TAX CUT MULTIPLIER tax cuts have less of an expansionary effect than an increase in government spending consumers will not increase their expenditures by the full amount of the tax cut instead, they save a portion of the tax cut based on their MPS USING CONTRACTIONARY FISCAL POLICY TO CLOSE AN INFLATIONARY GAP contractionary fiscal policy involves reduced government expenditures, tax hikes or some combination of the 2 to cool inflationary pressures TAX CUTS OR INCREASED G? Is it more preferable to increase G or cut T  to eliminate recessionary and inflationary gaps? answer depends on one's view of the appropriate size of the government rather than pure economics LIBERALS VS CONSERVATIVES Liberals/Democrats prefer increased government spending during recessions and tax increases to fight demand-pull inflation this expands or preserves the size of the government Conservatives/Republicans want to shrink government: 1 tax cuts during recessions 2 government spending cuts to fight demand-pull inflation both shrink the size of the government

August 16
COMPONENTS OF INVESTMENT total investment expenditures account for roughly 15% of total aggregate expenditures investment expenditures include: 1 purchases of residential structures 2 investment in business plant and equipment biggest category 70% of total investment annually 3 additions to a company's inventory ALGEBRA OF THE INVESTMENT FUNCTION investment expenditures are assumed to occur independently of the level of income this assumption is for simplicity algebraically this assumption means that I = I0  or investment is equal to autonomous investment this assumption allows economists to represent the investment function as a horizontal line DETERMINANTS OF INVESTMENT? Keynes believed investment was sensitive to  changes in the interest rate when rate falls, investment rises when interest rises, investment falls KEYNES VS THE CLASSICALS REDUX Keynes did not believe that falling interest rates and increased investments would necessarily lead to full employment equilibrium like the Classical economists did KEYNES'S ANIMAL SPIRITS investment is driven by ANIMAL SPIRITS these are the EXPECTATIONS businesses have regarding potential sales and profits if businesses believe the economy will go bad it could become a self-fulfilling prophecy businesses with a bearish view of the economy would cut back on investment and production and help trigger a recessionary spiral THE GOVERNMENT EXPENDITURE FUNCTION government purchases of equipment like tanks and road-building equipment payment for services of judges and public school teachers determined DIRECTLY by the government's own decisions for example, the Pentagon's purchase of a new jet fighter adds directly to the GDP government expenditures account for almost 20% of  total aggregate expenditures the Keynesian model assumes G to be autonomous ie determined OUTSIDE the model G = G0 (autonomous government expenditures) as with the investment function the government expenditure can be graphically portrayed as a horizontal line VOLATILITY OF GOVERNMENT EXPENDITURES government expenditures are less volatile than investment episodic events such as wars and natural disasters can lead to large fluctuations in G KEYNESIAN FISCAL POLICY in the Keynesian model, increased or decreased government expenditures together with tax cuts or tax increases serve as the primary tools of fiscal policy that are used to counterbalance changes in investment and consumption spending APPLIED FISCAL POLICY EXPANSIONARY FISCAL POLICY increase G and/or cut T to close a recessionary gap CONTRACTIONARY FISCAL POLICY cut G and/or raise T to cool down an overheated economy and curb inflation TRANSFER PAYMENTS ARE AUTOMATIC STABILIZERS in addition to discretionary changes in government spending and taxes, there are also important non-discretionary government expenditures that act as built-in macroeconomic stabilizers called: TRANSFER PAYMENTS include unemployment compensation, welfare payments and subsidies AUTOMATIC STABILIZERS: they help stabilize the economy because they automatically rise during recessions and fall during expansions for example during recessions as more and more people become unemployed, they become eligible for these programs in contrast as the economy expands there is less need for welfare payments THE NET EXPORTS FUNCTION this component equals the value of exports minus the value of imports NET EXPORTS represent the difference between the exports we sell to the world and the foreign imports we buy exports add to GDP, imports subtract exports create domestic production, income and employment for an economy exports add to aggregate expenditures buying imports means no production income or employment is created imports subtract from aggregate expenditures NET EXPORTS ASSUMED AWAY IN SIMPLE KEYNESIAN MODEL net exports are a critical part of an OPEN ECONOMY but they were not central to the development of  the Keynesian model the simplified Keynesian model assumes a CLOSED ECONOMY in which there is no international trade!!! this assumption allows to focus solely on the role of government spending in fiscal policy

August 16
AGGREGATE PRODUCTION total amount of goods and services produced in the economy production creates an equal amount of income so the aggregate production curve is a 45degree line upward sloping curve means that at any point along the surve production equals income AGGREGATE EXPENDITURES total spending or aggregate expenditures may be  represented algebraically: AE = C + I + G + (X - M) (exports, imports) the aggregate expenditures curve is simply the vertical summation of these four components slopes upward but has a flatter slope than the 45degree line that represents the Aggregate Production curve also, AE curve intersects the vertical axis above zero taken literally, this means that even if income is zero people will still spend a certain amount of money on consumption --> AUTONOMOUS CONSUMPTION (happens  independently of income) THE KEYNESIAN EXPENDITURE FUNCTION to understand the Keynesian model, we have to understand: 1 autonomous consumption 2 why the AE curve is flatter than the AP curve components of the Keynesian Expenditure Function 1 consumption largest component accounts for almost 70% of total AE in the U.S.  categories: 1 durable goods (motor vehicles, household equipment, etc) 2 nondurable goods (food, clothing and apparel, energy, etc) 3 services (housing, household operation, transportation, medical care,etc) 2 investment 3 government expenditures 4 net exports THE KEYNESIAN CONSUMPTION FUNCTION Total Consumption = Autonomous Consumption + Induced Consumption AUTONOMOUS CONSUMPTION consumption that occurs even if a person loses his job unemployed people dip into their savings to consume level of consumption that occurs regardless of changes in one's income INDUCED CONSUMPTION depends on an individual's DISPOSABLE INCOME (amount of money  left after paying taxes to the government) MARGINAL PROPENSITY TO CONSUME (MPC) aka: marginal propensity to expend the extra amount people consume when they receive an extra dollar of disposable income equals the slope of the CONSUMPTION FUNCTION the AE curve is flatter than the 45degree line in the Keynesian model precisely because the MPC is less than one! MARGINAL PROPENSITY TO SAVE (MPS) measures the extra amount people save when they receive an extra dollar of disposable income MPS = 1 - MPC equals the slope of the SAVINGS FUNCTION THE ALGEBRA OF THE CONSUMPTION FUNCTION C = C0 + MPC * Yd C consumption C0 autonomous consumption MPC * Yd induced consumption MPC marginal propensity to consume Y disposable income MALTHUS' CRITIQUE OF SAY'S LAW REDUX people won't spend everything they earn aggregate expenditures need not equal aggregate production that is, supply might not create its own demand

August 16
KEYNESIAN MODEL gave birth to FISCAL POLICY some economists refer to it as the MULTIPLIER MODEL others call it the AGGREGATE PRODUCTION-AGGREGATE EXPENDITURES model FISCAL POLICY use of government expenditures or tax changes to stimulate or contract an economy THE BASIC KEYNESIAN MODEL a straightforward approach to using fiscal policy to close a recessionary gap the theoretical model may be used to exactly calculate how much government spending must be increased or how much taxes must be cut to  stimulate an economy back to full employment A WARNING macroeconomics is not this simple the harsh reality: economists learned in the 1970s within the context of stagflation that Keynesian solutions don't always work! THE ASSUMPTION OF FIXED PRICES the Keynesian model assumes prices are fixed Keynes didn't believe this! Keynes did believe that when the economy is in recessionary range, prices and wages were sufficiently inflexible so that income would adjust much faster than prices so the fixed price assumption is justified the fixed price assumption allowed Hansen and Samuelson to develop the Keynesian Aggregate Production-Aggregate Expenditures model this Keynesian model is readily distinguishable from the Classical Aggregate Supply-Aggregate Demand model which allows prices to vary THE KEYNESIAN MODEL vertical axis: measures total spending or aggregate expenditures horizontal axis: measure real GDP or output 45degree line: measures aggregate production aggregate expenditures curve: AE = C consumption + I investment + G government spending + X net exports equilibrium occurs where AE and AP curves cross and doesn't necessarily have to occur at the economy's  full potential output 1 recessionary gap 2 inflationary gap SAY'S LAW AND THE CIRCULAR FLOW DIAGRAM one useful way of thinking about these recessionary and inflationary gaps is through the concept of  LEAKAGES vs INJECTIONS Aggregate Demand (AD) = consumption + investment Aggregate Supply (AS) = employee compensation, rents, interest, profits LEAKAGE is income not directly spent on domestic output but is diverted from the circular flow INJECTION is an addition of income to the circular flow SAVINGS is a leakage while investment is an injection LEAKAGES 1 consumer saving 2 business saving 3 taxes 4 imports INJECTIONS 1 investment 2 government spending 3 exports BROADER POINT: any particular macroeconomic equilibrium will depend on the balance between these injections and leakages

August 14
THREE RANGES OF THE ECONOMY AS curve as three distinct ranges: 1 Keynesian Range increasing output will not leas to inflation economy either in severe recession or full blown depression large amounts of unused machinery and equipment and unemployed workers available putting these resources back to work will have no effect on inflation in this Keynesian range prices are fixed (hence the flat portion of the curve) fiscal policy can be used without causing inflation! 2 Intermediate Range any expansion of real output is accompanied by a rising price level as economy moves to full employment movements in all product and resource markets may not occur simultaneously as economy expands, auto and steel workers may still be unemployed but high-tech computer industry may begin to experience shortages in skilled workers raw-material shortages or bottlenecks in production may begin to appear in other industries 3 Classical Range economy has reached absolute full capacity level any attempt to increase production further will not increase real output but only cause a rise in the price level just as the classical economists quantity theory of money predicted the only impact of expansionary policy is inflation!!!!! demand-pull inflation: shifts in AD are pulling up the price level expansionary fiscal and monetary policies will clearly not be effective THE CLASSICAL PRICE ADJUSTMENT MECHANISM use AS-AD framework to illustrate how an economy is  supposed to recover from a recession under classical assumptions 1 economy is at full employment 2 economy suffers a demand shock shifting AD inward eg: threat of war may cause consumers to reduce spending and businesses to reduce investment 3 wages prices and interest rates fall as a result of the recession this causes AD to move downward along the AD curve through the wealth, interest rate, and net export effects at the same time AS shifts outward as firms hire more workers and expand output together these price and wage adjustments drive the economy back to full employment and close the recessionary gap but at a new and lower price we know that for whatever reasons, this classical price adjustment mechanism didn't work to lift the economy out of    the great depression THE CLASSICAL PRICE ADJUSTMENT FAILED DURING THE GREAT DEPRESSION to John Maynard Keynes the problem was this: the price adjustments necessary to bring about a recovery were overwhelmed by a much more powerful and deadly INCOME ADJUSTMENT MECHANISM

August 14
WHY THE AD CURVE CAN SHIFT remember: the AD graph shows the various amounts of  real output that would be purchased at each possible price level HOLDING OTHER THINGS CONSTANT by understanding what these OTHER THINGS are we can understand why the AD curve shifts! OTHER THINGS: grouped by the four major categories of real GDP 1 consumption 2 investment 3 government spending 4 net exports DETERMINANTS OF AGGREGATE DEMAND determine the location of the AD curve factors that shift the AD curve 1 changes in consumption spending consumer wealth consumer expectations household indebtedness or credit conditions tax policy 2 change in investment spending interest rates profit expectations on investment projects business taxes technology degree of excess capacity 3 changes in government spending 4 change in net export spending national income abroad exchange rates AS CURVE shows the level of real GDP or domestic output that will be produced at each price level again holding other things constant slopes upward because higher price levels create an incentive for businesses to produce and sell additional output while lower price levels reduce output FACTORS SHIFTING THE AS CURVE 1 change in input prices domestic resource availability land labor capital entrepreneurial ability prices of imported resources market power 2 change in technology and productivity 3 change in legal-institutional environment business taxes and subsidies government regulations which way will the AS curve shift if the cost of imported oil rises? increase in the cost of oil will shift AS inward while equilibrium output falls, price level goes up this is an example of COST-PUSH INFLATION PRODUCTIVITY productivity = total output / total input an increase in productivity means the economy can obtain more real output from its limited resources/inputs if productivity increases, the average production cost of a unit of output will fall and this will cause the aggregate supply curve to shift outward increases in productivity increase the potential output of an economy

August 14
THE AS-AD FRAMEWORK price level is represented on the vertical axis real domestic output or GDP is represented on the horizontal axis AD slopes downward AS slopes upward equilibrium occurs at point where AD and AS curves cross at this point price and output combination is compatible with the intentions of both buyers and sellers equilibrium does not necessarily have to occur at  the full employment potential output GDP It can aslo be at a recessionary level where actual GDP is below potential GDP what can happen to make either AS or AD curve shift and therefore change equilibrium? AD CURVE show the various amounts of real output that domestic consumers businesses and government along with foreign buyers collectively desire to purchase at each possible price level holding other things constant downward slope means that as the general price level falls consumers and businesses will increase their demand for goods and services 3 reasons why this happen: 1 REAL BALANCE or WEALTH EFFECT as price level falls, purchasing power increases and consumers demand more goods and services this is because the real value of money is measured by how many goods and services each dollar will buy a lower price level will increase the real value or purchasing power of accumulated financial assets such as savings accounts and bonds that have fixed money values 2 INTEREST RATE EFFECT as price level falls, so do interest rates falling interest rates increase investment spending by businesses and certain kinds of consumer spending on items such as automobiles and housing 3 FOREIGN PURCHASES / FOREIGN TRADE / NET EXPORT EFFECT as the domestic price level falls the relative price of foreign goods increases this reduces demand for the now more expensive foreign imports, increases export demand and thereby increases aggregate quantity demanded

August 14
CLASSICAL ECONOMICS GIVES WAY TO KEYNESIAN ECONOMICS the failure of classical economics during the great depression resulted in a search for an  alternative solution: Keynesian economics WHY CLASSICAL ECONOMICS FAILED problem with Classical economics was not the PRICE ADJUSTMENT MECHANISM it relied on Keynes believed that before the price mechanism could work it would be dwarfed by a much more powerful INCOME ADJUSTMENT MECHANISM THE INCOME ADJUSTMENT MECHANISM when an economy sinks into recession, peoples' incomes fall a fall in income causes people to spend and save less businesses respond by inventing and producing less this reduction in consumption savings investment and output drives the economy deeper into recession rather than back to full employment AN ECONOMY STUCK IN A CLASSICAL RUT eventually income falls far enough so that savings and investment return to equilibrium however the economy will be at a level well below full employment in other words the economy is stuck in a rut with a glut of goods this is just as Thomas Malthus predicted in his original critique of the Classical model out of this classical-Keynes debate have emerged two important models that are frequently used in  macroeconomic analysis 1 AS-AD model 2 Keynesian model A KEY DIFFERENCE IN PRICE ASSUMPTIONS the AS-AD framework has its roots in Classical economics it allows for price adjustments the Keynesian model assumes PRICES ARE FIXED

August 14
THE TWO PILLARS OF CLASSICAL ECONOMICS why did Keynesian economics triumph? the two major pillars of Classical Economics crumbled under the weight of Keynes' argument 1 Say's Law: Supply Creates Its Own Demand 2 The Quantity Theory of Money: PQ=MV SAY'S LAW SAYS... formulated in the 1800s by French businessman Jean Baptiste Say popularized by David Ricardo "Supply creates its own demand" when people work to produce goods and services they earn income for doing so Say's Law states the total income must equal the value of the goods and services If the workers spend this income it must be enough to pay for all the goods and services they produce therefore supply creates its own demand i.e. aggregate demand must equal aggregate supply!!!! THOMAS MALTHUS' CRITIQUE suppose income earners don't spend all their money and instead save some of it? Thomas Malthus raised this possibility in his criticism of Say's Law If all people don't spend all of their money there would be a glut of goods and people would be  out of work THE DISMAL SCIENCE the Malthusian doctrine says population will grow faster than the production of food which will lead to mass starvation Malthus' dark vision earned the economics profession its label as the "dismal science" SAY AND RICARDO RESPOND TO MALTHUS if people save some of their money, all of these savings will still be invested in the economy therefore aggregate demand which equals consumption plus investment will always equal aggregate supply UNEMPLOYMENT WOULD GO AWAY Say acknowledged unemployment could exist however if wages prices and interest rates are allowed to adjust unemployment goes away on its own THE QUANTITY THEORY OF MONEY classical economists supported their Say's Law analysis with the Quantity Theory of Money the quantity theory of money determines the price level while Say's law analysis determines the real output THE EQUATION OF EXCHANGE M*V = P*Q M = money supply V = velocity of money or the amount of income generated each year by a dollar of money P = general price level as measured by an index such as the consumer price index Q = quantity of real output sold P*Q = nominal inflation-adjusted output as measured by GDP M*V = P*Q price level varies in response to changes in quantity of money changes in the price level are caused by changes in the money supply if M up 20%, P up 20% if M down by 5%, P down by 5% TWO ASSUMPTIONS & AN IMPLICATION Assumption #1: Velocity Is Constant Assumption #2: The Veil of Money real output is not influenced by the money supply it doesn't matter how much money the government prints, it will not increase the amounts of goods and services that the economy can actually produce Implication: Increasing M will not increase Q  Given MV=PQ why will increasing M only lead to an increase in P, ie inflation? MV=PQ if V is constant on the left side and if Q on the right side in unaffected by M the only thing that can change if M changes is P!

August 14
CLASSICAL-KEYNESIAN DEBATE debate goes back to the 1930s and the Great Depression but very important today! many of the macroeconomic policies now favored by  conservatives have their roots in Classical economics those on the other side of the ideological spectrum are generally more supportive of the Keynesian approach THE MOST IMPORTANT POINT the Classical versus Keynesian controversy: primarily a dispute over how an economy adjusts during a recession and finds its way back to full employment THE CLASSICAL VIEW a PRICE ADJUSTMENT MECHANISM would cure the economy in the event of unemployment, prices, wages and interest rates would all fall this would increase consumption, production and investment and quickly return the economy back to its full employment equilibrium THE KEYNESIAN VIEW before price adjustment mechanism can work, it is  overpowered by an INCOME ADJUSTMENT MECHANISM when an economy sinks into a recession people's incomes fall they spend and save less while businesses invest and produce less this income adjustment mechanism drives the economy further into recession rather than back to full employment LAISSEZ-FAIR ECONOMICS the Classical approach believes that the best cure for a recession is to leave the free market alone Laissez faire economists believe most government policies will probably make things worse - not better so the best policy is relatively little government ACTIVIST ECONOMICS Keynesians prescribe large-scale government expenditures to prime the economic pump Keynesians are ACTIVIST economists who believe that the government can create and implement policies that will positively affect the economy CLASSICAL ECONOMICS roots are in the free market writings of Adam Smith David Ricardo and Jean Baptiste Say unemployment is a natural part of the business cycle and is self-correcting there is no need for government intervention into the free market!! CLASSICAL UNEMPLOYMENT unemployment results when wages are too high in the event of a recession, unemployed workers would be willing to work for less wages would then fall back down to levels where it once again made it profitable for firms to hire the workers and the recession would end THERE IS NO CYCLICAL UNEMPLOYMENT classical economists agreed that FRICTIONAL and STRUCTURAL unemployment could exist they did not agree that CYCLICAL unemployment could be  caused by a shortage of aggregate demand JOHN MAYNARD KEYNES born in 1883, son of British economist John Neville Keynes stock speculator who made millions arts patron Cambridge University professor key appointee to the British Treasury KEYNES' GENERAL THEORY flatly rejected the Classical notion of a self-correcting economy that would solve unemployment through adjustments in wages and prices THE KEYNESIAN BOTTOM LINE waiting for eventual recovery was fruitless because "in the long run, we're all dead" under certain circumstances, a recessionary economy would not rebound but fall into a deep spiral the only way to get the economy moving again was to prime the economic pump with massive government expenditures!!!!! KEYNES' AN ECONOMIC HERETIC at the time Keynes' approach was economic heresy Keynesian policies were initially rejected by  virtually the entire economics profession Keynes and his followers were branded as socialists or communists for advocating an activist role for the central government KEYNESIAN ECONOMICS IS BORN Keynes stuck to his guns as the Depression wore on, his teachings gained adherents and disciples

August 13
THE SUPPLY SIDE PROMISE in the 1980 presidential election, Ronald Reagan ran on a supply-side platform that promised to simultaneously cut taxes, increase government tax revenues and accelerate the rate of economic growth WITHOUT inducing inflation Arthur Laffer: father of Supply Side economics THE SUPPLY SIDE PHILOSOPHY a Supply Side tax cut looks very similar to a Keynesian tax cut however the Supply Siders viewed such tax cuts from a  very different behavioral perspective KEYNESIANISM: tax cut increased demand for goods producers may increase prices possible inflation SUPPLY SIDE ECONOMICS: tax cut workers keep more of what they earn individuals work harder and increase their productivity increased output and employment shifts Supply Surve out, reducing inflation! SUPPLY SIDERS PREDICTED LOWER BUDGET DEFICITS! the loss in tax revenues from a Supply Side tax cut would be more than offset by the increase in  tax revenues from increased economic growth thus under supply side economics the budget deficit would actually be reduced!!!!! END RESULT OF THE REAGAN TAX CUTS? the Supply Side prediction didn't come true the economy boomed but so did America's budget deficit America's trade deficit also soared GEORGE BUSH'S "NEW CLASSICAL" APPROACH the budget and trade "twin deficits" deeply concerned Reagan's successor George Bush after the budget deficit jumped over 200bn in 1990 the economy slid into recession the Keynesian solution would have been more fiscal or monetary stimulus Bush refused more stimulus based on the advice of his "New Classical" advisors NEW CLASSICAL ECONOMICS based on the theory of "rational expectations" if you form your expectations "rationally" you will take into account the future effects of  activist fiscal and monetary policies Robert Lucas won the Nobel Prize in Economics for his work on rational expectations CENTRAL IDEA OF RATIONAL EXPECTATIONS activist Keynesian policies might be able to fool people for a while people eventually learn from their experiences then you can't fool people at all A PROFOUND POLICY IMPLICATION: rational expectations render Keynesian policies ineffective so they should be abandoned!!!! GOOD ECONOMICS MAKES BAD POLITICS? refusing to engage in Keynesian stimulus was bad politics for President Bush Bush's advisors rejected a Keynesian "quick fix" even as the recession deepened instead these advisors called for more "stable and systematic" policies based on long term goals the deepening recession likely cost Bush the election!!! IT'S THE ECONOMY STUPID! Pres Bush took his advisors advice and refused any Keynesian stimulus the economy limped into the 1992 election Democrat Bill Clinton ran on a platform that highlighted the failure of Bush's economic policies Clinton beat Bush in 1992 just like Kennedy beat Nixon in 1960 -- because of a weak economy CLINTON RESTORED CONFIDENCE Pres Clinton actually did very little to stimulate the economy upon taking office the mere fact, however that Clinton promised a more activist approach helped restore business and consumer confidence AN EASY RE-ELECTION clinton's 1993 deficit reduction legislation signaled Wall Street Clinton was serious about budget balance these factors helped accelerate a recovery already begun towards the end of the Bush presidency the booming economy also set the stage for Clinton's easy re-election in 1996 the 1990s marked the longest economic recovery in  peacetime history THE 2000s: A DECADE NOT SO KIND OR PROSPEROUS after Pres Bush took office in 2001: a recession 9/11 terrorist attach 2 wars in Iraq and Afghanistan CHINA JOINS WORLD TRADE ORGANIZATION IN 2001 begins flooding American markets with illegally subsidized exports over 50000 American factories disappear more than 5mn manufacturing jobs lost american GDB growth rate falls by 2/3rds THE GREAT RECESSION OF 2007 massive housing bubble bursts US enters its worst recession since the Great Depression of the 1930s KEYNESIAN ECONOMICS ON STEROIDS? White House and Congress orchestrate biggest fiscal stimulus in history Federal Reserve engineers an equally massive monetary stimulus Fed Chairman Ben Bernanke inaugurates tools like QUANTITATIVE EASING A NEW FAILURE OF KEYNESIASNISM? fiscal and monetary stimulus packages have been less successful this century than last economies around the globe seem to face structural problems increasingly resistant to Keynesian solutions PURPOSE OF THIS COURSE help better understand the complex global economic forces affecting both your personal and professional life!!!! IN THE MEANTIME economics is not something to be memorized but rather something to conceptualize so as you study it, think about it too your job and your business might just depend upon it

August 13
DEMAND-PULL INFLATION "Too much money chasing too few goods" when america tried to finance both the Vietnam War and the Great Society severe demand pull inflation resulted during war time increased defense spending shifts AD curve outward; output increases as real GDP expands however when real output rises far above potential output price level moves up sharply as well in 1972 Pres Nixon imposed price and wage controls and gained the nation a brief respite from the Johnson-era inflation however once controls were lifted in 1973 inflation jumped back up to double digits: a new kind of inflation cost push or supply-side inflation COST-PUSH INFLATION rapid increases in raw material prices or wage increases drive up production costs can happen as a result of SUPPLY SHOCKS 1970s shocks included crop failures a worldwide drought, and a quadrupling of the world price of crude oil sharply higher oil, commodity and labor costs increased the cost of doing business: output declines while prices rise this leads to STAGFLATION: recession or stagnation combined with inflation economy suffers the double whammy of both lower output and higher prices A BUDDING KEYNESIAN PARADOX prior to the 1970s economists didn't believe you could have simultaneous high inflation and high unemployment: if inflation went up, unemployment had to go down and vice versa Keynesian economics turned out to be incapable of solving the new stagflation problem THE KEYNESIAN DILEMMA if expansionary policy were used to stimulate the economy to reduce unemployment, it would exacerbate inflation if contractionary policy were used to fight inflation it would increase unemployment ergo, traditional Keynesian tools could solve only half of the stagflation problem at any one time -- and only by making the other half worse THE RISE OF MONETARISM it was this inability of Keynesian economics to cope with stagflation that set the stage for Prof Milton Friedman's Monetarist challenge to what had become the Keynesian orthodoxy FRIEDMAN'S MONETARIST SCHOOL the problems of both inflation and recession may be traced to one thing -- the rate of growth of the money supply inflation happens when the government prints too much money recessions happen when it prints too little money THE MONETARIST PERSPECTIVE stagflation is the inevitable result of activist fiscal and monetary policies activist Keynesians try to push the economy beyond its so-called "natural rate of unemployment" the "natural rate of unemployment" is also called the "lowest sustainable unemployment rate" or LSUR THE LSUR OR NATURAL RATE the lowest level of unemployment that can be attained without upward pressure on inflation expansionary attempts to go beyond the LSUR may result in short run spurts of growth after each growth spurt, prices and wages inevitably rise and drag the economy back to its LSUR -- at a higher rate of inflation! SOME BITTER MEDICINE attempts to push the economy beyond its natural rate are futile they lead to an upward inflationary spiral monetarists believe that the only way to wring inflation and inflationary expectations out of the economy is  to push the actual unemployment rate rise ABOVE the LSUR that means inducing a recession!!!!!! INDUCING A RECESSION this is one interpretation of what the Federal Reserve did in 1979 under the Monetarist banner of setting monetary growth targets under Chairman Paul Volcker, the Fed adopted a sharply contractionary monetary policy interest rates soared to over 20%!! interest rate-sensitive sectors were particularly hard hit like housing construction, automobile purchases and business investment A SWEETER ECONOMIC CURE the Fed's bitter medicine worked to wring inflation out of the economy but after three years of hard economic times americans wanted a sweeter cure enter stage right: SUPPLY SIDE ECONOMICS

August 13
CLASSICAL ECONOMICS dates back to the late 1700s rooted in the laissez faire writings of Adam Smith David Ricardo and Jean Baptiste Say unemployment a natural part of business cycle economy is self-correcting no need for government intervention like fiscal or monetary policy CLASSICAL ECONOMISTS GET RUN OVER BY THE GREAT DEPRESSION between Civil War and Roaring 20's a series of booms and busts five depressions! economy always self-corrected like Classical Economists predicted classical economists were no match however for the Great Depression THE GREAT DEPRESSION COMETH stock market crash in 1929 GDP falls by almost a third between 1929 and 1933 25% of work force unemployed business investment fell from 16bn in 1929 to 1bn by 1933 BIRTH OF KEYNESIAN ECONOMICS Pres Herbert Hoover wrongly believed prosperity just around the corner classical economists waited fruitlessly for the "inevitable recovery" enter stage left: economist John Maynard Keynes Pres Franklin Delano Roosevelt THE KEYNESIAN VIEW keynes flatly rejected the classical notion of a self-correcting economy warned that patiently waiting for eventual recovery was fruitless because "in the long run, we're all dead" CLASSICAL ECONOMICS' DEATH SPIRAL under certain circumstances economy would not naturally rebound instead it would stagnate or fall into a death spiral! THE KEYNESIAN SPENDING CURE only way to get the economy moving again? -> prime the economic pump with increased government expenditures! -> fiscal policy was born -> Keynesian prescription became the underlying philosophy of Franklin Delano Roosevelt's New Deal ROOSEVELT'S NEW DEAL AND WWII LIFTS THE ECONOMY the New Deal's public works projects PLUS a World War II manufacturing boom lift the American economy up to unprecedented heights! KEYNESIAN CURE REDUX Korean War expenditures stimulate the economy out of a 1950s recession the famous Kennedy tax cuts lifts the economy out of the doldrums in the 1960s THE PROMISE OF "FINE TUNING" Pres Kennedy's chief economic advisor popularized the term "fine tuning" the concept: by mechanically applying Keynesian principles the US economy could be held very close to full employment with minimal inflation THE KENNEDY TAX CUT 1962: Heller recommend a large tax cut to stimulate the sluggish economy this was revolutionary: usually fiscal stimulus meant more government spending and NOT tax cuts the Kennedy tax cut made the 1960s one of the most prosperous decades in America THE FOUNDATION OF STAGFLATION fiscal stimulus by tax cuts laid the foundation for the emergence of STAGFLATION STAGFLATION is simultaneous high inflation and high unemployment would prove difficult to cure with traditional Keynesian tools ROOTS OF STAGFLATION Guns or butter - you can't have both Pres Johnson increased expenditures on the Vietnam War he refused to cut spending on his Great Society social welfare programs LBJ's refusal to cut "butter" while buying "guns" helped spawn a virulent "demand pull" inflation

August 13
MAJOR MACROECONOMIC POLICY TOOLS in dealing with problems such as inflation and unemployment the Federal government has a number of policy tools at its disposal: 1 Fiscal policy 2 Monetary policy FISCAL POLICY TOOLS to stimulate the economy to fight recession increased government spending tax cuts to contract the economy to fight inflation decreased government spending tax hikes MONETARY POLICY to stimulate the economy to fight recession increase the money supply to contract economy to fight inflation decrease the money supply MACRO POLICY A DOUBLE-EDGED SWORD good macroeconomic policies can create prosperity and growth bad macroeconomic policies can inflict great harm MACROECONOMICS FROM AN HISTORICAL PERSPECTIVE outline the historical evolution of macroeconomic thinking show how new theories emerged to cope with new macroeconomic problems like Keynesianism and Monetarism see how macroeconomics continues to be an evolving science learn how macroeconomics is relevant to much of what we do  in our personal and professional lives AGGREGATE SUPPLY AGGREGATE DEMAND ANALYSIS one of the most important tools of macroeconomics vertical axis: measures general price level for all goods and services horizontal axis: measures level of Real GDP AS: economy's aggregate supply or how much output the economy will produce at different price levels slopes upward: the higher the price level the more that businesses will produce AD: aggregate demand curve represents what everyone in the economy, consumers, businesses foreigners and government would buy at different aggregate price levels downward sloping: as general price levels fall consumers and businesses will increase their demand for goods and services Macroeconomic Equilibrium: point where AS and AD cross combination of overall price and quantity at which neither buyers nor sellers wish to change their purchases sales or prices example businesses want to sell quantity C but purchasers only want to buy quantity B    at this price goods will pile up on the shelves and eventually firms will have to cut production and prices this drives the economy back to equilibrium at point E

August 12
MACROECONOMICS DEFINED macroeconomics focuses on the big economic picture how the overall national economy performs microeconomics deals with behavior of individual markets and the businesses, consumers, investors, and workers that make up the economy BIG FOUR MACRO ISSUES 1 Inflation 2 Unemployment 3 Rate of Economic Growth 4 Forecasting Movements in the Business Cycle MACRO PROBLEM #1: INFLATION upward movement of prices from one year to the next measured by the percentage change in price indices: 1 Consumer Price Index (CPI) calculated by pricing a basket of goods and services purchased by a typical household includes prices of items like food, clothing, shelter fuel transportation and college tuition 2 Producer Price Index (PPI) based on a number of important raw materials 3 GDP deflator INFLATION: THE CRUELEST TAX eats away at savings and paychecks if inflation (prices of goods) is greater than increase in paychecks, our purchasing power is declining even though wages are rising not everyone loses from inflation unanticipated inflation can actually benefit borrowers at the expense of lenders how can borrowers gain from inflation? EXAMPLE suppose you borrow 1000 from a bank and promise to repay it in 2 years if price level doubles because of inflation the 1000 which you repay will have only half of  the purchasing power of the 1000 originally borrowed borrowers can win from inflation! lenders can lose! MACRO PROBLEM #2: UNEMPLOYMENT unemployment rate: number of unemployed persons divided by the number of people in the labor force kinds: 1 Frictional the least of the macroeconomist's worries natural part of the job-seeking process people quit their jobs just long enough to look for and find another one 2 Cyclical much more serious problem occurs when economy dips into a recession macroeconomists spend most of their time trying to solve this 3 Structural occurs when a change in technology makes someone's job or job skills obsolete VERY hard to cure! MACRO PROBLEM #3: THE RATE OF ECONOMIC GROWTH measured by growth in the Gross Domestic Product or GDP GDP: market value of all the final goods and services produced in a country in a given year 2 ways to measure: 1 Flow-of-cost or Income approach GDP = wages for workers + rents for property owners + interest for lenders + profits for firms 2 Flow-of-product or Expenditures approach GDP = consumption by households + investment expenditures by businesses + government purchases + net exports (exports - imports) ACTUAL VS POTENTIAL GDP Actual GDP: What we produce Potential GDP: Maximum economy can produce without causing inflation Recessionary Range: Actual < Potential Risk of Inflation: Actual > Potential GDP GAP difference between Actual and Potential GDP measures the output the economy sacrifices because it fails to fully use its productive potential high unemployment rate means large GDP gap NOMINAL VS REAL GDP Nominal GDP: Measured in actual market prices Real GDP: Nominal GDP adjusted for inflation calculated in constant prices for a particular year, eg 1992 GDP Deflator = Nominal GDP/Real GDP (valuable inflation index) OUTPUT GROWTH GDP: Best measure of the level and growth of output in the economy Real GDP: Following its movement gives best pulse on economy MACRO PROBLEM #4: BUSINESS CYCLES & ECONOMIC GROWTH business cycle: recurrent ups and downs in real GDP over several years forecasting the business cycle is an important part of  successfully managing an organization or investment portfolio PHASES OF THE BUSINESS CYCLE looks like a roller coaster there is a peak where business activity reaches a maximum there is a trough which is brought about by a  recessionary downturn in total output recovery or upturn in which the economy expands towards full employment each phase oscillate around a growth trend line a central concern of macroeconomist is to determine whether a recurring business cycle exists and if so  what are the forces behind it FORECASTING FOR PUBLIC POLICY what are the forces behind movements in the business cycle? CENTRAL POINT: both macroeconomists and political leaders want to know what macroeconomic policies may be used to harness expansionary ups and recessionary downs of the business cycle FORECASTING FOR BUSINESS business executives want to know if the economy is going to expand or go into recession forecasting business cycle movements allows executives to plan things like production and inventory levels if a business bets on an economic expansion and increases production but then gets a recession, it could fail! that's why businesses use forecasters to lower their business cycle risk!

August 12
TERESA'S AMERICAN DREAM Dream to own her own home Marketing director for a major corporation With a good salary, she saved up to put a down payment on a new home TERESA'S CHOICE - AND GAMBLE! A modest condo near work or a big, more expensive dream home out in the suburbs? Buying dream home meant taking a variable rate mortgage two points below a fixed rate mortgage Variable mortgage payments would be much lower than a fixed rate mortgage - but only if inflation and interest rates stayed low SOME WARNING SIGNS Felt a little nervous about choosing variable rate but mortgage banker told her not to worry Rates had been stable so "it shouldn't be a problem" However Teresa failed to see numerous warning signs of growing inflationary pressures INFLATIONARY PRESSURES 1. Demand-Pull Side Unemployment rate had reached 8-year low Higher Demand For Goods Businesses Raise Prices of Goods Sold 2. Supply of Goods (Cost Push) Bad Coffee Crop World-wide drought and food shortages Supply Decreases Reduction in Oil Supply Fall in Value of the Dollar Price of Imports Increase Producers Raise Prices DISASTER STRIKES Interest rates climbed to double digits Teresa couldn't afford variable rate mortgage payments Rising interest rates plunged the economy into a recession Real estate market crashed Teresa forced to sell her dream home for much less than she bought it for, and lost every cent of her equity

August 12
JIM WELLS' DECISION Owned a manufacturing business that made high precision components for computer games Had to decide how many components to produce for the upcoming holiday season Every year had double his production Because he never had trouble moving inventory decided to do the same thing again even though it meant taking out a big short term loan to finance the expansion DANGER SIGNS 1. Federal Reserve recently raised bank discount rate and sold bonds to open market Federal Reserve sell bonds to public Individuals Buy (Give dollars) to Fed Individuals have less money to spend Possible Recession Jim didn't see this as CONTRACTIONARY MONETARY POLICY that might trigger a recession Instead he just grumbled about the higher interest rate on his business loan 2. Recessionary Implications of several stories on CNN reporting a fall in consumer confidence and a slight uptick in   the unemployment rate Low Consumer Confidence = Less Spending High Unemployment = Less Spending Recessionary Implications 3. Small blurb in Business Week about Japan's shift towards a more expansionary monetary policy Expansionary Monetary Policy Decrease Value of Yen Relative to Dollar Japanese Imports Into US Become Less Expensive Decrease in Demand For Jim's Computer Components BANKRUPTCY LOOMS Jim got caught with inventories up and pants down By October, a foreign competitor had taken over half of a market already shrinking fast from the onset of a recession JIM'S COMPANY: A TURKEY BY THANKSGIVING By Thanksgiving, Jim was sitting on a huge inventory that he couldn't give away By December he was unable to pay a huge loan that wouldn't go away By June Jim's company was bankrupt

August 11
MACROECONOMICS IN OUR PERSONAL LIVES helps make important decisions: 1. is it a good time to switch jobs? 2. should you ask for a raise? 3. go buy that new house now or wait? 4. get a fixed or variable rate mortgage? MACROECONOMICS IN OUR PROFESSIONAL LIVES helps make critical business decisions! 1. how much to manufacture? 2. inventory levels? 3. invest in new plant and equipment? 4. expand into foreign markets? 5. downsize firm? THE REAL POWER OF MACROECONOMICS 1. arms us with a new way of thinking about the world we live and work in 2. helps filter, sort, and process information that will affect business decisions SEEING PATTERNS AND TRENDS 1. Federal Reserve Bank raises interest rates 2. A fall in consumer confidence 3. coffee been shortage in brazil 4. value of yen falls relative to dollar these seemingly unrelated bits of information reveals, first, patterns and trends, and ultimately courses of action which we might fruitfully follow, or ignore at own peril IGNORANCE IS COSTLY - NOT BLISS Jim never took a course in the principles of macroeconomics His lack of knowledge would be very costly He missed some significant danger signs THE DISMAL SCIENCE despite the enormous impact macroeconomics has on our personal and professional lives most of use view it as a remote, complicated and indeed dismal science HISTORY PROVIDES A REAL WORLD CONTEXT FOR THE STUDY OF MACROECONOMICS HISTORY REMINDS US MACROECONOMICS IS AN EVOLVING POLICY SCIENCE