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Chapter Nine Business Cycles and Unemployment Macroeconomics ● Macroeconomics is the study of the economy as a whole ● The four central problems are: ○ Growth ○ Business cycles ○ Unemployment ○ Inflation Two Frameworks: The Long Run and the Short Run ● Issues of growth are considered in a long-run framework, which focuses on supply ● Business cycles are generally considered in a short-run framework, which focuses on demand ● Unemployment and inflation fall within both frameworks Growth ● Recall: The primary measurement of growth is changes in real gross domestic product (real GDP)- the market value of final goods and services produced in an economy, states in the prices of a given year ● The U.S. secular growth rate and the per capita real output growth have been 2.5 to 3.5 percent per year ● Per capita real output is real GDP divided by the total population Business Cycles ● The business cycle is the upward and downward movement of economic activity that occurs around the growth trend ● There are two main views on policy regarding business cycles: ○ Classical economists argue that fluctuations are to be expected and favor laissez-faire ○ Keynesians feel that fluctuations are symptoms of underlying problems and should be addressed with activist government policy Unemployment ● The unemployment rate is the percentage of people who are willing and able to work but are not working ● Cyclical unemployment is that which results from fluctuations in economic activity ● Structural unemployment is that caused by economic restructuring making some skills obsolete

Unemployment as Government’s Problem ● In the Employment Act of 1946, the U.S. government took responsibility for unemployment ● Full employment- and economic climate where nearly everyone who wants a job has one ● Some unemployment is unavoidable ● Frictional unemployment occurs as resources move from one use to another Target Rate of Unemployment ● The full-employment rate of unemployment (or natural rate of unemployment- NRU) is the lowest sustainable rate of unemployment achievable under existing conditions ○ NAIRU: non-accelerating inflation rate of unemployment ● At NRU, the economy is producing such the real GDP = potential output ● Today it is thought to be 5%. Earlier thought to be 5-7% Why the Target Rate Changed ● In the 1970s and early 1980s, a low inflation rate seemed to be incompatible with low unemployment rate ● Demographics have changed- different age groups have different unemployment rates ● Technology, social, and institutional structures have changed ● Government institutions changed with programs such as unemployment insurance and public welfare Whose Responsibility is Unemployment ● Classical economists believe that individuals are responsible for their own jobs ○ If people really want a job, they will find one ● Keynesian economists tend to say that society owes people jobs commensurate with their training or past job experience ○ Jobs should be close enough to home so that people don't have to move Calculating the Unemployment Rate ●

U nemploymentRate =

N umberunemployed Laborf orce

100 

● The labor force- those people in an economy who are willing and able to work ● The labor force excludes those incapable of working and those not looking for work Accuracy of the Unemployment Rate ● Does not include discouraged workers ● Does not take into account the underemployed ● Includes people who say they are unemployed, but aren’t ● The labor force participation and unemployment rates provide additional information

Unemployment and Potential Output ● Potential output- output that would be achieved at the full-employment rates of unemployment and of capacity utilization ● GDP gap = actual GDP - potential GDP Microeconomic Categories of Unemployment ● Microeconomic policies are sometimes used to supplement macroeconomic policies for unemployment. ● The following are microeconomic categories of unemployment are analyzed: ○ How people become unemployed ○ Demographic unemployment ○ Duration of unemployment ○ Unemployment by industry Labor Market Equilibrium and Wage Stickiness ● Contracts and implicit contracts ● Efficiency wage theory ● Insider-outsider model Review Question ● Suppose that a number of people, at least 16 years old, able to work is 200. The labor force is 150 and the number of employed people is 140. Fin the labor force participation rate and the employment rate ○ L abor forceparticipation = 150 100 = 75%  200 150 140 ○ U nemploymentrate = 150 100 = 6.67% 

Chapter Ten Inflation Inflation ● Inflation is a continual rise in the price level. ● Deflation is a continual fall in the price level. ● Inflation or deflation is measured with changes in price indices. ● Price index – a number that summarizes what happens to a weighted composite of prices of a selection of goods over time.

Creating a Price Index ● A price index is calculated by dividing the current price of a basket in a base year then multiplying by 100 of abasketincurrentyear ● P riceIndex = P rice 100  P riceof basketinbaseyear Calculating the Inflation Rate ● The inflation rate is a rate of change calculation: ●

I nflationRate =

P riceindexcurrentyear priceindexprior year P riceindexprior year

100 

Real World Price Indexes ● The GDP deflator ○ Measures prices for aggregate output ○ Favored because it is broad ● Consumer Price Index ○ Measures prices facing consumers ○ Based on a fixed basket of goods ○ May overstate true inflation ● Personal consumption expenditure (PCE) deflator ○ Measures prices facing consumers ○ Updates the fixed basket of goods yearly ○ Favored by the federal reserve ● Producer Price Index (PPI) ○ Measures prices facing producers ○ Early predictor of consumer inflation Real and Nominal Concepts ● Nominal output is the total amount of goods and services measured at current prices ● Real output is the total amount of goods and services produced, adjusted for price level changes

●

RealOutput =

N ominalOutput P riceIndex

100 

Expected and Unexpected Inflation ● Expected and unexpected inflations affects behavior differently ● Expected inflation is inflation people expect to occur ● Unexpected inflation is inflation that surprises people ● Inflationary expectations can accelerate large inflation Costs of Inflation ● Inflation may not make a nation poorer ● It can redistribute income from those who do not raise their prices to those who do ○ How inflation raises the tax burden on savings worksheet ● It can reduce the amount of information that prices convey ● Inflation is a very serious problem: exceptionally high levels of inflation, 100% or more a year Does Inflation Affect Output ● Cost-Push Inflation: increases in resource prices drive up costs of production which results in less output and lower employment ● Demand-Pull Inflation: if the economy’s resources are fully employed, as aggregate demand increases, price increase ● Hyperinflation Review Question ● Suppose that the nominal price of gasoline is $2 per gallon. THe CPI (1982 base year) is 190%. Find the real price of a gallon of gasoline. rice ● R ealP rice = NPominalP 100 = $1.05  = $2.00 riceIndex 190

Chapter Eleven The Balance of Trade Merchandise Trade ● Balance of Trade ○ Exports ○ Imports ○ Surplus ○ Deficit International Trade ● International trade ○ Buy/sell current goods or services ○ Imports and exports ● International asset transactions ○ Buy/sell real or financial assets ○ Buy stock ○ Sell your house to a foreigner ● Requires currency exchange Balance of Payments ● Sum of international financial transactions ● Current account ○ Balance on goods and services ○ Net investment income ○ Net transfers ○ Balance on current account ● Capital and financial account ● Balance of payments accounts sum to zero ● Current account deficits generate asset transfers to foreigners ● Official reserves The National Saving and Investment Identity ● The national saving and investment identity is based on the relationship that the total quantity of financial capital supplied from all sources must equal the total quantity of financial capital demanded from all sources ● If S is private savings, T is taxes, G is government spending, M is imports, X is exports, and I is investment, then for an economy with a current account deficit and a budget deficit: ● Supply of financial capital = Demand for financial capital ○ S + (M X ) = I + ( G T ) 

Domestic Savings and Investment Determine the Trade Balance ● Trade deficit = Domestic investment - Private domestic saving - Government savings ○ (M X ) = I S (T G)  ● Trade surplus = Private domestic savings + Public savings - Domestic investment ○ (X M ) = S + (G T ) I  Exploring Trade Balances One Factor at a Time ● A recession tends to increase the trade balance (meaning a higher trade surplus or lower trade deficit) ● While economic boom will tend to decrease the trade balance (meaning a lower trade surplus or a larger trade deficit)

Week 6 Problem Set ● The country of Freedonia uses the same method to calculate the unemployment rate as the U.S. Bureau of Labor Statistics uses. From the data below, compute Freedonia's unemployment rate. Population = 10,000,000 Worked one hour or more in previous week = 4,000,000 Searched for work during previous weeks = 1,000,000 ○ 2.0% ● Kara voluntarily quit her job as an insurance agent to return to school full-time to earn an MBA degree. With a degree in hand she is now searching for a position in management. Kara presently is: ○ Frictionally unemployed ● Suppose there are 5 million unemployed workers seeking jobs. After a period of time, 1 million of them become discouraged over their job prospects and cease to look for work. As a result of this, all else equal, the official unemployment rate would: ○ Decline ● What is meant by implicit contract? ○ An unwritten agreement in the labor market that the employer will try to keep wages from falling when the economy is weak or the business is having trouble, and the employee will not expect huge salary increases when the economy or the business is strong. ● Which of the following refers to the theory that the productivity of workers, either individually or as a group, will increase if they are paid more? ○ Efficiency wage theory ● If actual GDP is $500 billion and there is a negative GDP gap of $10 billion, potential GDP is $510 billion. ● Assume the natural rate of unemployment in the U.S. economy is 5 percent and the actual rate of unemployment is 9 percent. According to Okun's law, the negative GDP gap as a percent of potential GDP is 8%. ● What is meant by Index Number? ○ When one arbitrary year is chosen to equal 100, and then values in all other years are set proportionately equal to that base year. ● Which of the following characteristics relate to quality/new goods bias? ○ Inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living because it doesn’t take into account improvements in the quality of existing goods or the invention of new goods. ● If the consumer price index falls from 120 to 116 in a particular year, the economy has experienced: ○ Deflation of 3.33% ● If the rate of inflation is 12 percent per year, the price level will double in about 6 years

● Suppose that a person's nominal income rises from $10,000 to $12,000 and the consumer price index rises from 100 to 105. The person's real income will: ○ Rise by about 15% ● Suppose the nominal annual interest rate on a two year loan is 8 percent and lenders expect inflation to be 5 percent in each of the two years. The annual expected real rate of interest is 3 percent. ● Unanticipated inflation: ○ reduces the real burden of the public debt to the Federal government. ● The term import is used to describe what those in one country buy from those in other countries. ● The term trade surplus describes circumstances where a country's exports exceed its imports. ● What name is given to a broad measure of the balance of trade that includes trade in goods and services, as well as international flows of income and foreign aid? ○ Current account balance ● With respect to the national saving and investment identity for any country, the quantity of _______________ at any given time by savings must ________________ for purposes of making investments. ○ Financial capital supplied; equal the quantity of financial capital demanded ● Trade surpluses and trade deficits can be __________________ for an economy in certain circumstances. ○ Beneficial and harmful ● At the outset of the 21st century, most global trade took the form of ○ Goods, rather than services. ● From an economic perspective, returns on foreign investment are included in the overall measure of trade because financial investments ○ Are a form of trade that takes place in the financial capital market. ● In 2013, the country of Vesey exported goods worth $312 billion and services worth $198 billion. It imported goods worth $525 billion and services worth $255 billion. It sent $1.2 billion in famine relief to Africa, and received $3 billion to support its first democratic election efforts. What was the merchandise trade deficit in Vesey in 2013? ○ $213 billion ● In 2013, a country imported goods worth $500 billion and exported goods worth $443 billion. It exported services worth $248 billion and imported services worth $330 billion. Payments on investments abroad totaled $199 billion, while returns paid on foreign investments were $125 billion. Unilateral transfers from the country to other nations amounted to $94 billion. What was the country’s current account balance for 2013? ○ $159 billion ● Which of the following represents the national savings and investment identity - Supply of financial capital = Demand for financial capital - expressed in algebraic terms?

○ S + (M X ) = I + ( G T )  ● Assume that the level of domestic investment in a country rises, while the level of private and public saving remains unchanged. In these circumstances, ○ The rise in domestic investment will mean a higher trade deficit.

Chapter Twelve The Aggregate Supply and Aggregate Demand Model AD/AS Model ● Variable price model ○ Real variables at fixed price level vs. real variables at different price levels ● Insights on inflation, unemployment, growth Aggregate Demand ● Real GDP desired at each price level ○ Schedule or graph ● Inverse relationship ○ Real balances effect ○ Interest effect ○ Foreign purchases effect Consumer Spending ● Consumer wealth ● Household borrowing ● Consumer expectations ● Personal taxes Investment Spending ● Real interest rates ● Expected returns ○ Expectations about future business conditions ○ Technology ○ Degree of excess capacity ○ Business taxes Government Spending ● Government spending increases ○ Aggregate demand increases (as long as interest rates and tax rates do not change) ○ More transportation projects ● Government spending decreases ○ Aggregate demand decreases ○ Less military spending Net Export Spending ● National income abroad ● Exchange rates

○ Dollar depreciation ○ Dollar appreciation Aggregate Supply ● Total real output produced at each price level ● Relationship depends on time horizon ○ Short run ○ Long run Changes in Aggregate Supply ● Determinants of aggregate supply ○ Shift factors ● Collectively position the AS curve ● Changes raise or lower per-unit production costs Input Prices ● Domestic resource prices ○ Labor ○ Capital ○ Land ● Prices of imported resources ○ Imported oil ○ Exchange rates Productivity ● Real output per unit of input ○ Increases in productivity reduce costs ○ Decreases in productivity increase costs otaloutput ● P roductivity = TT otalinputs ●

P er

inputcost unitP roductionCost = T otal  T otaloutput

Legal-Institutional Environment ● Legal changes alter per-unit costs of output ○ Taxes and subsidies ○ Extent of government regulation Income Consumption and Saving ● Consumption and saving ○ Primarily determined by DI ○ Direct relationship

● However, we should consider the functional for other effects on consumption A Rational Consumer ● Smooths consumption based on expected total wealth ● Times purchases in response to price of financing ● Accounts for ‘free’ retirement income from employer or government ● Increases saving when uncertainty (health & life expectancy) ● Increases saving for desired bequests Two Hypotheses ● Life Cycle Hypothesis: Franco Modigliani (MIT) - consumers make plans based on the horizon of entire life ● Permanent Income Hypothesis: Milton Friedman (U. Chi) - consumers think of current and future income and wealth Realistic Consumption Model ● Should include ○ Lifecycle restrictions ○ Liquidity restriction ○ Uncertainty and risk aversion ○ Bounded rationality ● C t = C (T otalW ealtht ,  Costof Consumptiont ,  expectedremaining lif e) ● C t , = C (Y D t , T otalfuturewealth t, P t, r t, expectedremaininglif e) ● However, for accessibility of model: Income Consumption and Saving ● Consumption and saving ○ Primarily determined by DI ○ Direct relationship ● Consumption schedule ○ Planned household spending ● Saving schedule ○ DI minus C ○ Dissaving can occur Average Propensities ● Average propensity to consume (APC) ○ Fraction of total income consumed ● Average propensity to save (APS) ○ Fraction of total income saved

●

AP C =

Consumption Income Saving Income

● AP S = ● APC + APS = 1

Marginal Propensities ● Marginal propensity to consume (MPC) ○ Proportion of a change in income consumed ● Marginal propensity to save (MPS) ○ Proportion of a change in income saved ●

MPC =

●

MPS =

Changeinconsumption Changeinincome Changeinsaving Changeinincome

● MPC + MPS = 1 Non Income Determinants ● Amount of disposable income is the main determinants ● Other determinants ○ Wealth ○ Borrowing ○ Expectations ○ Real interest rates Other Important Considerations ● Switching to real GDP ● Changes along schedules ● Simultaneous shifts ● Taxations ● Stability Interest-Rate-Investment ● Expected rate of return ● The real interest rate ● Investment demand curve Shifts of Investment Demand ● Acquisition, maintenance, and operating costs ● Business taxes ● Technological change ● Stock of capital goods on hand ● Planned inventory changes

● Expectations Instability of Investment ● Variability of expectations ● Durability ● Irregularity of innovation ● Variability of profits Government Spending and Taxes as a Function of National Income ● Government spending is treated as exogenous in our model because its level is determined by political considerations, not by the current level of income in the economy ● Taxes are taken into account by adjusting the consumption function Exports and Imports as a Function of National Income ● The export function is treated as an exogenous variable in our model because exports don’t change as a result of changes in domestic income, but they move as a result of changes in foreign income, as well as changes in exchange rates. ● The import function is drawn as a downward-sloping line because imports rise with national income, but imports are a subtraction from aggregate demand. ● Thus, a higher level of imports means a lower level of expenditure on domestic goods. The marginal propensity to import (MPI) can be changed by movements in exchange rates.

The Multiplier Effect ● The multiplier effect describes how the impact of an original change in aggregate demand is multiplied as it cycles repeatedly through the economy ● The size of the multiplier is determined by three leakages: spending on savings, taxes, and imports. The multiplier is defined as: T otalinaggregateexpenditures ● M ultiplier = Original increaseinexpenditures ● A change in spending changes real GDP more than the initial change in spending ChangeinrealGDP ● M ultiplier = Initial changeinspending ● Change in G DP = M ultiplier

Initialcha...