Transcript Document 7107089

Circular
Flow
The Government’s Role
Correct for:
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Imperfect Information
Externalities
Public Goods
Lack of Competition
Business Cycles
Externalities
• Someone outside a transaction benefits
from the transaction ... and doesn’t pay
Too little produced.
• Someone outside a transaction incurs costs
because of it ... but isn’t paid
Too much produced.
Public Goods

Consumption by one person does not
diminish the quantity or quality
available to others.
Public goods can be jointly consumed
Public goods are non-excludable
Everybody has incentive to be a free rider
• When everyone free rides, too little (or
none) is produced.
Macroeconomic Policy
• Monetary Policy
– Policies that influence money and credit
(money supply and interest rates).
• Fiscal Policy
– Policies that control government spending
and taxation.
GDP  “Output”
• Gross Domestic Product (GDP) is the
market value of final goods and services
produced within a country during a year.
 Market Value: The worth of a thing is
the price it will bring.
 Only Final Goods and Services Count
 GDP must be produced within our
borders

Net additions to inventory are current
output so they are also included in GDP.
GDP as Valued-Added
GDP as Expenditures: C + I + G + X
GDP (GNP) as Income
GDP – GNP – NNP – NI – PI – DI
Real and Nominal GDP
• “Real“ GDP adjusts for inflation.
• Nominal GDP ($GDP) measures national
output based on current prices of goods
and services.
• Real GDP measures of the quantity of final
goods and services produced
– Real GDP measures current output at
constant prices
• Consumer Price Index (CPI)
– measures the cost over time of a typical bundle of
goods and services purchased by households.
• Producer Price Index (PPI)
– measures average prices received by producers
over time for raw materials, intermediate, and
final goods.
• GDP Price Deflator (GDP Price Index, GDPPI)
– measures average prices over time of all goods
and services included in GDP.
Foreign Exchange
• Foreign Exchange
Foreign money, including paper money and bank
deposits that are denominated in foreign
currency
• Foreign Exchange Market
A global market in which people trade one
currency for another
• Exchange Rate
The price of one country’s currency in terms of
another country’s currency
Appreciation and Depreciation
• A currency appreciates when it buys more of a
foreign currency.
– Appreciation of a nation’s currency makes foreign
goods cheaper.
– Appreciation  Imports Up and Exports Down.
• A currency depreciates when it buys less of a
foreign currency.
– Depreciation makes foreign goods more expensive.
– Depreciation  Imports Down and Exports Up.
Current Account
Categories of current account transactions:
1. Merchandise trade
-- import and export of goods
2. Service trade
-- import and export of services
3. Income
-- both investment income and
employee compensation
4. Unilateral transfers
-- gifts to and from foreigners
Current Account vs. Financial Account
• The balance of payments must balance—that is,
Current Account + Financial Account = 0
• If there is a current account deficit, then there
must be a financial account surplus that exactly
offsets that deficit.
– If we buy more goods and services from
foreigners than they buy from us, we have to
borrow the difference  sell them our IOUs.
U.S. Real GDP
(Recessions Shaded)
Unemployment
The unemployment rate is the percentage
of the labor force that is not working.
Rate of
Unemployment
=
number unemployed
number in the Labor Force
• Discouraged Workers: workers who have looked
for work in the past year, but have stopped
because they believe no one will offer them a job.
• Underemployment: employment of workers in
jobs that do not fully utilize their productive skills.
Flavors of Unemployment
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Seasonal Unemployment
Frictional Unemployment: searching
for jobs
Structural Unemployment
 Reflects imperfect match between
employee skills and requirements of
available jobs.
Cyclical Unemployment
 Results from business cycle
fluctuations.
• “Natural” Rate of Unemployment
A normal rate, considering both frictional and
structural factors.
– Also called the NAIRU (Nonaccelerating Inflation
Rate of Unemployment) -- ~5% for US economy
The “natural” rate can change
• Potential Real GDP
The level of output when nonlabor resources are
fully utilized and unemployment is at its natural
rate.
• GDP gap = potential real GDP – actual GDP
•
Flavors of Price Inflation
Demand-pull inflation:
– caused by increases in aggregate demand
outpacing increases in aggregate supply.
• Cost-push inflation:
– increased production costs cause firms to
raise prices.
• Wage-push inflation
• Energy costs and inflation
•
Hyperinflation:
– extremely high rate of inflation.
• Printing money as last resort
Interest Rates
• Nominal Interest Rate (i): the observed
interest rate in the market.
• Real Interest Rate (r): nominal rate
adjusted for inflation ().
• r=i-
Aggregate Demand (AD): the economywide demand for goods and services.
• Aggregate demand curve relates aggregate
expenditure for goods and services to the price
level
• The aggregate demand curve slopes downward
owing to price-level effects:
– Wealth Effect (Real Wealth/Real Balances)
– Interest Rate Effect
– International Trade Effect (Substitution)
The Aggregate Demand Curve
Changes in the
price level result in
changes in quantity
demanded.
Factors that Affect AD  Shifts in AD
AD = C + I + G + NX
• Consumption
– Income
– Wealth
– Interest Rates
– Expectations
– Demographics
– Taxes
• Investment
– Interest Rates
– Technology
– Cost of Capital Goods
– Capacity Utilization
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
Government Spending
Net Exports
– Domestic & Foreign
Income
– Domestic & Foreign
Prices
– Exchange Rates
– Government Policy
Shifting Aggregate Demand Curve
Aggregate Supply: Short – Run & Long – Run
Short-run Aggregate Supply
• Aggregate Supply (AS) shows the quantity of
real GDP produced at different price levels.
• Short-run AS slopes upward
– a higher price level (holding production costs and
capital constant in the short-run)
higher profit margins
firms want to produce more.
The Shape of Long-run AS (LRAS)
• Resource costs are NOT fixed in the long-run.
– As prices rises, workers demand and get
higher wages
Profits don’t rise with price
• AS is set by production possibilities in the longrun
– LRAS is not affected by prices
– LRAS is vertical: higher prices cannot elicit
more output in the long-run.
Shifting the LongRun Aggregate
Supply Curve
Growth occurs
as the labor
force and capital
stock grow and
as technological
innovation
improves
production
efficiency.
Aggregate
Demand Aggregate
Supply
Equilibrium
Aggregate
Demand and
Supply
Equilibrium:
Short-run and
long-run
responses to
increase in
aggregate
demand