Ch: 16 12/15/10 6:18 PM Aggregate supply in SR: Labor: 70 percent of production cost the higher the price level the less given money wage purchases so the less attractive that wage is to workers. Norminal wage: wage in dollars of the year Real wage: wage in constant dollars (WE CARE MORE) Potential output and the natural rate of unemployment: Potential output: amount produced when there are no surprises about the PL (economy?s max sustainable output, given the supply of resources, the state of tech and the formal and informal production incentives offered by the rules of the game) Natural rate of unemployment: occurs when the economy produces its potential GDP (cyclical is zero) Actual PL is higher than expected: Profit=TR-TC A PL that is higher than expected results in a higher profit per unit, so firms have a profit incentive in the SR to increase production beyond the economy?s potential Why costs rise when output exceeds potential: As output expands, the cost of additional output increases As the economy expands, unemployment decreases, additional workers become harder to find As production increases, the demand for resources (oil) will increase Because the prices of some resources are fixed by contracts, the PL rises faster than the per unit production cost so firms find it profitable to increase the qty. supplied Marginal cost of production increases An actual price level lower than expected: Because production is less profitable when prices are lower than expected, firms reduce their qty. supplied so the economy?s output is below its potential. Unemployment exceeds the natural rate, machines go unused and entire plants may shut down As resources are less used, resource prices decline in markets where prices are flexible SRAS: relationship between the actual PL and real GDP supplied Closing an expansionary gap: The amount by which short run output exceeds the economy?s potential is called the expansionary gap Actual output can exceed the economy?s potential in the SR but not in the LR. The expansionary gap is closed by LR market forces that shift the SR curve from 130140 Contradictory gap: amount by which actual output falls short of potential GDP When PL is lower than expected employers are no longer willing to pay as high a nomincal wage and with the unemployment rate higher than the natural rate, more workers are competing for jobs, putting downward pressure on the nominal wage If the price level and nominal wage are flexible enough the SR aggreagate supply curve shifts rightward until the economy produces its potential output GO BACK Wage flexibility and employment: An expansionary gap creates a labor shortage that eventually results in a higher nominal wage and a higher price level A contraditionary gap does not necessarily generate enough downward pressure to lower the nominal wage Nominal wages tend to be sticky in the downward direction Because of the this the supply side adjustments needed to close a contractionary gap may take so long as to seem ineffective Aggregate demand usually can close a contractionary gap To close the gap you can decrease the real wage and the real wages fall if the prices increase more than nominal wages PL increases by 4, nominal wage increases by 3, real wage falls by 1 percent If the real wage falls enough, firms demand enough additional labor to produce the economy?s potential When the actual price level differs from the expected price level, output in the short run departs form the economy?s potential. In the long run market forces shift the sras until the economy produces it potential output. Surprises about the price level change real GDP in the short run but not in the long run Shifts in the aggregate demand curve change the PL but do not affect the potential output or long run as Shifts of the aggregate supply curve: Supply shocks=unexpected events that affect aggregate supply Aggregate supply increase: Potential output is based on the ability of households to supply resources to firms, the level of tech and the institutional underpinnings of the economic system. Beneficial supply shocks: increase aggregate supply Aggregate supply decreases: Adverse supply shocks: sudden, unexpected events that reduce supply (ex, a drought) Depicted as a leftward shift of both the sr and lr aggregate supply curves Reduced output+higher PL=stagflation Ch 11: agg supply 12/15/10 6:18 PM Fiscal: focuses on the effect of taxing and public spending on aggregate economic activity Automatic stabilizers: revenue and spending progs in the fed budget that automatically adjust with the ups and downs of the economy to stablize disposable income and consumption and real GDP (ex, fed income tax) Discretionary fiscal policy: requires the deliberate manipulation of govt purchases, transfer payments and taxes to promote macroeconomic goals like full employment, price stability and economic growth (stimulus plan) Some are temporary such as a one time boost in govt spending to fight recession An increase in govt purchases or in a transfer payments increases real gdp demanded and an increase in net taxes decreases real gdp demanded The great depression and WWII: John Maynard Keynes published the general theory of employment, interest and money, he said that prices and wages didn?t seem to be flexible and were relatively inflexible in the downward direction (sticky) Govt intervention required to increase AD Impact of WWII on output and employment, the demands of war greatly increases production and erased cyclical unemployment Employment act of 1946: gave the fed responsibility for promoting full employment and price stability Automatic stabilizers: Smooth out fluctuations in DI over the business cycle by stimulating aggregate demand during recessions and dampening aggregate demand during expansions Fed income tax=progressive, meaning that the fraction of income paid in taxes increases as a taxpayers income increases. During economic expansion=employment and incomes rise, moving taxpayers into higher tax brackets and thus slows the growth in DI and slows the growth in consumption. Unemployment insurance=during economic expansions the system automatically increases the flow of unemployment insurance taxes from the income stream into the unemployment insurance fund and there by moderating consumption and AD During contractions=unemployment increase and the system reverses itself. Flow from insurance fund to unemployed Discretionary fiscal policy: demand management policy, the objective is to increase or decrease aggregate demand to smooth economic fluctuations Ch: 12: fiscal policy 12/15/10 6:18 PM The fed budget=plan of outlays and revenues for specified period Outlays=govt purchases and transfer payments Budget resolution=congressional agreement about total outlays, spending by major category and expected revenues and it guides spending and rev decisions by the many congressional committees and subcommittees Outlays>revenues=deficit Deficit=stimulates AD in the sr but reduces national saving which in the long run could impede economic growth Revenues>outlays= surplus Dampens AD in the sr but boosts domestic saving which in the long run could promote economic growth Problems with the fed budget process: Congress often ignores the timetable for developing and approving a budget (typically run year to year based on continuing resolutions) Lengthy budget process: by the time congress and the prez agree on a fiscal remedy, the economy has often recovered on its own Uncontrollable budget items: about ¾ of the fed budget outlays are determined by existing laws (ex, entitlement progs) No separate capital budget: congress mixes capital and operating expenditures together Overly detailed budget Reforms: The annual budget could become a two year budget Simplify the budget document by concentrating only on major groupings and eliminating line items Sort federal spending into capt budget and an operating budget Annually balanced budget: budget philosophy prior to the great depression aimed at matching annual rev with outlays except during times of war Cyclically balance budget: calling for budget deficits during recessions to be financed by budget surpluses during expansions Functional finance: policy makers should be concerned less with balancing the budget annually or even over the business cycle and more with ensuring that the economy produces its potential output Large deficits came from combo of tax cuts and spending increases Fed officials are not required to balance the budget Elected officials try to max their support by saying they are spending progs and cutting taxes Crowding out: the displacement of interest sensitive private investment that occurs when higher govt deficits drive up market interest rates Increse in the fed deficitreduces national savinghigher IRcrowd out some private investment Some argue that deficit may displace private sector borrowing, expansionary fiscal policy results in a net increase in AD leading to greater output and employment in the short run Others believe crowding out, borrowing for the public in a way results in little or no net increase in aggregate demand and output (public spending merely subs for private spending) Crowding in: potential for govt spending to stimulate private investment in an otherwise dead economy Businesses may be reluctant to invest in a seemingly lifeless economy. The economic stimulus resulting from deficit spending could encourage some investors to crowd in To finance huge deficits, the govt must sell a lot of IOUs and must offer higher IR so it pushes up the market IR and thus foreigners find treasury securities more attractive The rising value of the dollar=foreign goods cheaper in the US and US goods more expensive abroad Ch: 13 12/15/10 6:18 PM medium of exchange: anything that is generally accepted in payment for goods and services commodity money: gold and silver unit of account: common unit for measuring the value of each good or service store of value: anything that retains its purchasing power over time greshams law: people tend to trade away inferior money and hoard the best fractional reserve banking system: bank reserves amounted to just a fraction of total deposits reserve ratio: measured reserves as a percentage of total claims against the goldsmith or total deposits goldsmith had reserves=4000 but deposits of 10000 RR=40 percent bank notes=promising the bearer specific amounts of gold or silver when the notes were presented to the issuing bank for redemption representitive money=bank notes that exchange for a specific commodity such as gold fiat money: money not redeemable for any commodity, its status as money is conferred initially by govt decree but eventually by common experience legal tender: currency that constitutes a valid and legal offer of payment of debt hyperinflation: when money performs poorly financial intermediaries: earn a profit by buying low and selling high (paying a lower IR to savers than they charge borrowers) Ch: 14 12/15/10 6:18 PM FED: to buy and sell govt securities, to extend loans to member banks, to clear checks in the banking system and to require that member banks hold reserves equal to at least some specified fraction of their deposits Ch: 15 12/15/10 6:18 PM
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