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1Chapter     1- The Nature of Economics
2I.    The Power of Economic Analysis: The analytical framework of the course is the economic way of thinking. The economic way of thinking permits the student to reach informed conclusions about what is happening in the world.
3II.    Defining Economics: The study of how people allocate their limited resources to satisfy their unlimited wants. The ultimate purpose of economics is to explain choices.
4III.    Microeconomics versus Macroeconomics: Economics is divided into two types of analysis: macroeconomics and microeconomics.
51.    Microeconomics: The part of economic analysis that studies individual decision making undertaken by individuals (or households) and by firms.
62.    Macroeconomics: The part of economic analysis that studies the behavior of the economy
7as a whole. It deals with economy wide phenomena such as changes in unemployment, the general price level, and national income.
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10IV.    The Economic Person: Rational Self-Interest: Economists assume that individuals act as if they are motivated by self-interest and respond predictably to opportunities for gain.
11A.    The Rationality Assumption: The assumption that individuals will not intentionally make decisions that would leave them worse off.
12B.    Responding to Incentives: An incentive is the reward for engaging in a given activity. People react to an incentive by making a rough comparison of costs and benefits.
13C.    Defining Self-Interest: The pursuit of goals that make the individual feel better off. In economic analysis, these goals are often those which can be measured in monetary terms, although the pursuit of other goals such as prestige, love, or power can be analyzed using
14this concept.
15V.    Economics as a Science: Economics is a social science that utilizes the same types of methods
16used in biology, chemistry, and physics. Economic models or theories, which are simplified representations of the real world, are developed and used as aids in understanding, explaining,
17and predicting economic phenomena in the real world.
18A.    Models and Realism: A model should capture the essential relationships that are sufficient to analyze the specific problem or answer the specific question being asked. No economic model is complete in the sense of capturing every detail and relationship that exists in the real world. A model is by definition an abstraction from reality. This does not mean that models are deficient simply because they are unrealistic and use simplified assumptions. Every model in every science requires simplification compared to the real world.
19B.    Assumptions: Assumptions define the set of circumstances in which a model is most likely to be applicable. Every model, therefore, must be based on a set of assumptions.
201.    The Ceteris Paribus Assumption: All Other Things Being Equal: The assumption that nothing changes except the factors being studied. It is used to isolate the effect of a change in one variable on another one by assuming that all other variables do not change.
21C.    Deciding on the Usefulness of a Model: A model is useful if it yields usable predictions and implications for the real world. If a model makes a prediction and factual evidence supports the prediction, then the model is useful.
22D.    Models of Behavior, Not Thought Processes: Models relate to the way people act in using limited resources and not to the way they think. Models normally generalize people’s behavior. Economists are interested in what people actually do rather than what they think they will do.
23E.    Behavioral Economics and Bounded Rationality: An approach to consumer behavior that emphasizes psychological limitations and complications that potentially interfere with rational decision-making.
241.    Bounded Rationality: The idea that people are nearly, but not fully, rational so that they cannot examine every choice available to them, but instead use simple rules of thumb to sort among the alternative available to them.
252.    Rules of Thumb: A behavioral implication of bounded rationality is the people will use rules of thumb, that is a simplified method of decision-making. An important issue is that persons who appear to use rules of thumb may behave as if they are fully rational.
263.    Behavioral Economics: A Work in Progress: So far, proponents of behavioral economics have not conclusively demonstrated that paying closer attention to psychological thought processes can improve economic predictions.
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29VI.    Positive versus Normative Economics: Positive economics deals with what is. Positive economic statements are “if-then” statements. Normative economics deals with what some person thinks ought to be. Normative economic statements involve value judgments and normally have the words “ought” or “should” in them. Since positive economics predicts consequences of actions, it can be used to predict the effects of various policies to see if the policies aid in achieving desired goals. Positive economics cannot provide criteria for choosing which outcomes or goals are preferable.
30A.    Distinguishing Between Positive and Normative Economics: Positive economics is analysis that is strictly limited to making either purely descriptive statements or scientific predictions. Normative economics is analysis involving value judgements about economic policies.
31A statement about what ought to be.
32B.    A Warning: Recognize Normative Analysis: While it is easy to define positive economics,
33it is often difficult to identify unlabeled normative statements, even in a textbook.
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51Chapter     2 – Scarcity and the World of Tradeoffs
52I.    Scarcity: Scarcity is a situation in which the ingredients for producing the things that people desire are insufficient to satisfy all wants. It exists in all societies and at all income levels because human wants exceed what can be produced with the limited resources and time that nature makes available.
53A.    What Scarcity Is Not: Scarcity is not a shortage. It is also not poverty. High incomes do not reduce scarcity.
54B.    Scarcity and Resources: Resources or factors of production are inputs used in the production of things that people want. Production is any activity that results in the conversion of resources into products that can be used in consumption.
551.    Land: Land is often called the natural resource and consists of all the gifts of nature.
562.    Labor: Labor is the human resource that includes all productive contributions made by individuals who work involving both mental and physical activities.
573.    Physical Capital: Capital is all manufactured resources that are used for production.
584.    Human Capital: The accumulated training and education workers receive that increases their productivity.
595.    Entrepreneurship: Human resources that perform the functions of organizing, managing, and assembling the other factors of production to create and operate business ventures, and takes the risks associated with introducing new methods and other types of new thinking that could lead to more money income.
60C.    Goods versus Economic Goods: All things from which individuals derive satisfaction or happiness.
611.    Economic Goods: Goods which are scarce. The quantity of such goods desired exceeds the quantity that is available at a zero price.
622.    Services: Mental or physical labor or help purchased by consumers. They can be viewed as intangible goods.
63II.    Wants and Needs: Needs are not objectively definable. Perhaps the best way to view needs is as an absolute necessity to stay alive. Wants refer to desired goods and are unlimited.
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65     Scarcity,     Choice, and Opportunity Cost: Scarcity requires choices be made.     When one choice is made, then another is given up.
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67A.    Valuing Forgone Alternatives: Only the individual can determine the value of each choice
68that is available.
69B.    Opportunity cost is the highest valued, next-best alternative that must be sacrificed for the choice that was made. In economics, cost is always a foregone opportunity.
70IV.    The World of Trade-Offs: Whenever you engage in any activity using any resource you are trading off the use that resource for one or more alternative uses. For example, the more time devoted to studying economics the less time that can be devoted to studying mathematics. Thus, a higher grade in economics has a “cost” of a lower history grade.
71A.    The Production Possibilities Curve: A curve representing the maximum possible combinations of total output that could be produced assuming a fixed amount of resources of a given quality. A movement from one point to another on the PPC shows that some of one good must be given up to have more of another.
72V.    The Choices Society Faces: The production possibilities curve does not in practice have constant trade-offs of one good for another and is typically a curve that is bowed outward.
73A.    A Two Good Example.
74B.    Production Trade-Offs.
75C.    Assumptions Underlying the Production Possibilities Curve:
761.    Resources are fully employed.
772.    Production takes place over a specific time period—for example, one year.
783.    Resources are fixed in both quantity and quality. Technology     does not change over this period of time.
79a.    Technology is defined as society’s pool of applied knowledge concerning how goods and services can be produced.
80D.    Being Off the PPC: Any point outside the PPC cannot be reached for the time period
81assumed. Any point inside the PPC is attainable, but resources are not being fully utilized.
82E.    Efficiency: The case in which a given level of inputs is used to produce the maximum output possible. Also, a situation in which a given output is produced at a minimum cost. An economy is efficient when it is on its PPC. An inefficient point is any point below the production possibilities curve.
83F.    Law of Increasing Relative Cost: As society takes more and more resources and applies them to the production of any one item, the opportunity cost increases for each additional unit produced. This law is illustrated by the PPC being bowed outward. The more highly specialized resources are, the more bowed outward the PPC will be.
84VI.    Economic Growth and the Production Possibilities Frontier: Economic growth is illustrated by an outward shift of the production possibilities curve.
85VII.    The Trade-Off Between the Present and the Future
86A.    Why We Make Capital Goods: Capital goods are one of society’s resources. Producing more of them allows a society to produce more of all types of goods.
87B.    Forgoing Current Consumption: When existing resources are used to produce capital goods, we are forgoing current consumption. When we forgo consumption to invest in capital goods, we are waiting to consume what will be produced from use of those capital goods then.
88C.    Trade-Offs Between Consumption Goods and Capital Goods: To have more consumer goods in the future, we must produce capital goods today. The more capital goods that are produced today, the less consumer goods that are produced today. In the future there will be more consumption goods as the economy grows.
89VIII.    Specialization and Greater Productivity: Specialization means working at a relatively well-defined, limited activity. It means the organization of economic activity so that what each person or region consumes is not identical to what each person or region produces.
90A.    Comparative Advantage: The ability to produce a good or service at a lower opportunity cost compared to other producers. This is the basis for specialization.
91B.    Absolute Advantage: The ability to produce more units of a good or service using a given quantity of labor or resource inputs. This is the ability to produce the same quantity of a good
92or service using fewer units of labor or resource inputs. This is not the basis for specialization.
93C.    Scarcity, Self-Interest, and Specialization: Persons who are making decisions that further
94their self-interest will make choices that maximize the benefits net of opportunity cost. The result is that they choose their comparative advantage and end up specializing.
95D.    The Division of Labor: The segregation of a resource into different specific tasks.
96IX.    Comparative Advantage and Trade Among Nations: The analysis of absolute advantage, comparative advantage, and specialization applies equally to nations.
97A.    Trade Among Regions: Specialization along lines of comparative advantage in agricultural products in the plains states and industrial products in the northeastern states and resulting trade between them allows each region to have higher incomes and living standards. The result would be the same if the plains states and the northern states were separate countries.
98B.    International Aspects of Trade: A produce in one part of the U.S. must adapt to improvements in production along lines of comparative advantage by those in another part. Producers in the U.S. will try to raise political barriers to trade with foreign producers by arguing about “unfair” competition and loss of U.S. jobs.
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132Chapter     3 – Supply and Demand
133I.    Demand: A schedule showing how much of a good or service that people will purchase at any price during a specified time period, other things being equal. The law of demand states that there is an inverse relationship between relative price and quantity demanded, i.e., when the relative price of a good goes up, people buy less of it and when the relative price of a good goes down, people buy more of it, other things being equal.
134A.    The Law of Demand: The observation that there is a negative or inverse relationship between the price of any good and the quantity demanded, holding other factors constant.
135B.    Relative Prices versus Money Prices: Relative price is the price of a good or service in terms of another. Money price is the price that is observed in terms of today’s dollars.
136II.    The Demand Schedule: The demand schedule is a numerical representation of the inverse relationship between specific prices and quantities demanded of a good measured in terms of constant quality units in a given time period.
137A.    The Demand Curve: The demand curve is a graphic representation of the demand schedule. It is a negatively sloped line showing the inverse relationship between the price and the quantity demanded, other things being equal.
138B.    Individual versus Market Demand Curves: Individual demand shows the quantity demanded of a good or service by an individual consumer at different prices. Market demand is the demand of all consumers in the marketplace for a good or service by the summing at each price the quantity demanded by each individual.
139III.    Shifts in Demand: A shift of the entire demand curve so that at each price the quantity demanded changes. A leftward shift of the demand curve means the quantity demanded at each price decreases, while a rightward shift of the demand curve means the quantity demanded at each price increases.
140A.    The Other Determinants of Demand: These are non-price factors which determine how much will be bought, other things held constant. A change in any one of these factors will cause a change in demand.
1411.    Income: For a normal good, an increase in income leads to an increase in demand, while
142a decrease in income leads to a decrease in demand. For an inferior good, an increase in income leads to a decrease in demand, while a decrease in income leads to an increase in demand.
1432.    Tastes and Preferences: If consumer tastes change in favor of a good, then there is an increase in demand for it. If consumer tastes move against the good, then there is a decrease in demand for it.
1443.    Prices of Related Goods: Substitutes and Complements: When two goods are related, a change in the price of one of them changes the demand for the other. Substitutes are goods that can be used to satisfy a similar want. If the price of one changes, demand for the other changes in the same direction. Complements are goods that are consumed together. If the price of one changes, the demand for the other changes in the opposite direction.
1454.    Expectations: Expectations of future increases in the price of a good, increases in income, and reduced availability lead to an increase in demand now. Expectations of future decreases in the price of a good, decreases in income, and increased availability lead to a decrease in demand now.
1465.    Market Size (Number of Buyers): An increase in the number of buyers in the market causes an increase in demand. A decrease in the number of buyers causes a decrease in demand.
147B.    Changes in Demand versus Changes in Quantity Demanded: A change in demand refers to a shift of the entire demand curve to the right or left if there is a change in a determinant of demand other than price. A change in quantity demanded refers to a movement along a given demand curve caused by a change in price.
148IV.    The Law of Supply: A schedule showing the relationship between price and quantity supplied at different prices in a specified time period, other things being equal. The law of supply states that the higher the price of a good, the larger the quantity sellers will make available over a specified time, other things being equal.
149V.    The Supply Schedule: A table that shows a direct relationship between price and quantity supplied at each price in a given time period.
150A.    Supply Curve: The graphical representation of the supply schedule, which is a curve, which generally slopes upward (has a positive slope) other things being equal.
151B.    The Market Supply Curve: A market supply curve is the supply of all individual producers in the market. Summing the quantity supplied at each price by each producer (horizontal summing of the individual supply curves) derives the market supply curve.
152VI.    Shifts in Supply: A change in supply is a rightward shift of the entire supply curve so that at each price the quantity supplied changes. A leftward shift of the supply curve means that the quantity supplied at each price decreases and is called a decrease in supply, while a rightward shift of the supply curve means that quantity supplied at each price increases and is called an increase in supply.
153A.    Other Determinants of Supply: These are factors other than price which determine how much will be produced and are held constant when identifying supply. A change in one of these factors will cause the supply curve to shift.
1541.    Cost of Inputs Used to Produce the Product: An increase (decrease) in the price of one or more inputs will cause a decrease (increase) in supply.
1552.    Technology and Productivity: An improvement in technology will cause an increase in supply.
1563.    Taxes and Subsidies: Increases (decreases) in indirect taxes have the same effect as raising (lowering) costs and, thus, decreases (increases) supply. A subsidy is a negative tax.
1574.    Price Expectations: An expected increase (decrease) in the relative price of a good can lead to a decrease (increase) in supply.
1585.    Number of Firms in the Industry: If the number of firms increases (decreases), supply will increase (decrease).
159B.    Changes in Supply versus Changes in Quantity Supplied: A change in quantity supplied refers to a movement along a given supply curve caused by a change in price. A change in supply refers to a shift of the entire supply curve to the right or left caused by a change in a non-price determinant of supply.
160VII.    Putting Demand and Supply Together: The intersection of demand and supply determines the prices that prevail in the U.S. economy and other economies.
161A.    Demand and Supply Schedules Combined: When the supply and demand schedules are combined, an equilibrium or market-clearing price is determined. This is a price at which quantity demanded equals quantity supplied. There is neither an excess quantity supplied (surplus) nor an excess quantity demanded (shortage).
1621.    Equilibrium: Equilibrium is a stable point. When equilibrium is reached, there is no tendency for change unless supply and/or demand change. Equilibrium is a situation where quantity supplied equals quantity demanded at a particular price. Equilibrium occurs where the supply and demand curves intersect.
1632.    Shortages: A shortage is a situation in which quantity demanded is greater than quantity supplied at a price below the market-clearing price. A shortage is corrected when price increases. Quantity demanded will fall and quantity supplied will increase until equilibrium is reached.
1643.    Surpluses: A surplus is a situation in which quantity demanded is less than quantity supplied at a price above the market-clearing price. A surplus is corrected when price decreases. Quantity demanded will rise and quantity supplied will fall until equilibrium is reached.
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166    Chapter     4 – Extensions of Demand and Supply Analysis     
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168    Outline
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170I.    The Price System and Markets: An economic system in which relative prices constantly change
171to reflect changes in demand and supply. Prices act as signals of relative scarcity to persons in the system.
172A.    Exchange and Markets: Exchanges in markets are voluntary. Voluntary exchange is the act of trading between individuals on a voluntary basis, making both parties subjectively better off. The terms of exchange are usually the price paid and are determined by supply and demand.
173B.    Transaction Costs: The costs of negotiating and enforcing contracts and of acquiring and processing information about alternatives.
174C.    The Role of Middlemen: Middlemen specialize in lowering transactions costs by bringing buyers and sellers together.
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177II.    Changes in Demand and Supply: Market equilibrium can change when there is a shock caused by a change in the ceteris paribus conditions for demand or supply. A shock can be represented by a shift in the supply curve, the demand curve, or both curves.
178A.    Effects of Changes in Either Demand or Supply: Whenever one curve shifts and the other does not, it is possible to determine what will happen to both price and quantity. When there is an increase in demand with supply stable, equilibrium price and quantity increase. A decrease in demand with supply stable results in an equilibrium price and quantity decrease. When there is an increase in supply with demand stable, equilibrium price falls and the equilibrium quantity rises. A decrease in supply with demand stable results in equilibrium price rises and the equilibrium quantity falls.
179B.    Situations in Which Both Demand and Supply Shift: When both supply and demand curves shift, the outcome is indeterminate for either equilibrium price or equilibrium quantity. When there is an increase in supply and demand, equilibrium quantity will rise, and when there is a decrease in supply and demand, equilibrium quantity will fall. Price can increase, decrease, or remain the same depending on relative changes in supply and demand. In the event of a decrease in demand and increase in supply, equilibrium price will fall. An increase in demand and a decrease in supply will cause the equilibrium price to rise. In these last two situations quantity can increase, decrease, or remain unchanged depending on the relative changes in supply and demand.
180C.    Price Flexibility and Adjustment Speed: When demand increases in a market, a shortage develops and price rises. The shortage can be eliminated quickly or slowly, depending on the characteristics of the market. There are markets where price flexibility may take the form of indirect adjustments, such as by way of hidden payments or quality changes.
181III.    The Rationing Function of Prices: The synchronization of decisions by buyers and sellers that creates equilibrium is called the rationing function of prices. Prices are indicators of relative scarcity and ration goods to those who are willing to pay the most.
182A.    Methods of Non-price Rationing: First come-first served, political power, physical force,
183and cultural, religious and physical differences have and are being used as rationing methods throughout the world.
1841    Rationing by Waiting: Also called rationing by queues because whoever is willing to wait in line the longest obtains the good which is being sold at less than the market clearing price. To calculate the total price we must add the price paid plus the opportunity cost of the time spent waiting.
1852.    Rationing by Random Assignment or Coupons: Random assignment means being given the good or service by some random selection process. Coupons are used to limit purchases by requiring the consumer to pay a price and give up a coupon.
186B.    The Essential Role of Rationing: Because of scarcity, it is not possible for everyone to have everything they want. There must be some method of rationing. Rationing by a freely functioning price system is the most efficient because all gains from mutually beneficial trade will be exhausted.
187IV.    The Policy of Government-Imposed Price Controls: The rationing function of prices is often not allowed to operate when government sets price controls called price floors (minimum legal prices) and price ceilings (maximum legal prices).
188A.    Price Ceilings and Black Markets: When a price ceiling is below the market-clearing price a shortage occurs. The result is fewer exchanges. Whenever the price system is not allowed to work, non-price rationing devices will evolve to ration the affected goods and services. An obvious example is queuing. Typically, an effective price ceiling leads to a black market in which the price-controlled good is sold at an illegally high price
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191V.    The Policy of Controlling Rents: Rent control is the placement of price ceilings on rents in particular municipalities.
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194A.    The Functions of Rental Prices:
1951.    Rent Controls and Construction: Rent controls have discouraged the construction of new rental property by depressing the most important long-term determinant of profitability—rent.
1962.    Effects on the Existing Supply of Housing: When rental rates are held below equilibrium levels, owners cannot recover through rents the cost of maintenance, repairs, and capital improvements, so owners curtail repairs and maintenance and quality decline. In some cases, buildings are abandoned or destroyed through arson, so the owners can collect insurance.
1973.    Rationing the Current Use of Housing: Rent controls restrict renter mobility and can cause housing gridlock.
198B.    Attempts to Evading Rent Controls: Landlords will make life unpleasant for tenants or evict them on the slightest pretense to be able to raise rents that can only be changed if tenants change. Tenants try to sublet apartments at fees above their rental payments. Rent courts attempt to prevent or restrict these activities.
199C.    Who Gains and Who Loses from Rent Controls?: Landlords are the biggest losers. Low-income persons lose because of “key money,” an illegal payment charged up front by some landlords and a reduced amount of housing. Upper income tenants who occupy rent-controlled housing gain the most.
200VI.    Price Floors in Agriculture
201A.    Price Supports: These are price floors. When a surplus develops, the government buys the surplus and stores it or sells it to foreign countries at a reduced price.
202B.    Who Benefits from Agricultural Supports?: Owners of big farms which produce more output get a large percentage of subsidies. All of the benefits derived from price support subsidies ultimately accrue to landowners on whose land price-support crops can be grown.
203VII.    Price Floors in the Labor Market: A minimum wage is a wage floor legislated by government below which it is usually illegal to pay workers. The effect is to cause unemployment for some low skill workers and depressed wages in areas not covered by the minimum wage.
204A.    Minimum Wages in the United States: The federal minimum wage began in 1938 at 25 cents per hour. It was raised to $5.15 in 1997 and may be higher now. Many states have minimum wages that exceed the federal minimum wage.
205B.    Economic Effects of a Minimum Wage: When the minimum wage exceeds the market-clearing wage, the quantity of labor supplied exceeds the quantity of labor demanded. There are fewer workers employed at the higher minimum wage but those who are employed earn a higher than market clearing wage.
206VIII.    Quantity Restrictions: Governments can impose quantity restrictions on a market, such as a ban on ownership or trading of goods (human organs and certain psychoactive drugs). The most common quantity restrictions in international trade are import quotas. A quota is a quantity restriction that prohibits the importation of more than a specified quantity of a particular good in a one-year period. The United States has had import quotas on tobacco, sugar, and immigrant labor. The beneficiaries of quotas are importers who get the quota rights and the domestic producers of the restricted good.
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242Chapter     5 – Public Spending and Public Choice
243I.    What a Price System Can and Cannot Do: The benefits of a price system are high levels of economic efficiency, the existence of consumer sovereignty, promotion of personal freedom, and prevention of coercion of buyers and sellers by the existence of competition. A price system can also produce market failure.
244II.    Correcting for Externalities: In a pure market system, competition generates economic efficiency only when individuals know and must bear the true opportunity costs of their actions.
245A.    Externalities: A consequence of an economic activity that spills over to affect third parties, i.e., parties who are not directly involved in a given activity or transaction. A lack of clearly assigned property rights, that is rights of an owner to use and exchange property, prevents market prices from reflecting all costs that spillover on third parties.
246B.    External Costs in Graphical Form:
247C.    External Benefits in Graphical Form:
248D.    Resource Misallocations of Externalities:
249E.    How the Government Can Correct Negative Externalities: When there are external costs the market will over allocate resources to the production of goods and services in question, that is price is too low and quantity is too high because all costs are not reflected in the good’s price.
2501.    Special Taxes: Taxes on output would reduce output, but would not provide an incentive to reduce pollution per unit of output. An effluent fee or tax on the amount of pollutants emitted would provide an incentive to reduce pollution per unit of output.
2512.    Regulation: The government could specify a maximum allowable rate of pollution.
252F.    How the Can Government Can Correct Positive Externalities
2531.    Government Financing and Production: When positive externalities are large (e.g., public goods), government may finance and produce the good or service.
2542.    Subsidies: A subsidy is a negative tax: a payment to the consumer or producer of a good or service for consuming or producing a good or service.
2553.    Regulation: Government can require that certain actions be undertaken, e.g., inoculations of school children.
256III.    The Other Economic Functions of Government: The functions of government that affect the way in which exchange and resource allocation are carried out in the economy.
257A.    Providing a Legal System: All relationships among consumers and businesses are governed by legal rules. Much of the legal system is involved with defining and protecting property rights.
258B.    Promoting Competition: Promoting competition is a way of increasing the efficiency of the economy. Antitrust legislation is used to reduce the power of monopolies and to discourage certain activities that restrain trade.
259C.    Providing Public Goods: Public goods are goods to which the principle of rival consumption does not apply and are jointly consumed by many individuals simultaneously. This is in contrast to private goods that can be consumed by only one person at a time.
2601.    Characteristics of Public Goods
261(a)    Public goods can be used by more and more people at no additional cost and without depriving others of any services of the goods.
262(b)    It is difficult to design a collection system for a public good on the basis of how much individuals use it.
2632.    Free Riders: The free rider problem is a situation associated with public goods when individuals presume others will pay for public goods, so they can escape paying for their portion without causing a reduction in production.
264D.    Ensuring Economywide Stability: The federal government is charged under the Employment Act of 1946 to stabilize the economy at high levels of employment.
265IV.    The Political Functions of Government: These are normative functions of government.
266A.    Merit and Demerit Goods: The government defines certain goods and services as desirable or undesirable. A merit good is a good that has been deemed socially desirable by the political process, and will be provided by government or subsidized. A demerit good is a good that has been deemed socially undesirable by the political process. It will be prohibited, taxed, or regulated to reduce consumption.
267B.    Income Redistribution: Government explicitly redistributes income by progressive taxation and by transfer payments and transfers in kind. Transfer payments are money payments made to individuals for which no services or goods are concurrently rendered. Transfers in kind are payments in the form of goods and services for which no goods or services are concurrently rendered.
268V.    Public Spending and Transfer Programs: Governments use tax revenues to fund spending on public goods, merit goods, and transfer payments.
269A.    Publicly Subsidized Health Care: Medicare: A federal program which pays hospital and physicians bills for persons over the age of 65. In return for paying a tax on earnings while in the workforce (currently 2.9 percent of wages and salaries), retirees are ensured that the majority of their hospital and doctor’s bills will be paid with public monies.
2701.    The Simple Economics of Medicare: By providing a subsidy, consumers of medical care perceive price to be lower than it is, while raising the price of care received by providers (hospitals and doctors).
2712.    Medicare Incentives at Work:
272(a)    A rapid growth of physicians’ incomes and medical school applications, the spread of for-profit hospitals and the rapid proliferation of new medical tests and procedures.
273(b)    Government expenditures on Medicare have routinely been higher than forecast.
274(c)    Total spending on medical services consumes far more income than initially expected.
2753.    Healthcare Subsidies Continue to Grow: Medicare’s cost has risen from 0.7 percent of U.S. National Income in 1970 to 2.8 percent today. This is about $400 billion per year today.
276B.    Economic Issues of Public Education: State and local governments in the U.S. spend about $500 billion or over 5 percent of national income on education. The federal government now also spends tens of billions of dollars through grants and transfers to state and local governments.
2771.    The Now-Familiar Economics of Public Education: Governments provide public education at prices well below those that would otherwise prevail in the marketplace for these services. The quantity of education services demanded is provided by the public schools as long as there is a large enough subsidy from state and local governments.
278The     Incentive Problems of Public Education: Since the 1960s, various     measures of the performance of U.S. primary and secondary students     have failed to increase even as spending on public education has     increased. Many economists argue that a higher subsidy results in     parents and students demanding lower valued services from schools.     Also public schools do not compete with each other and face no     unsubsidized competition.
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280VI.    Collective Decision Making: The Theory of Public Choice: Collective decision-making is how voters, politicians, and other interested parties act to influence nonmarket decisions. The theory of public choice is the study of collective decision-making.
281A.    Similarities in Market and Public–Sector Decision Making: There is an assumption of self-interest being the motivating force in both sectors.
2821.    Opportunity Cost: Because everything that is spent by government plus everything
283spent by the private sector must add up to total available income at any given time,
284every government action has an opportunity cost.
2852.    Competition: In the public sector the competition is between bureaucrats, elected representatives, and appointed officials for available funds. Economists assume that they will compete and act in their own interest not that of society.
2863.    Similarity of Individuals: Persons in government face a different incentive structure, i.e., the system of rewards and punishments individuals face with respect to their own actions. They are no different than persons who hold similar jobs in the private sector.
287B.    Differences Between Market and Collective Decision Making
2881.    Government Goods at Zero Price: Most goods and services governments produce or provide are provided to the user free of charge and are paid for by general tax revenues. Rarely does government adopt a user charge system whereby the consumer pays more or less directly for these goods and services by specific fees or taxes.
2892.    Use of Force: Governments can legally use force in the regulation of economic affairs, but those in the private sector cannot.
2903.    Voting versus Spending: In the market sector a dollar voting system exists and differs from the voting system in the public sector in three ways:
291(a)    In the political system one person equals one vote. In the market system one dollar equals one vote.
292(b)    The political system is run by majority rule. The market system is run by proportional rule.
293(c)    The spending of dollars can indicate intensity of want, whereas because of the all-or-nothing nature of political voting, a vote cannot.
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314    Chapter     6 – Funding the Public Sector
315     
316    Outline 
317
318I.    Paying for the Public Sector: The government budget constraint states that the sum of public spending on goods, services, and transfer payments during a given period cannot exceed tax revenues and borrowed funds.
319II.    Systems of Taxation: Because there is a government budget constraint, a major concern of any government is how to collect taxes.
320A.    The Tax Base and the Tax Rate: The tax base is the value of goods, services, wealth, or incomes subject to taxation. The government then sets a tax rate that is the proportion of a tax base that must be paid to government as taxes.
321B.    Marginal and Average Tax Rates: The marginal tax rate is defined as the change in the tax payment divided by the change in income, or the percent of additional dollars of income that must be paid in taxes. The average tax rate is defined as the total tax payment divided by total income. It is the proportion of total income paid in taxes.
322C.    Taxation Systems: All taxes can fit into one of three types of taxation systems: proportional, progressive, and regressive.
3231.    Proportional Taxation: A tax system in which as the individual’s income goes up, the tax bill goes up in exactly the same proportion. Average and marginal tax rates are equal and constant at each income level.
3242.    Progressive Taxation: A tax system in which as one earns more income, a higher percentage of the additional dollars is taxed. The marginal tax rate exceeds the average tax rate and both rise as income rises.
3253.    Regressive Taxation: A tax system in which as more dollars are earned, the percentage of tax paid on them falls is called a regressive tax system. The marginal tax rate is less than the average tax rate and both the marginal and average tax rates fall as income rises.
326III.    The Most Important Federal Taxes: The federal government imposes income taxes on both individuals and corporations. It collects social security taxes and a variety of other taxes.
327A.    The Federal Personal Income Tax: This tax accounts for 43 percent of federal revenues and is the most important tax in our economy. It is progressive up to a given income level. The evidence is not strong that the tax system has done much redistribution of income.
328B.    The Treatment Capital Gains: A capital gain is the positive difference between the selling and buying price of an asset. The capital gains tax is progressive.
329C.    The Corporate Income Tax: This tax accounts for about 11 percent of federal revenues. Corporations pay taxes on corporate profits and that tax is progressive.
3301.    Double Taxation: Corporate profits are taxed once as corporate profits with the tax paid by the corporations. Profits distributed as dividends to individuals are taxed again as personal income. If the corporation retains profits and invests them, the value of the business increases and its stock price rises. Upon selling the stock, the shareholder pays tax on the gain.
3312.    Who Really Pays the Corporate Income Tax?: Corporations do not really exist apart from owners, employees, and customers. The question arises of tax incidence, i.e., who pays the corporate income tax. Some economists say that corporations charge higher prices to pay the tax, while others argue that shareholders and employees get lower incomes.
332D.    Social Security and Unemployment Taxes: These are taxes on payrolls. The Social Security tax is a tax on earnings up to a taxable base. Currently, the employer and employee each pay 6.2 percent of the first $98,000 of earnings. A Medicare tax is imposed on all wage earnings at a rate of 2.9 percent. The Unemployment Tax is a payroll tax paid by the employer of 0.8 percent of the first $7,000 in annual wages of each employee who earns more than $1,500. The tax finances unemployment benefits.
333IV.    Tax Rates and Tax Revenues: The two fundamental issues that governments face when they try to fund their operations by taxing market activities are how tax rates can be set to maximize tax revenues for the government.
334A.    Sales Taxes: Taxes assessed on the prices paid on a large set of goods and services. They are ad valorum taxes, i.e., taxes assessed as a (constant) tax rate equal to the market price of each unit purchased. Sales taxes are proportional taxes. The revenue collected by the government equals the sales tax rate times the tax base, which is the market value of total purchases.
335B.    Static Tax Analysis: The economic evaluation of the effects of a change in tax rates that assumes that a change in tax rates has no effect on the tax base. The assumption is that an increase in the tax rate will increase tax collections.
336C.    Dynamic Tax Analysis: The economic evaluation of tax rate changes that recognizes that the tax base eventually declines with ever higher tax rates, so that tax revenues may eventually decline if the tax rate is raised sufficiently.
337D.    Maximizing Tax Revenues: Dynamic tax analysis indicates that as a tax rate increases, the tax base decreases. Initially, the tax rate increases faster than the tax base decreases and tax revenues increase. With ever higher tax rates, the tax base at some point decreases faster than the tax rate increases and government revenues fall.
338V.    Taxation from the Point of View of Producers and Consumers: Taxes on goods and services are levied by all levels of government. These taxes affect market prices and quantities.
339A.    Taxes and the Market Supply Curve: When governments levy taxes on producers and require them to charge these taxes when they sell their output, the effect is to cause a decrease in supply.
340B.    How Taxes Affect the Market Price and Equilibrium Quantity: The decrease in supply caused by the imposition of a tax causes equilibrium price to increase and equilibrium quantity to decrease.
341C.    Who Pays the Tax?: Both producers and consumers end up paying the tax depending on the price elasticity of demand. The amount paid by consumers is the difference between the (higher) equilibrium price after the tax is imposed and the initial equilibrium price. The amount paid by the producers is the difference between the initial equilibrium price and (lower) price net of tax after the tax is imposed.
342VI.    Financing Social Security: Along with Medicare, Social Security is one of the two major federal transfer programs. Based on current laws Social Security and Medicare will account for nearly half of federal spending within the next 20 years.
343A.    Good Times for the First Retirees: Social Security was passed during the Great Depression as a means of providing a minimum level of pension benefits to all residents.
3441.    Big Payoffs for the Earliest Recipients: The rate of return (also the inflation-adjusted return), which is the proportional annual benefit that results from making an investment, for the average 1940 retiree was 135 percent. This means that for every $100 in combined employee and employer contributions, the average 1940 retiree got $135 in benefits. The rate of return has fallen since then.
3452.    Slowing Membership Growth: Membership growth has decreased as the baby boom generation reached retirement, which has decreased the rate of return. Unless the system is reformed, persons under 30 will receive a negative rate of return.
346B.    What Will It Take to Salvage Social Security?: Benefits could exceed tax revenue by 2010.
3471.    Raise Taxes: One proposal, to increase the payroll tax rate, would require an increase
348by 2.2 percent of wages and salaries currently subject to the tax. Another proposal is to eliminate the wage cap to which the payroll tax is applied. Even these increases would
349not keep revenues greater than benefits in the long-run.
350    
351     Reduce     Retirement Benefit Payouts: Proposals include raising the age     for full eligibility
352 to 70 and imposing “means testing” on     some or all Social Security benefits.
353     
354    Reduce     Disability Benefits: Tighten up eligibility requirements or     separate it from Social Security.
355
3564.    Reform Immigration Policies: Modify the immigration laws to admit persons based on their skills or training that makes them valuable in the labor market in the United States. They will increase payroll tax payments.
3575.    Find a Way to Increase Social Security’s Rate of Return: Have the Treasury buy stocks. One problem is politically motivated investing. Others are that the market returns are uncertain.
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384    Chapter     7 – The Macroeconomy: Unemployment, Inflation and Deflation
385     
386    Outline 
387
388I.    Unemployment: Unemployment is the number of adults (16 years or older) who are willing and able to work and who are actively looking for work but have not found a job.
389A.    Historical Unemployment Rates: The proportion of the labor force that is unemployed. The labor force is the number of persons 16 years of age or older whom have jobs plus the number who are looking and available for jobs.
390B.    Employment, Unemployment, and the Labor Force: All persons 16 years of age and over can be classified as not in the labor force (i.e., homemakers, and those in school), employed, or unemployed. Then the employed are subtracted from the labor force to get the unemployed. The unemployment rate is the number of unemployed divided by the labor force times 100.
391C.    The Arithmetic Determination of Unemployment: The number of unemployed is a stock while the number getting jobs and losing jobs is a flow concept. As long as the flows are equal, the unemployment rate is constant.
3921.    Categories of Individuals Who Are Without Work: A person is considered unemployed in any of the following instances:
393(a)    A Job Loser: A person who was involuntarily terminated or laid off (40–60 percent of the unemployed).
394(b)    A Reentrant: A person who has worked full-time before, but who left the labor force (20–30 percent of the unemployed).
395(c)    A Job Leaver: A person who voluntarily ended employment (10–15 percent of the unemployed).
396(d)    A New Entrant: A person who has never worked at a full-time job for more than two weeks or more (10–13 percent of the unemployed).
3972.    Duration of Unemployment: The duration of unemployment is inversely related to the overall level of economic activity. The average duration of unemployment is 3.4 months.
3983.    The Discouraged Worker Phenomenon: Individuals who have stopped looking for jobs because they do not believe that they can find one are called discouraged workers.
3994.    Labor Force Participation: This is the proportion of working age persons who are in the labor force. The statistic can be computed for any group.
400D.    The Major Types of Unemployment:
4011.    Frictional Unemployment: Unemployment due to the fact that workers must search for appropriate job offer. This takes time, so they remain temporarily unemployed.
4022.    Structural Unemployment: Unemployment resulting from a poor match of workers’ skills and abilities with current requirements of employers. It also includes persons who are unemployed because of labor-market policies by government that make it expensive to employ workers (e.g., social insurance programs) and to fire them or lay them off by closing plants.
4033.    Cyclical Unemployment: Unemployment resulting from recessions.
4044.    Seasonal Unemployment: Unemployment resulting from the seasonal pattern of work in specific industries due to weather or demand patterns. The official reported unemployment rate reported each month is seasonally adjusted and thus reflects only the sum of frictional, structural, and cyclical unemployment.
405E.    Full Employment and the Natural Rate of Unemployment: Economists use the concept of the natural unemployment rate, which is an unemployment rate that takes into account only frictional and structural unemployment as a measure of full employment. It is estimated to be an unemployment rate of roughly 5 percent today.
406II.    Full Employment and the Natural Rate of Unemployment: Full employment does not mean that everyone has a job. The transactions costs in the labor market are not zero.
407A.    Full Employment: A level of unemployment that corresponds to frictional unemployment in the labor market.
408B.    The Natural Rate of Unemployment: The rate of unemployment that is estimated to prevail in long-run macroeconomic equilibrium, when all workers and employers have fully adjusted to any changes in the economy. It includes only frictional and structural unemployment.
409III.    Inflation and Deflation: The situation in which the average of all prices of goods and services in an economy is rising. Deflation is a situation in which the average of all prices in an economy is falling.
410A.    Inflation and the Purchasing Power of Money: The value of a person’s money income in buying goods and services is its purchasing power or the real value of the money. The price of anything expressed in today’s dollars. The purchasing power of money varies inversely with the price level.
411B.    Measuring the Rate of Inflation: Inflation is measured by a price index.
4121.    Computing a Price Index: A fixed quantity price index is the cost of today’s market basket of goods expressed as a percentage of the cost of the same market basket in a base year. It
413is computed by dividing the cost of today’s market basket by the cost of that same market basket in the base year times 100.
4142.    Real World Price Indexes:
415(a)    The CPI: The CPI is a weighted average of a specified set of goods and services purchased by consumers in urban areas.
416(b)    PPI: A statistical measure of a weighted average of prices of goods and services that firms produce and sell.
417(c)    GDP Deflator: The GDP Deflator is a price index that measures the changes in prices of all new final goods and services produced in the economy.
418(d)    PCE Index: A statistical measure of average prices using annually updated weights based on surveys of consumer spending.
419(e)    Historical Changes in the CPI:
420IV.    Anticipated versus Unanticipated Inflation: Unanticipated inflation is inflation that comes as a surprise. Anticipated inflation is the inflation rate that we believe will occur and can be either higher or lower than the actual rate.
421A.    Inflation and Interest Rates: The nominal interest rate is the market rate of interest. The real rate of interest is the nominal rate minus the anticipated rate of inflation. Evidence shows that inflation rates and nominal interest rates move together.
422B.    Does Inflation Necessarily Hurt Everyone?
4231.    Unanticipated Positive Inflation: Creditors Lose and Debtors Gain: Creditors lose because the debtor is charged an interest rate that does not cover the actual inflation rate. If unanticipated inflation is greater than actual inflation, creditors gain and debtors lose.
4242.    Protecting Against Inflation: Banks and other lenders raise interest rates to protect themselves from anticipated inflation. Workers seek cost-of-living adjustments, i.e., automatic increases in wage rates to offset inflation.
4253.    The Resource Cost of Inflation: Businesses and individuals use resources to protect themselves from inflation, e.g., re-pricing goods and service. The resources could have been used to produce additional goods and services.
426V.    Changing Inflation and Unemployment: Business Fluctuations: These are the ups (expansions) and downs (contractions) in business activity throughout the economy. A recession is a contraction or downturn in the level of business activity. The dating of recessions is done by the National Bureau of Economic Research
427A.    A Historical Picture of Business Activity in the United States: Historical changes in U.S. business activity are shown in book.
428B.    Explaining the Business Fluctuations: External Shocks: While many downturns in economic activity have been caused by external shocks to the economy, e.g., war, changes in oil prices, and weather, many others have occurred without any external shock. A macroeconomic theory is needed to explain business cycles and is presented in later chapters. Leading indicators are events that have been found to exhibit changes before changes in business activity.
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462    Chapter     8 – Measuring the Economy’s Performance
463     
464    Outline 
465
466I.    The Simple Circular Flow: The concept of a circular flow of income involves two principles; (1) in every economic exchange, the seller receives exactly the same amount that the buyer
467spends and (2) goods and services flow in one direction and money payments flow in the other.
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470A.    Profits Explained: Profits are a part of costs because entrepreneurs must be rewarded for providing their services, or they will not provide them.
471B.    Total Income or Total Output: Total income is the total of all individuals’ income and is also defined as the annual cost of producing the entire output of final goods and services. Total output is the value of all of the final goods and services produced in the economy during the year.
4721.    Product Markets: Product Markets are where households are the buyers and businesses are the sellers of consumer goods.
4732.    Factor Markets: In the Factor Markets households are the sellers; they sell resources such as labor, land, capital, and entrepreneurial ability.
474C.    Why the Dollar Value of Total Output Value Must Equal Total Income: Total income is income earned by households in payment for the production of these goods and services. The value of total output is identical to total income, since spending by one group is income to another.
475II.    National Income Accounting: A measurement system used to estimate national income and its components.
476A.    Gross Domestic Product (GDP): The total market value of all final goods and services produced by factors of production located within a nation’s borders in a year. GDP is a flow, i.e., an activity that occurs over time. Contrast this with a stock measured at a point in time.
477B.    The Stress on Final Output: GDP does not count intermediate goods (goods used up entirely in the production of final goods) because to do so would be to double count. Value added is the amount of dollar value contributed to a product at each state of production.
478C.    Exclusion of Financial Transactions, Transfer Payments, and Secondhand Goods: Many transactions occur that have nothing to do with final goods and services produced.
4791.    Financial Transactions: There are three categories of purely financial transactions:
480(a)    Securities: The value of brokers’ services is included in GDP when an investor buys or sells securities because they perform a service.
481(b)    Government Transfer Payments: Transfer payments are payments for which no productive services are concurrently provided in exchange.
482(c)    Private Transfer Payments: This is a private transfer of funds from one person to another and these are not included in GDP.
4832.    Transfer of Secondhand Goods: The value of secondhand goods is included in the GDP in the year they were produced.
4843.    Other Excluded Transactions
485(a)    Household Production: Tasks performed by homemakers within their households for which they are not paid through the marketplace.
486(b)    Otherwise Legal Underground Transactions: Legal transactions that are not reported and not taxed.
487(c)    Illegal Underground Activities: These activities include prostitution, illegal gambling, and sale of illegal drugs, etc.
488D.    Recognizing the Limitations of GDP: GDP is a measure of production and an indicator of economic activity. It is not a measure of a nation’s welfare. It excludes nonmarket activity and says little about our environmental quality of life.
489III.    Two Main Methods of Measuring GDP: The expenditure approach is a way of adding up the dollar value at current market prices of all final goods and services. The income approach could also be used, by adding up the income received by everybody producing final goods and products.
490A.    Deriving GDP by the Expenditure Approach: The components of total expenditures are added together.
4911.    Consumption Expenditures (C): Consumption expenditures fall into three categories; durable consumer goods, non-durable goods, and services.
4922.    Gross Private Domestic Investment (I): When economists refer to investment, they are referring to expenditures that represent an addition to our future productive capacity. Investment consists of fixed investment, changes in inventories, and consumer expenditures on new residential structures.
4933.    Fixed versus Inventory Investment: Fixed investment is the purchase of capital goods which increase productive capacity in the future. Inventory investment represents net additions to the stock of goods that can be consumed in the future.
4944.    Government Expenditures (G): The government buys goods and services from private firms and pays wages and salaries to government employees. Since many government
495goods are not sold in the marketplace, we value them at their cost.
4965.    Net Exports (Foreign Expenditures): Net exports (X) are equal to total exports minus total imports.
497B.    Presenting the Expenditure Approach: GDP is C I G X. C is consumption spending, I is investment spending, G is government purchases, and X is net exports.
4981.    The Historical Picture: When we sum up the expenditures of the household, government, business, and foreign sectors, we get GDP.
4992.    Depreciation and Net Domestic Product: Depreciation is a reduction in the value of capital goods over a one-year period due to physical wear and obsolescence; also, called capital consumption allowance. NDP GDP – depreciation (capital consumption allowances) or NDP C I G net exports depreciation. Since net I gross I depreciation: NDP C net I G net exports. Net investment measures changes in our capital stock over a one-year period.
500C.    Deriving GDP by the Income Approach: The second approach to calculating GDP is the income approach, which looks at total factor payments. Total income is all income earned by the owners (or resources) who put their factors of production to work. Using this approach gross domestic income or GDI is computed and GDI is identically equal to GDP.
5011.    Wages: Wages, salaries, and other forms of labor income, such as income in kind and incentive payments. Social Security taxes paid by both the employees and employers are also counted.
5022.    Interest: Only interest received by households plus net interest paid to us by foreigners is included.
5033.    Rent: Income earned by individuals for the use of their real (non-monetary) assets, such as farms and houses.
5044.    Profits: Total corporate profits plus proprietors’ income, i.e., income earned from the operation of unincorporated businesses, which include sole proprietorships, partnerships, and producers’ cooperatives.
5055.    Indirect Business Taxes: All business taxes except the tax on corporate profits. Indirect business taxes include sales and business property taxes.
5066.    Depreciation: Depreciation must be added to Net Domestic Income to get Gross Domestic Income. Depreciation can be thought of as the portion of the current year’s GDP that is used to replace physical capital consumed in the process of production. Since somebody has paid for the replacement, depreciation must be added as a component of gross domestic income. Net Domestic Product (NDP) is GDP minus depreciation.
507D.    Other Components of National Income Accounting:
5081.    National Income (NI): National Income is the total of all factor payments to resource owners. It can be obtained by subtracting indirect business taxes from NDP.
5092.    Personal Income (PI): Personal Income (PI) is the amount of income that households actually receive before they pay personal income taxes.
5103.    Disposable Personal Income (DPI): DPI is personal income after personal income taxes have been paid.
511IV.    Distinguishing Between Nominal and Real Values: Nominal values are the values of variables such as GDP and investment expressed in current dollars (actual market prices), also called money values. Real values measure economic values after adjustments have been made for changes in the average of prices between years.
512A.    Correcting GDP for Price Changes: A price index that approximates the changes in overall prices is divided into the value of GDP in current dollars to adjust the value of GDP to what is called constant dollars. Constant dollars are dollars expressed in terms of purchasing power using a base year or standard of comparison. Price-corrected GDP is called real GDP.
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515B.    Plotting Nominal and Real GDP:
516C.    Per Capita Real GDP: This is the calculation of the amount of GDP per person. Compute real GDP and divide by the total population.
517V.    Comparing GDP Throughout the World: It is easy to compare living standards of families living in the same country because they use the same currency. When we compare families in different countries, there is a problem with different currencies and cost of living differences.
518A.    Foreign Exchange Rates: A foreign exchange rate is the price of one currency in terms of another. Thus if one franc costs 20 cents and French per capita income is 100,000 francs per year, then French per capita dollar income is $20,000 per year. GDP can be calculated the same way.
519B.    True Purchasing Power: Using purchasing power parity, an adjustment is made in exchange rate conversions that takes into account the true cost of living across countries.
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531    Chapter     9 – Global Economic Growth and Development
532     
533    Outline
534
535I.    How Do We Define Economic Growth?: Increases in per capita real GDP over time. It is measured by the rate of change of real GDP per capita per year. If there is economic growth, the production possibilities curve will shift outward
536A.    Problems in Definition: Real standards of living can go up without any positive economic growth when individuals are, on average, enjoying more leisure by working fewer hours, but producing as much as before. Growth tells us nothing about the distribution of output and income.
537B.    Is Economic Growth Bad?: Anti-growth proponents suggest that economic growth is bad because it raises expectations faster than income. Our measures of growth allow us to make comparisons across countries and time and provide a serviceable measure of productivity.
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540C.    The Importance of Growth Rates: Small differences in the growth rate are important. In50 years, $1 trillion per year becomes $4.38 trillion per year if compounded at 3 percent per year. One percentage point more in the growth rate, i.e., to a growth rate of 4 percent, increases the amount to $7.11 trillion.
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543II.    Productivity Increases: The Heart of Economic Growth: Labor productivity is real GDP divided by the number of workers (output per worker). Increases in labor productivity lead to increases in the standard of living. If all resources are divided up into labor and capital, then the growth of per capita GDP is the cumulative contribution of the growth of capital, the growth of labor, and the rate of growth of capital and labor productivity
544III.    Saving: A Fundamental Determinant of the Rate of Economic Growth: Higher savings rates lead to higher living standards in the long-run, other things equal, because investment and the capital stock will increase.
545IV.    New Growth Theory and the Determinants of Growth: New Growth Theory examines factors that determine why technology, research, innovation, and the like are undertaken and how they interact.
546A.    Growth in Technology: The growth of the power of the personal computer is given as an example of technological change.
547B.    Technology: A Separate Factor of Production: One of the major foundations of new growth theory is that the greater the rewards, the more technological advances we will get.
548C.    Research and Development: Technological advance can come from R&D that develops new materials, products, and processes. Thus, some technological advance depends on the rate of spending on R&D and business spending on R&D depends on expected profits. The greater the reward, the more technological advances we will get.
5491.    Patents: A 20-year monopoly on a new product or technique granted by the federal government to an inventor.
5502.    Positive Externalities and R&D: Some of the results of R&D spending accrue to others who benefit without paying. An estimated 25 percent of R&D spending in the top 7 industrialized countries accrues to foreigners.
551D.    The Open Economy and Economic Growth: Open economies can experience higher rates
552of growth than closed economies, because free trade encourages a more rapid spread of technology and industrial ideas and may give domestic industries access to a bigger market.
553E.    Innovation and Knowledge: Innovation involves transforming an invention into something that benefits the economy. Much innovation involves small improvements in the use of an existing technology.
554F.    The Importance of Ideas and Knowledge: Past investment in capital may make it more profitable to acquire more knowledge. There exists the possibility of an investment-knowledge cycle where investment spurs knowledge and knowledge spurs investment. Therefore knowledge, like capital, has to be paid for by forgoing current consumption. Knowledge can be viewed as a store of ideas. Thus, economic growth can continue as long as we keep coming up with new ideas.
555G.    The Importance of Human Capital: Increases in the productivity of the labor force are a function of increases in human capital. Human capital is at least as important as physical
556capital.
557V.    Immigration, Property Rights, and Growth: New theories of growth shed light on the impact of immigration and property rights on the rate of growth of real GDP per capita.
558A.    Population and Immigration as They Affect Economic Growth: Population increases the labor supply, technological progress by increasing the number of geniuses, and by creating new spending that stimulates new businesses.
559B.        Property Rights and Entrepreneurship: The more securely property rights are assigned, the more capital investment there will be and thus the higher will be the rate of economic growth.
560VI.    Economic Development: The essential issue of development economics is why some countries grow and develop and others do not and the policies that might help developing countries get richer.
561A.    Putting World Poverty into Perspective: At least one-third of the world’s population lives at subsistence level. The official poverty level in the United States exceeds the average income of at least one-half of the world’s population.
562B.    The Relationship Between Population Growth and Economic Development: World population is expected to reach approximately 9.3 billion by the year 2050, up from 7 billion today. Excessive population growth has been a concern ever since Malthus’ day (1798).
5631.    Malthus Was Proved Wrong: As population has grown, the amount of food produced as measured by calories per person has increased. Also, the relative price of food has fallen for more than a century.
5642.    Growth Leads to Smaller Families: As nations get richer, the average family size declines.
565C.    The Stages of Development: Agriculture to Industry to Services: Modern rich nations
566went through three stages as they developed, from the dominance of agriculture to that of manufacturing and finally to the dominance of services. It is important that nations that wish to develop specialize in those products in which they have comparative advantage.
567D.    Keys to Economic Development
5681.    Establishing a System of Property Rights: The more certain property rights are, the more capital accumulation and economic growth there will be, other things being equal.
5692.    Developing an Educated Population: Developing countries can advance more rapidly if they increase investments in education.
5703.    Letting “Creative Destruction” Run Its Course: “Creative destruction” occurs when new businesses ultimately create new jobs and economic growth after first destroying old jobs, old companies, and old industries.
5714.    Limiting Protectionism: Open economies experience faster economic development than do economies that are closed to international trade.
572    Chapter     10 – Real GDP and the Price Level in the Long Run     
573     
574    Outline
575
576I.    Output Growth and the Long-Run Aggregate Supply Curve: The total of all planned production for the entire economy is referred to as the aggregate supply of real output.
577A.    The Long-Run Aggregate Supply Curve: The long-run aggregate supply curve (LRAS) is some amount of output of real goods and services in a world in which technology is constant, the price level has not changed, labor productivity has not changed, all resources are fully employed, and people have fully adjusted to all the information they have. The curve is a vertical line relating full employment real GDP to the price level.
578B.    Economic Growth and Long-Run Aggregate Supply: Economic growth is shown by the outward shifting of the production possibilities curve or as the LRAS curve shifting to the right over time. A long-run growth or trend path can be derived showing real GDP at full employment over time.
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581II.    Total Expenditures and Aggregate Demand: The spending decisions of individuals, firms, governments, and foreigners determine the total value of nominal GDP. There are two issues that need to be addressed. The first issue is what determines the total amount that individuals, governments, businesses, and foreigners want to spend? Second, what determines the equilibrium price level and the rate of inflation? The total of all planned expenditures in the entire economy is called aggregate demand.
582A.    The Aggregate Demand Curve: The aggregate demand curve shows planned purchase rates for all final goods and services in the economy at various price levels, other things constant.
583B.    What Happens When the Price Level Rises?
5841.    The Real-Balance Effect: The change in expenditures resulting from the real value of money balances when the price level changes. A rise in the price level decreases the real value of a given amount of money balances and planned spending will decrease.
5852.    The Interest Rate Effect: Higher prices result in a rising interest rate. Households spend less on consumer durables businesses spend less on capital investments, and the aggregate quantity of goods and services demanded decreases.
5863.    The Open Economy Effect: The Substitution of Foreign Goods: An increase in the price level in the United States makes U.S. goods relatively more expensive compared with foreign produced goods. Planned purchases of domestically produced goods will fall and planned purchases of foreign produced goods (imports) will rise. Foreigners will no longer want to purchase as much U.S. production as before and U.S. exports will fall. The aggregate quantity of U.S. produced goods and services demanded falls.
587C.    What Happens When the Price Level Falls?: There are the same three effects when the price level falls as when it rises, they just have the reverse effect on the aggregate quantity of goods and services demanded.
588D.    Demand for All Goods and Services versus Demand for a Single Good or Service: When the aggregate demand curve is derived, the entire economic system is viewed. The aggregate demand curve differs from an individual demand curve because it shows the circular flow of income and product constructed as AD.
589III.    Shifts in the Aggregate Demand Curve: When non-price level determinants of aggregate demand change, a shift in the aggregate demand curve occurs. Any non-price-level change that increases aggregate spending on domestic goods shifts AD to the right. Any non-price-level change that decreases aggregate spending on domestic goods shifts AD to the left.
590IV.    Long-Run Equilibrium and the Price Level: Long-run equilibrium occurs at the intersection of the aggregate demand and the long-run aggregate supply curve. At this point planned real expenditures for the entire economy equal actual full employment real GDP produced by firms.
591A.    The Long-Run Equilibrium Price Level: The economy’s long-run equilibrium price level occurs at the point at which the aggregate demand curve crosses the long-run aggregate supply curve.
5921.    Economic Growth and Secular Deflation: If all factors that affect total planned real expenditure are unchanged so that the aggregate demand curve does not move during 10 year interval, then economic growth as shown by an outward shifting long-run aggregate supply curve results in deflation.
5932.    Secular Deflation in the United States: Between 172 and 1895 the price level in the U.S. fell. Founders of populism wanted the U.S. government to issue new money backed by silver. The effect would have been to increase aggregate demand. The movement was not successful in getting the money supply growing fast enough.
594B.    The Effects of Economic Growth on the Price Level: If LRAS increased over time and aggregate demand stayed constant, the price level would fall and there would be secular deflation. If aggregate demand increased at the same rate as LRAS, the price level would remain constant.
5951.    Economic Growth and Secular Deflation: From 1872 to 1894 the price level fell. To counter the deflation, a group of populists called for an increase in the money supply by having the government issue new currency backed by silver. The effect would have been
596to increase aggregate demand and stop the deflation.
5972.    Secular Deflation in the United States: In 1890 the experiment with silver backed money began. In 1893 there was a financial panic and the experiment ended with the repeal of the Silver Purchase Act.
598V.    Causes of Inflation:
599A.    Supply-Side Inflation?: Inflation could be caused by a decrease in aggregate supply with a given aggregate demand curve. This cannot be the explanation of inflation for the persistent
600or secular inflation, because of the long-run increase in population, productivity, and real GDP, i.e., the aggregate supply curve has shifted to the right
601B.    Demand-Side Inflation: If the aggregate demand curve shifts rightward over time at a pace faster than the rightward progression of aggregate supply, then persistent or secular inflation will occur.
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617    Chapter     11 – Classical and Keynesian Macro Analysis
618     
619    Outline
620
621I.    The Classical Model: This model, which traces its origins to the 1770s, was the first systematic attempt to explain the determinants of the price level and the national levels of output, income, employment, consumption, saving and investment.
622A.    Say’s Law: Supply creates its own demand, or desired aggregate expenditures will equal actual aggregate expenditures. People only produce more goods than they want because they want to trade them for other goods. It follows that full employment of labor and other resources would be the normal state of affairs in such economies.
623B.    Assumptions of the Classical Model: Supply creates its own demand, or desired expenditures will equal actual expenditures. There are four major assumptions:
6241.    Pure Competition Exists: No single buyer or seller of a commodity or an input can affect its price.
6252.    Wages and Prices Are Flexible: Prices, wages, and interest rates are free to move to the level dictated by supply and demand in the long-run.
6263.    People Are Motivated by Self-Interest: There is an underlying assumption that businesses want to maximize their profits and households want to maximize their economic well–being.
6274.    People Cannot Be Fooled by Money Illusion: Buyers and sellers react to changes in relative prices.
628C.    Equilibrium in the Credit Market: When income is saved, it is not reflected in product demand. Consumption expenditures can fall short of total output when saving occurs. The classical economists argued that each dollar saved would be invested by businesses. In the credit market the interest rate equates the quantity of credit demanded with the quantity of credit supplied and thus planned investment equals planned saving. Saving represents the supply of credit and investment represents the demand for credit.
6291.    The Relationship Between Saving and Investment: The Classical Economists believed that each dollar saved would be invested by business.
6302.    The Equilibrium Interest Rate: Equilibrium between the saving plans of consumers and investment plans of businesses occurs at the interest rate that is determined by the intersection of the desired saving and desired investment curves.
631D.    Equilibrium in the Labor Market: In the Classical Model if an excess quantity of labor is supplied at a particular wage level, the wage level is too high and some workers are unemployed. By accepting lower wages, unemployed workers will be put back to work. Only structural and frictional unemployment will exist in this model, that is, there is a natural rate of unemployment.
6321.    The Relationship Between Employment and Real GDP: The level of employment in an economy determines, other things held constant, it’s real GDP.
633E.    Classical Theory, Vertical Aggregate Supply, and the Price Level: In the Classical Model long-term involuntary unemployment is impossible. Say’s law, coupled with flexible interest rates, prices, and wages, tends to keep workers fully employed so the aggregate supply curve (LRAS) is vertical at full employment. Full employment is the amount of employment that would be produced year in and year out in an economy with full information and full adjustment of wages and prices.
6341.    Effect of an Increase in Aggregate Demand in the Classical Model: There will be an increase in the price level as wages rise in response to an increase in the demand for labor which is at full employment. Other input prices will also rise. The level of real GDP will remain unchanged on the LRAS curve.
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6372.    Effect of a Decrease in Aggregate Demand in the Classical Model: There will
638be a decrease in the price level as wages fall in due to a decrease in the demand for labor which causes workers to bid down wages in response to an increase in unemployment. Other input prices will fall. The level of real GDP will remain unchanged on the LRAS curve.
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641II.    Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve: A horizontal short-run aggregate supply curve is called the Keynesian short-run aggregate supply curve. According to Keynes, the existence of unions and long-term contracts between workers and employers in and outside unionized environments can explain downward inflexibility of nominal wage rates. Such “stickiness” of wages makes involuntary unemployment of labor a possibility. Even in situations of excess capacity and large amounts of unemployment, the price level may not fall. There may be continuing unemployment and a reduction in the equilibrium level of real GDP per year.
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644III.    Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short-Run: An increase in aggregate demand using the Keynesian SRAS curve results in real GDP increasing by the amount of the increase in aggregate demand. When the price level can vary, i.e., the SRAS curve is upward sloping, then real GDP increases by less than the increase in aggregate demand because part of the increase in nominal GDP is a result of an increase in the price level.
645A.    Reasons for Upward-Sloping Short-Run Aggregate Supply
6461.    Flexibility of Hours and Work. Employers can require workers to work more hours and to work harder.
6472.    Existing Capital Can Be Used More Intensively.
6483.    Profits Rise if Prices Go Up but Wage Rates Do Not. Firms will produce more as profit rise.
649IV.    Shifts in the Aggregate Supply Curve: There is a core class of events that causes a shift in both the short-run and long-run aggregate supply curves.
650A.    Shifts in Both Short- and Long-Run Aggregate Supply: Any change in the endowments of the factors of production, and any change in the level of technology or knowledge shifts the aggregate supply curve.
651B.    Shifts in SRAS Only: The most obvious occurrence that causes a shift in SRAS is a temporary change in input prices.
652V.    Consequences of Changes in Aggregate Demand: Aggregate demand shocks are any unanticipated shocks that cause the aggregate demand curve to shift inward or outward. Aggregate supply shocks are any unanticipated shocks that cause the aggregate supply curve to shift inward or outward.
653A.    Effects When Aggregate Demand Falls While Aggregate Supply Is Stable: A decrease
654in AD will decrease the price level and real GDP. If equilibrium real GDP is less than full employment real GDP on LRAS, the difference between full employment real GDP and equilibrium real GDP is defined as a recessionary gap.
655B.    Short-Run Effects When Aggregate Demand Increases: The price level and real GDP increase. If equilibrium real GDP is greater than full employment real GDP on LRAS, the difference between full employment and actual real GDP is defined as an inflationary gap.
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658VI.    Explaining Short-Run variations in Inflation
659A.    Demand-Pull versus Cost-Push Inflation: Inflation caused by increases in AD that are not matched by increases in aggregate supply.
660B.    Aggregate Demand and Supply in an Open Economy: The effect of exchange rates and trade with the rest of the world has an impact on both the aggregate supply and the aggregate demand curves.
6611.    How a Weaker Dollar Affects Aggregate Supply: A weaker dollar increases the dollar price of imported inputs and shifts the SRAS to the left.
6622.    How a Weaker Dollar Affects Aggregate Demand: A weaker dollar increases the dollar price of imports and decreases the price of exports in terms of foreign currency. Thus U.S. exports increase and imports decrease, that is, net exports increase, and the aggregate demand curve shifts to the left.
6633.    The Net Effects on Inflation and Real GDP: An increase in aggregate demand and a decrease in aggregate supply will have an indeterminate effect on real GDP. If AD increases by more than SRAS decreases then real GDP will increase. If AD increases by less than SRAS decreases then real GDP will decrease. What is clear is that the price level will increase.
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690    Chapter     12 – Consumption, Real GDP, and the Multiplier
691     
692    Outline
693
694I.    Some Simplifying Assumptions in a Keynesian Model: (1) Businesses pay no indirect taxes, such as sales taxes. (2) Businesses distribute all of their profits to shareholders. (3) There is no depreciation, or capital consumption allowances, so gross private domestic investment equals net investment.
695(4) The economy is closed. Given all these simplifying assumptions, real disposable income or after-tax real income will be equal to real GDP minus taxes.
696A.    Another Look at Definitions and Relationships: Consumption is the act of using income for the purchase of consumption goods. Consumption goods are goods purchased by households for immediate satisfaction. By definition, whatever is not consumed is saved.
6971.    Stocks and Flows: The Difference Between Saving and Savings: It is important to distinguish between saving and savings. Saving is an action that occurs at a particular rate. This rate is a flow. It is expressed per unit of time. Savings, by contrast, is a stock measured at a certain point or instant in time.
6982.    Relating Income to Saving and Consumption: Consumption saving disposable income. This is called an accounting identity. It has to hold true at every moment in time. From it the definition of saving is: Saving disposable income – consumption.
6993.    Investment: A flow concept that includes fixed investment which is defined as expenditures on new machines, buildings and equipment, i.e., capital goods, and inventory investment, (changes in business inventories).
700II.    Determinants of Planned Consumption and Planned Saving: The consumption function shows the relationship between planned consumption and various levels of disposable income. Real saving and consumption decisions depend primarily on an individual’s present real disposable income
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703A.    Graphing the Numbers:
704B.    Dissaving and Autonomous Consumption: The amount of planned consumption that does not depend at all on disposable income is called autonomous consumption. Changes in autonomous consumption shift the consumption function. Dissaving is negative saving. It is a situation where spending exceeds income.
705C.    Average Propensity to Consume and to Save:
7061.    Average Propensity to Consume (APC): Consumption divided by disposable income; the proportion of total disposable income that is consumed.
7072.    Average Propensity to Save (APS): Saving divided by disposable income; the proportion of total disposable income that is saved.
708D.    Marginal Propensity to Consume and to Save:
7091.    Marginal versus Average Propensities: The change in consumption divided by the change in disposable income.
7102.    Distinguishing the MPC from the APC: The change in saving divided by the change in disposable income.
711E.    Some Relationships:
7121.    APC APS 1 (100 percent of total income).
7132.    MPC MPS 1 (100 percent of the change in income)
714F.    Causes of Shifts in the Consumption Function: Whenever there is a change in non-income determinants of consumption, the consumption curve shifts upward or downward. A change in population up or down, a change in expectations or a change in real household wealth will cause the consumption function to shift.
715III.    Determinants of Investment: Investment is defined as expenditures on new plant, capital equipment, and changes in business inventories. Real gross private domestic investment in the United States has been volatile compared to real consumption, because investment decisions of business people are based on highly variable, subjective expectations of the economic future.
716A.    The Planned Investment Function: At all times businesses perceive an array of investment opportunities. Since each project is profitable only if its rate of return exceeds the rate of interest; it follows that as the interest rate falls, planned investment spending increases, and vice versa. The investment function is represented as an inverse relationship between the rate of interest and the quantity of planned investment.
717B.    What Causes the Investment Function to Shift: If non-interest rate determinants of investment change, the investment schedule will shift. Expectations of businesses concerning sales and profits, changes in productive technology, and changes in business taxes cause a shift in the investment function.
718IV.    Determining Equilibrium Real GDP: Net taxes average about 15 percent of real GDP. Assuming that real disposable income differs from real GDP by the same absolute amount every year, real GDP can be substituted for real disposable income in the consumption function.
719A.    Consumption as a Function of Real GDP: The model of consumption is simplified by assuming that real disposable income differs from real GDP by a constant amount. Thus real GDP can be substituted for real disposable income in the consumption function.
720B.    The 45-Degree Reference Line: The line along which planned expenditures are equal to real GDP.
721C.    Adding the Investment Function: In the simplified Keynesian model real investment per year is assumed to be autonomous with respect to real GDP.
722D.    Savings and Investment: Planned versus Actual: Equilibrium occurs at the intersection of the planned saving and planned investment schedules. There is no tendency for businesses to alter the rate of production or the level of employment because they are neither increasing nor decreasing their inventories in an unplanned way. When the saving rate planned by households differs from the investment rate planned by businesses, there will be an increase or decrease in real GDP in the form of unplanned inventory changes. Real GDP and employment will change until unplanned inventory changes are again zero.
7231.    Unplanned Increases in Business Inventories: If consumers buy less than businesses had anticipated, then inventories will increase to levels that businesses had not planned. They will reduce production and employment and real GDP will decrease.
7242.    Unplanned Decreases in Business Inventories: If consumers buy more than businesses had anticipated, then inventories will decrease to levels that businesses had not planned. They will increase production and employment and real GDP will increase.
725V.    Keynesian Equilibrium with Government and the Foreign Sector Added:
726A.    Government: Resource-using federal, state, and local government purchases are politically determined and can thus be considered autonomous.
727B.    The Foreign Sector: The level of exports depends on international economic conditions in the countries that buy U.S. products. Imports depend on economic conditions in the United States. The difference between imports and exports is net exports.
728C.    Determining the Equilibrium Level of Real GDP per Year: The equilibrium level of real GDP exists when total planned expenditures equal total production, given a constant price level.
729VI.    The Multiplier: The multiplier is the number by which a permanent change in autonomous spending such as autonomous investment or autonomous consumption is multiplied to get the change in the equilibrium level of real GDP. Any permanent increase in autonomous spending will cause a more than proportional increase in real national income.
730A.    The Multiplier Effect: The autonomous spending multiplier is equal to the reciprocal of the marginal propensity to save, i.e., the multiplier 1/(1 – MPC) 1/MPS. The multiplier is directly related to the MPC and inversely related to the MPS. The change in the equilibrium level of real national income due to a change in autonomous spending is the multiplier times the change in autonomous spending.
731B.    The Multiplier Formula
732C.    The Significance of the Multiplier: The multiplier magnifies changes in equilibrium real GDP caused by changes in autonomous spending.
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735VII.    How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change: The multiplier effect on equilibrium overall level of real nation income will be smaller if part of the increase in nominal GDP occurs because the price level increases. The price level does not stay fixed because SRAS normally is positively sloped. The multiplier is smaller because part of the additional income is used to pay higher prices; not all is spent on increased output, as is the case when the price level is fixed.
736VIII.    The Relationship Between Aggregate Demand and the C I G X Curve: The C I G X curve is drawn assuming a given price level. If the price level goes up, the real balance effect, decreased borrowing with a resulting increase in the nominal interest rate, and a decline in net exports will cause the C I G X curve to shift downward. Real GDP will fall.
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759    Chapter     13 – Fiscal Policy
760     
761    Outline
762
763I.    Discretionary Fiscal Policy: The discretionary changing of government expenditures and/or taxes in order to achieve national economic goals, such as high employment with price stability. It is a deliberate attempt to cause the economy to move to full employment and price stability more quickly than it otherwise might.
764A.    Changes in Government Spending:
7651.    When There Is a Recessionary Gap: An expansionary fiscal policy, which would cause the AD curve to shift to the right, is required. By increasing government expenditures policymakers can shift the aggregate demand curve to the right, and the price level and real GDP will go up.
7662.    When There Is an Inflationary Gap: A contractionary fiscal policy, which would cause the AD curve to shift to the left, is required. By decreasing government expenditures policymakers can shift the aggregate demand curve to the right, the price level and real GDP will go down.
767B.    Changes in Taxes: Holding all other things constant, a rise in taxes creates a reduction in AD for one of three reasons: (1) it reduces consumption, (2) it reduces investment, or (3) it reduces net exports.
7681.    When the Current Short-Run Equilibrium Is to the Right of LRAS: An increase in taxes will cause AD to shift inward, real GDP and the price level index falls.
7692.    When the Current Short-Run Equilibrium Is to the Left of LRAS: A decrease in taxes will cause AD to shift outward, real GDP and the price level will rise.
770II.    Possible Offsets to Fiscal Policy: Fiscal policy does not operate in a vacuum, so offsets can occur.
771A.    Indirect Crowding Out: An increase in government spending without raising taxes creates additional government borrowing from the private sector or from foreigners.
7721.    Induced Interest Rate Changes: Deficit spending tends to crowd out private spending reducing the positive effect of increased government spending on AD. Planned investment and consumption in the private sector decrease because of the rise in interest rates.
7732.    The Firm’s Investment Decision: The rise in interest rates causes monthly loan payments to go up and discourages some firms from making investments.
7743.    Graphical Analysis:
775B.    Planning for the Future: The Ricardian Equivalence Theorem: The proposition that an increase in the government budget deficit has no effect on aggregate demand. The idea is that people’s horizons extend beyond this year, and they take into account the effects of today’s government policies on the future. If government spending increases without increasing taxes (increased budget deficit), taxes will have to be higher in the future and individual saving has to take place now to be able to pay this future tax liability. In the extreme case there is long-run no effect on AD.
776C.    Direct Expenditure Offsets: Actions on the part of the private sector in spending income that offset fiscal policy actions. Any increase in government spending that competes with the private sector will have some offset effect.
7771.    The Extreme Case: In this case the offset is dollar for dollar, so we merely end up with a relabeling of spending from private to public. Aggregate demand and GDP are unchanged.
7782.    The Less Extreme Case: To the extent that there are some offsets to fiscal policy, predicted changes in aggregate demand will be lessened and real output and the price level will be less affected.
779D.    The Supply-Side Effects of Changes in Taxes: Supply-side economics is the notion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward. Thus the government will not necessarily lose tax revenues by lowering marginal tax rates. The lower marginal rates will be applied to a growing tax base because of economic growth.
780III.    Discretionary Fiscal Policy in Practice: Coping with Time Lags: The political process of fiscal policy and the various time lags involved in conducting fiscal policy create problems of achieving the policymakers’ goals. A recognition time lag is the time required to gather information about the current state of the economy. An action time lag is the time required between recognizing an economic problem and putting policy into effect. The action time lag is short for monetary policy but quite long for fiscal policy, which requires congressional approval. The effect time lag is the time that elapses between the onset of policy and the results of that policy. By the time a proposed change in fiscal policy works its way through the system, it may no longer be applicable and may even be harmful.
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783IV.    Automatic Stabilizers: Types of automatic (or nondiscretionary) fiscal policies which do not require new legislation on the part of Congress which are provisions of the tax laws and certain entitlement programs that cause changes in desired aggregate demand.
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786A.    The Tax System as an Automatic Stabilizer: As taxable income rises, marginal tax rates rise. The progressive nature of the personal and corporate income tax systems means that when the economy expands, tax collections increase faster than income, while during contractions, tax collections fall faster than income.
787B.    Unemployment Compensation and Income Transfer Payments: As the economy contracts, unemployment compensation and welfare payments rise. As the economy expands, unemployment compensation and welfare payments fall. Disposable income does not fluctuate by as much as does total income.
788C.    Stabilizing Impact: The automatic stabilizers mitigate undesirable changes in disposable income, consumption, and the equilibrium level of national income. If disposable income is not allowed to fall as far as it would during a recession, the downturn will be moderated. If disposable income is not allowed to rise as rapidly as it would during an expansion, the boom will not get out of hand.
789V.    What Do We Really Know About Fiscal Policy?
790A.    Fiscal Policy During Normal Times: Discretionary fiscal policy probably is not very effective at these times. Automatic stabilizers are probably the most useful.
791B.    Fiscal Policy During Abnormal Times: Fiscal policy can be important during these times. Consider some classic examples: the Great Depression and war periods.
7921.    The Great Depression: When there is a substantial drop in GDP, such as in the Great Depression, fiscal policy can probably stimulate aggregate demand. However, there was in fact very little stimulation by government in the form of aggressive expansionary fiscal policy during this period.
7932.    Wartime: War expenditures have little or no direct expenditure offsets. So, war spending
794as part of expansionary fiscal policy usually has significant effects.
795C.    The “Soothing” Effect of Keynesian Fiscal Policy: The knowledge by consumers and investors that the federal government can use fiscal policy to prevent another great depression may induce more buoyant and stable expectations, thereby smoothing investment decisions.
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799    Chapter     14 – Deficit Spending and the Public Debt
800     
801    Outline
802
803I.    Public Deficits and Debts: Flows versus Stocks: The deficit is the excess of government spending over government revenues during a given period of time. The deficit is financed by the U.S. Treasury borrowing by selling bonds to U.S. and foreign households, businesses, and governments.
804A.    Distinguishing Between Deficits and Debts: The deficit is a flow and is the negative
805difference between tax receipts and total federal spending during a given time period. The federal government has a balanced budget when revenues equal spending during a given period of time.
806B.    The Public Debt: The total accumulated value of all outstanding federal government securities. The public debt is a stock measured at a given point in time. It increases when there is a deficit.
807II.    Government Finance: Spending More Than Tax Collections:
808A.    The Historical Record of Federal Budget Deficits: Surpluses have occurred in only 13 years since 1940. In all of the other years the federal government has run deficits. In recent years the size of the real annual budget deficit as a percentage of GDP peaked during the Reagan administration and began rising during the first George W. Bush administration and fell in fiscal 2005.
809B.    The Resurgence of Federal Budget Deficits: Between 2002 and 2006 federal spending increased faster than at any time since World War II. In 2001 tax rates were reduced near the end of a recession that reduced federal revenue for a time. When the economy began to grow rapidly in 2003 tax revenues began to grow rapidly as well.
810III.    Evaluating the Rising Public Debt: All federal government debt is the gross public debt. The net public debt is the gross public debt minus the debt held by government agencies.
811A.    Accumulation of the Net Public Debt: The U.S. net public debt, as a percentage of GDP, fell steadily from the end of World War II until the early 1970s when it leveled off until the 1980s. It has risen since, except for declining slightly in the period of budget surpluses from 1998–2001.
812B.    Annual Interest Payments on the Public Debt: Around 1975 interest payments on the public debt as a percentage of GDP started rising dramatically and have declined since. Today they are about 16 percent higher than they were about a half a century ago. Foreigners currently own around 50 percent of the U.S. public debt.
813C.    Burdens of the Public Debt
8141.    How Today’s Budget Deficits Might Burden Future Generations: Future generations will pay higher taxes to pay interest on a larger public debt resulting from the present generation’s increased consumption of public goods.
8152.    The Crowding-Out Effect: In a full employment economy the increased level of consumption by the present generation crowds out investment and reduces the growth of capital goods leaving them with a smaller capital stock and thereby reducing their wealth. In this case future taxpayers will have higher taxes.
8163.    Paying Off the Public Debt in the Future: If the debt had to be paid off by raising taxes, what would mostly happen is that taxpayers would incur higher tax liabilities while bondholders, who are also mostly U.S. taxpayers would get the money. As a generation
817U.S. citizens would both pay higher taxes and receive (most of) the money back.
8184.    Our Debt to Foreign Residents: The percentage of the U.S. public debt owned by foreigners is about 50 percent. If foreigners buy U.S. government bonds, we do not owe that debt to ourselves, and a burden on future generations may result. If government expenditures financed by foreigners are made on wasteful projects rather than on goods and services that increase productivity and output, then a burden may be placed on future generations.
819IV.    Federal Budget Deficits in an Open Economy: There is a link between U.S. trade deficits and government budget deficits. By virtue of trade deficits, foreigners have accumulated U.S. dollars and purchased U.S. assets.
820A.    Trade Deficits and Government Budget Deficits: Larger trade deficits tend to accompany larger fiscal deficits.
821B.    Why the Two Deficits Are Related: Part of the money to finance the federal government deficit must come from abroad. When the U.S. runs large deficits, foreign dollar holders spend more on U.S. government securities, bonds, and less on U.S. produced goods and services, our exports. The effect is to further increase the trade deficit.
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824V.    Growing U.S. Government Deficits: Implications for U.S. Economic Performance
825A.    Which Government Deficit Is the “True Deficit?: There is disagreement about how the deficit is measured. The problem has to do with the use of measurements that minimize the reported deficit. The other is that the government does not track its expenditures and receipts in a business-like manner.
8261.    Capital Budgeting Theory: Businesses, as well as state and local governments, have an operating budget, which includes expenditures for current operations and a capital budget, which includes expenditures on investment items. The federal government has only one budget. It has been recommended that Congress set up a capital budget, removing investment outlays from its operating budget. Opponents say this would allow the government to grow even faster since the operating budget, and its deficit would be reduced and the pressure would be reduced on Congress to curtail federal spending.
8272.    Pick a Deficit, Any Deficit: The government figures can be used to report several different deficits. The problem is that no one number gives a complete picture of how much the government is spending over and above what it is receiving.
828B.    The Macroeconomic Consequences of Budget Deficits: The effects of deficits should be compared to the effects higher taxes to finance government spending. In addition the effects of a deficit when the economy is at full employment and when there is substantial unemployment.
8291.    Short-Run Macroeconomic Effects of Higher Budget Deficits: If there is a recessionary gap, then deficits due to higher government spending or lower taxes can increase aggregate demand and eliminate the recessionary gap. If the economy is at full employment, the increase in aggregate demand causes an inflationary gap with increased real GDP and inflation.
8302.    Long-Run Macroeconomic Effects of Higher Budget Deficits: Increases in aggregate demand have no effect on real GDP in the long-run. They only cause inflation. An increase in government spending redistributes a larger share of real GDP to government provided goods and services.
831C.    How Could the Government Reduce All Its Red Ink?
8321.    Increasing Taxes for Everyone: The office of Budget and Management estimated the 2007 budget deficit at about $260 billion. To have eliminated the deficit by raising taxes, every worker in the U.S. would have had to pay $1,800 more in taxes.
8332.    Taxing the Rich: Currently 84 percent of federal income taxes are paid by the top
83425 percent of families earning the highest incomes. The bottom 50 percent of families (below $60,000 per year) pay about 4 percent of federal income taxes. The top 5 percent pay about 57 percent of income taxes and the richest 1 percent pay about 37 percent of all income taxes paid. An increase in the top marginal tax rate from 35 percent to 45 percent will raise about $30 billion in additional taxes.
8353.    Reducing Expenditures: Reduced spending will reduce the deficit. Entitlements are legislated payments that anybody who qualifies is entitled to receive. They are the most important component of the federal budget today. Entitlements, such as welfare, Social Security, Medicare, and Medicaid, change automatically without direct action by the Congress.
8364.    Is It Time to Begin Whittling Away at Entitlements?: In 1960 entitlements represented 10 percent of the federal budget. Today they make up more than half. In the last two decades, real spending on entitlements grew between 7 and 8 percent per year, while the economy grew by less than 3 percent per year. Entitlement programs are believed to be necessary, and it is difficult to cut government benefits once they are established.
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874    Chapter     15 – Money, Banking and Central Baning     
875     
876    Outline
877
878I.    The Functions of Money: Anything that serves the four functions of money is money.
879
880
881A.    Money as a Medium of Exchange: Money serves as a medium of exchange, i.e., an asset that sellers will accept as payment. A medium of exchange allows people to eliminate the use of barter.
882B.    Money as a Unit of Accounting: A way of placing a specific price on economic goods and services. As a unit of accounting the monetary unit is used to measure the value of goods and services relative to other goods and services.
883C.    Money as a Store of Value: The ability of an item to hold value over time.
884D.    Money as a Standard of Deferred Payment: A property of an asset that makes it desirable for use as a means of settling debts maturing in the future.
885II.    Liquidity: The degree to which an asset can be acquired or disposed of without much danger of intervening loss in nominal value and with small transactions costs. Money is the most liquid asset. The opportunity cost of holding money is the interest yield obtainable by holding some other asset.
886III.    Monetary Standards, or What Backs Money: In the United States coins, paper currency and balances in transactions accounts are accepted in exchange for items sold. The payments arise from a fiduciary monetary system. A fiduciary monetary system is one in which currency is issued by the government, and its value is based uniquely on the public’s faith that the currency represents command over goods and services.
887A.    Acceptability: Transactions accounts and currency are money because they are accepted on exchange for goods and services. They are accepted because people have confidence that they can later be exchanged for other goods and services, since such exchanges have occurred in the past without problems.
888B.    Predictability of Value: The purchasing power of the dollar (that is, its value) varies inversely with the price level. Money retains its usefulness even if its value declines year in and year out, because of the predictability of its value in the future.
889IV.    Defining Money: The money supply is the amount of money in circulation. Changes in the money supply affect important economic variables in the short-run.
890A.    The Transactions Approach to Measuring Money: M1: The total value of currency plus checkable deposits (demand deposits in commercial banks and other checking accounts in thrift institutions) and travelers checks not issued by banks).
8911.    Currency: Coins minted by the U.S. Treasury and paper currency, usually in the form of Federal Reserve notes issued by the Federal Reserve banks.
8922.    Transactions Deposits: Any deposit in a thrift institution or a commercial bank on which a check may be written.
8933.    Traveler’s Checks: Financial instruments purchased from a non-banking institution that
894can be used as cash.
895B.    The Liquidity Approach to Measuring Money: M2: M2 is M1 plus near monies.
896
897
8981.    Saving Deposits: Interest-earning funds that can be withdrawn at any time without payment of a penalty but still earn interest. These include money market deposit accounts that pay a market interest rate with a minimum balance, limit on transactions, and no maturity date.
8992.    Small-Denomination Time Deposits: Time deposits are deposits in a financial institution that in principle requires a notice of intent to withdraw or must be left for an agreed period. Withdrawal of funds prior to the end of the agreed period results in a penalty. Time deposits include savings certificates and small certificates of deposit (CDs). To be included in the M2 definition of the money supply, such time deposits must be less then $100,000. A time deposit has a fixed maturity date and is offered by banks and other financial institutions.
9003.    Money Market Mutual Fund Balances: Deposits held by investment companies that obtain funds from the public. These funds are held in common and used to acquire short-term credit instruments, such as certificates of deposit and securities sold by the U.S. government.
9014.    M2 and Other Money Supply Definitions: Economists and researchers have come up with even broader definitions of money than M2. More assets are simply added to the definition. Currently the MZM definition of money is preferred by some businesspersons and policymakers. MZM is the sum of M1 and the deposits in M2 that do not have a set maturity including all money market funds, not just money market deposits in banks.
902V.    Financial Intermediation and Banks: The U.S. banking system is headed by a central bank called the Federal Reserve System. There are a large number of commercial banks, which are privately owned, profit-seeking institutions. Other depository institutions are called thrifts or thrift institutions. They consist of savings and loan associations, mutual savings banks and credit unions.
903A.    Direct versus Indirect Financing: Direct finance occurs when people lend to a business by buying a bond. Indirect finance occurs when people acquire a liability of a financial intermediary such as a bank, which lends the funds to a business.
904B.    Financial Intermediation: The process by which financial institutions transfer funds from savers to investors.
9051.    Asymmetric Information, Adverse Selection, and Moral Hazard: Three reasons why people might wish to direct their funds through financial intermediaries. The problems arising from asymmetric information—adverse selection, and moral hazard—can be reduced by lending to a financial institution that will be better able to evaluate the creditworthiness of business borrowers and monitor their progress until the loans are repaid.
9062.    Larger Scale and Lower Management Costs: Intermediaries pool the funds of large numbers of savers, thereby increasing the scale of the savings managed by an intermediary. Management costs and risks are lower than they would be if every saver tried to manage his/her lending.
9073.    Financial Institution Liabilities and Assets: Financial intermediaries’ liabilities are sources of funds and its assets are its uses of funds.
908C.    Payment Intermediaries: Institutions that finance transfers of funds between depositors who hold transactions deposits with those institutions.
9091.    Transmitting Payments via Debit-Card Transactions: A store customer with a bank account pays for a good with her debit card. The store electronically transmits the purchase information to its bank, which in turn transmits the information to the store’s customer’s bank. The store customer’s bank debits her account and transmits payment to the store’s bank, which credits the store’s account.
9102.    The Payoff from Financial Intermediation: About 28 percent of bank earnings come from debit card transfer services and another 10 percent from processing payments for credit cards, stocks and bonds.
911D.    Financial Intermediation Across National Boundaries: Some countries limit intermediation to within their national boundaries by legal restraints called capital controls. Other countries have few or no capital controls that allow for international financial diversification. Often this is through very large international banks called megabanks.
912VI.    Banking Structures Throughout the World: Multinational businesses have relationships with megabanks based in many nations. Banking systems vary from banks being a crucial component of the financial intermediation process to being simply part of a varied financial system. There are also differing legal environments regulating banks.
913A.    A World of National Banking Structures: The extent to which banks are the predominant means by which businesses finance their operations is one way that national banking systems differ. Another important way is universal banking in which banks can offer a full range of financial services. Other countries, including the United States limit universal banking.
914B.    Universal Banking: Another way banking systems are distinguished from one another is the extent to which universal banking has been permitted. Universal Banking is an environment in which banks face few or no restrictions on their powers to offer a full range of financial services and to own shares of stock in corporations.
915C.    Central Banks and Their Roles: The duties of central banks are in three categories. Central banks perform banking functions for their governments, provide financial services for private banks, and conduct their nations’ monetary policies.
916VII.    The Federal Reserve System: The Federal Reserve System, or the Fed, is the most important regulatory agency in our entire monetary system and is considered the monetary authority.
917A.    Organization of the Federal Reserve System: There are 12 regional Federal Reserve banks each headed by a president. The main authority of the Fed resides with the Board of Governors of the Federal Reserve System, whose seven members are appointed for 14-year terms by the president and confirmed by the Senate. Open-market operations are carried out through the Federal Open Market Committee (FOMC), consisting of the seven members of the Board of Governors plus five presidents of the regional banks (always including the president of the New York bank with the others rotating).
918B.    Depository Institutions: These are the banks and other financial institutions that accept deposits that make up our banking system and consist of approximately 8,000 commercial banks, 1,500 savings and loan associations, and 12,000 credit unions.
919C.    Functions of the Federal Reserve System: The Fed is the nation’s monetary authority.
9201.    Supplies the Economy with Fiduciary Currency: The Federal Reserve banks must supply the economy with paper currency called Federal Reserve notes.
9212.    Provides a System for Check Collection and Clearing: The Federal Reserve has established a clearing mechanism for checks to be deposited in one location and, eventually, clear the account of both payee and payer.
9223.    Holds Depository Institutions’ Reserves: The 12 Federal Reserve banks hold the reserves (other than vault cash) of depository institutions. Depository institutions are required by law to keep a certain percentage of their deposits in reserves.
9234.    Acts as the Government’s Fiscal Agent: The Federal Reserve is the banker and fiscal agent for the federal government.
9245.    Supervises Depository Institutions: The Fed along with the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision in the Treasury Department, and the National Credit Union Administration is a supervisor and regulator of depository institutions.
9256.    Acts as a Lender of Last Resort: The Fed stands ready to bail out any part of the banking system that is in trouble, i.e., it will lend money to troubled depository institutions.
9267.    Regulates the Money Supply: The Fed’s most important function is its ability to regulate the nation’s money supply. The major task of the Fed is to manage the supply of money.
9278.    Intervenes in Foreign Currency Markets: Sometimes the Fed buys and sells U.S. dollars in foreign exchange markets to keep the value of the dollar from changing.
928    Chapter     16 – Domestic and International Dimensions of Monetary Policy
929     
930    Outline
931
932I.    What’s So Special About Money?: Money is involved on one side of every non-barter transaction in the economy. Changes in the amount of money in circulation will have an effect on many transactions and, thus, upon elements of GDP. Money is a “social contract” in which people agree to express prices in terms of a common unit, called the dollar in the United States and use as a specific medium of exchange.
933A.    Holding Money: Because everyone engages in a flow of transactions, money must be held in order to buy goods and services. To use money, one must hold money.
934B.    The Demand for Money: What People Wish to Hold: The demand for money can be broken down into three components.
9351.    The Transactions Demand: Holding money as a medium of exchange. The level varies directly with nominal national income.
9362.    The Precautionary Demand: Holding money is to meet unplanned expenditures and emergencies. The cost is foregone interest earnings, but this is offset by the security provided.
9373.    The Asset Demand: Holding money as a store of value as opposed to having other assets such as small CDs, corporate bonds and stocks.
938C.    The Demand for Money Curve: If the amount of money demanded for transactions is fixed at a certain income level, assuming that the interest rate represents the cost of holding money, i.e., the opportunity cost of holding money, the demand for money curve shows a downward slope.
939II.    The Tools of Monetary Policy: The Fed uses one of three tools as part of its policymaking action to alter consumption, investment and aggregate demand.
940A.    Open Market Operations: The Fed changes the amount of reserves by purchases and sales of government bonds. Starting from an equilibrium level, if the Fed wants to conduct open market operations, it has to induce individuals, businesses and foreigners to hold more or less U.S. Treasury bonds. The inducement is in the form of making people better off by causing a change in the price of bonds.
9411.    Graphing the Sale of Bonds: When the Fed wishes to increase its sales of government bonds, it lowers bond prices.
9422.    The Fed’s Purchase of Bonds: When the Fed wishes to purchase government bonds, it raises bond prices.
9433.    Relationship Between the Price of Existing Bonds and the Rate of Interest: The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest.
944B.    Changes in the Difference Between the Discount Rate and the Federal Funds Rate: The discount rate is the interest rate the Fed charges banks when they borrow from the Fed. The Fed used the discount rate in the beginning to carry out monetary policy because it had no power over reserve requirements, and its initial portfolio of government bonds was practically nonexistent. Since 2003 the Fed has kept the discount rate 1 percentage point above the Federal Funds interest rate.
945C.    Changes in Reserve Requirements: Although rarely done, the Fed decreased reserve requirements on checkable deposits to 10 percent in 1992. If the Fed increases reserve requirements banks reduce their lending by raising interest rates. If the Fed decreases reserve requirements, banks increase their lending of their excess reserves by reducing interest rates.
946III.    Effects of an Increase in the Money Supply: If a large sum of money were arbitrarily distributed to people, they would have too much money relative to other things that they owned. There are a variety of ways to dispose of this “new” money.
947A.    Direct Effect: Excess money would cause aggregate demand to rise, because an increase in the money supply at any given price level would cause people to want to purchase more output of real goods and services.
948B.    Indirect Effect: When there is excess money some people would deposit it in banks. The recipient banks would have excess reserves and would lower interest rates to induce people to borrow. The increased loans would create a rise in aggregate demand.
949C.    Graphing the Effects of an Expansionary Monetary Policy: The direct and indirect effects of an expansionary monetary policy are to increase aggregate demand, real GDP, and the price level.
950D.    Graphing the Effects of Contractionary Monetary Policy: The direct and indirect effects of a contractionary monetary policy are to decrease aggregate demand, real GDP, and the price level.
951IV.    Open-Economy Transmission of Monetary Policy: In an open economy, international trade and purchase/sale of all assets and currencies must be considered.
952A.    The Net Export Effect of Contractionary Monetary Policy: Contractionary monetary policy causes interest rates to rise. Foreigners will demand more dollars for financial assets in the United States and the dollar will appreciate. The net export effect of contractionary monetary policy will be negative because exports will decrease and imports will increase.
953B.    The Net Export Effect of Expansionary Monetary Policy: Expansionary monetary policy causes interest rates to fall. Foreigners will demand fewer dollars for financial assets in the United States and the dollar will depreciate. The net export effect of expansionary monetary policy will be positive because exports will increase and imports will decrease.
954C.    Globalization of International Money Markets: If the Fed reduces the growth of the money supply, individuals and firms in the United States can increasingly obtain dollars from other sources. Due to the increase in technology, money transactions, on a global scale, can take place at the push of a button.
955V.    Monetary Policy and Inflation: Studies show a relatively stable relationship between excessive growth in the money supply in circulation and inflation in the long-run. If the supply of money rises relative to the demand for money, it takes more units of money to purchase goods and services.
956A.    The Equation of Exchange and the Quantity Theory: The equation of exchange says that the number of monetary units (M) times the number of times each unit is spent on final goods and services (V) is identical to the price level (P) times real GDP (Y) or MV PY. This equation shows the relationship between changes in the quantity of money in circulation and the price level.
9571.    The Equation of Exchange as an Identity: It is true by definition and is called an accounting identity. It states that the total amount of money spent on final output is equal to the total amount of money received for final output.
9582.    The Quantity Theory of Money and Prices: By making assumptions about variables in the equation of exchange a simplified theory, the quantity theory of money and prices, can be derived, to explain why prices change. The results reveal that a proportionate change in the money supply leads to a proportionate change in the price level.
959B.    Empirical Verification: There is considerable evidence for the validity between excessive monetary growth and high rates of inflation.
960VI.    Monetary Policy in Action: The Transmission Mechanism
961    
962     An     Interest-Rate-Based Transmission Mechanism: This theory asserts     that the main effect of monetary policy is through changes in the     interest rate. Money supply changes cause changes in the interest     rate. This changes planned investment and that causes changes in     income and employment.
963
964VII.    Fed Target Choice: Interest Rates or Money Supply?: Money supply and interest rate targets cannot be pursued simultaneously. Interest rate targets force the Fed to abandon control over the money supply. Money stock growth targets force the Fed to allow interest rates to fluctuate.
965A.    The Interest Rate or the Money Supply?: In the short-run the Fed can choose either a particular interest rate or a particular money supply.
966B.    Choosing a Policy Target: The choice of a policy target depends on the source of instability in the economy. If the source is instability of spending, then the money supply is the best target variable. If the source of instability is unstable demand for money then the best target variable
967is the interest rate.
968VIII.    The Way Fed Policy Is Currently Implemented: The Fed announces interest rate targets. If it says it is lowering the interest rate, it means that it is engaging in expansionary monetary policy. If it says it is increasing the interest rate, it means that it is engaging in contractionary monetary policy.
969A.    Laying Out the Fed Policy: The Fed uses open market operations to achieve its interest rate target. It determines its strategy in the FOMC. The Fed releases its FOMC Directive after the meeting of the FOMC every six to eight weeks.
970B.    Open Market Operations and the Federal Funds Rate Target: The Trading Desk of the Federal Reserve Bank of New York implements the FOMC directive by either increasing bank reserves by buying government securities to reduce the federal funds rate or by decreasing bank reserves by selling government securities to increase the federal funds rate.
971C.    Maintaining a Federal Funds Rate Target: The New York Fed’s Trading Desk buys or sells government securities to maintain a desired federal funds rate.
9721.    Keeping the Federal Funds Rate on Target: The New York Fed’s Trading Desk buys or sells government securities on a daily basis to maintain a desired federal funds rate.
9732.    The Fed Influences, but Does not “Set” the Federal Funds Rate: By adjusting bank reserves the Fed can keep the federal funds rate close to the desired level.
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994    Chapter     17 – Stabilization in an Integrated World Economy
995     
996    Outline
997
998    
999     Active     versus Passive Policymaking: Active (discretionary) policymaking     is all actions on the part of monetary and fiscal policymakers that     are undertaken in response to or in anticipation of some change in     the economy. Passive (nondiscretionary) policymaking is policy based     on a rule, and is therefore not a response to an actual or potential     change in overall economic activity.
1000
1001II.    The Natural Rate of Unemployment: The rate of unemployment that is estimated to prevail in long-run macroeconomic equilibrium when all workers and employers have fully adjusted to any changes in the economy. The rate consists of two parts: (1) frictional unemployment, which exists due to individuals taking time to search for the best job opportunities and (2) structural unemployment due to rigidities in the economic system. These rigidities include union activity that sets wages above equilibrium and restricts the mobility of labor, licensing arrangements that restrict entry into specific professions, minimum wage laws and other laws that require all workers to be paid union wage rates on government contract jobs, welfare and unemployment insurance that reduces incentives to work and a mismatch of skills with available jobs.
1002A.    Departures from the Natural Rate of Unemployment: Deviations of the actual unemployment rate from the natural rate are due to cyclical unemployment. This results from business recessions that occur when aggregate demand is insufficient to create full employment.
10031.    The Impact of Expansionary Policy: Unanticipated fiscal or monetary policy to stimulate the economy when it is in long-run equilibrium causes the price level and real GDP to rise in the short-run. In the long-run SRAS upward in response to higher resource prices and the economy returns to long-run equilibrium at a higher price level.
10042.    The Consequences of Contractionary Policy: An unanticipated reduction in aggregate demand when the economy is in long-run equilibrium results in a fall in the price level and real GDP in the short-run. In the long-run the SRAS curve shifts downward in response to lower resource prices and the economy returns to long-run equilibrium at a lower price level.
1005B.    The Phillips Curve: A Rationale for Active Policymaking?: A curve showing the relationship between the unemployment rate and changes in wages or prices. It was long thought that the Phillips curve depicted a trade-off between unemployment and inflation. If there is an unexpected increase in aggregate demand, greater inflation and lower unemployment results. An unexpected decrease in aggregate demand results in greater deflation and higher unemployment.
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10081.    The Negative Relationship Between Inflation and Unemployment: Looking at both unanticipated increases and decreases in aggregate demand, it is clear that high inflation rates are associated with low unemployment and low inflation with high unemployment.
10092.    Is There a Trade-Off? The negative relation between the inflation rate and the unemployment rate has come to be called the Phillips curve. It turned out to not be that simple.
10103.    The NAIRU: The NAIRU is a nonaccelerating inflation rate of unemployment which is the rate of unemployment below which the rate of inflation tends to rise and above which the rate of inflation tends to fall.
10114.    Distinguishing Between the Natural Unemployment Rate and the NAIRU: The natural rate of unemployment is the rate of unemployment when the economy is in long-run equilibrium. It changes slowly over time. The NAIRU is the rate of unemployment that is consistent with a steady rate of inflation. It varies by a relatively greater amount and relatively more often than does the natural rate.
1012C.    The Importance of Expectations: If wage offers to unemployed workers are unexpectedly high, these workers believe that the higher nominal wages are increases in real wages if aggregate demand fluctuates at random. But, if policy makers attempt to exploit the trade-off in the Phillips curve, aggregate demand will no longer fluctuate in a random manner.
10131.    The Effects of Unanticipated Policy: If the Fed attempts to reduce the unemployment rate when the inflation rate is zero, it must increase the money supply enough to produce a certain inflation rate. If the increase in the money supply is held constant, the inflation rate will eventually return to zero.
10142.    Adjusting Expectations and a Shifting Phillips Curve: Once workers expect the higher inflation rate, the rising nominal wage will no longer be sufficient to entice them out of unemployment and the unemployment rate will rise. If authorities continue the stimulus to keep unemployment down, worker’s expectations will adjust. Thus, policymakers cannot choose a permanently lower unemployment rate and in the long-run have an unchanged unemployment rate at the expense of a permanently higher inflation rate.
1015D.    The U.S. Experience with the Phillips Curve: Although there seems to have been a Phillips Curve trade-off from the mid-1950s to the mid-1960s, apparently once people in the economy realized what was happening, they started revising their forecasts accordingly. Once policymakers tried to exploit the Phillips Curve, the apparent trade-off disappeared as predicted by the Friedman-Phelps model.
1016III.    The Rational Expectations and the Policy Irrelevance Proposition: Rational expectations is a theory that states that people combine the effects of past policy changes on important economic variables with their own judgment about the future effects of current and future policy changes.
1017A.    Flexible Wages and Prices, Rational Expectations, and Policy Irrelevance: An increase in the money supply can raise output and lower unemployment in the short-run, but it has no effect on either in the long-run.
10181.    The Response to Anticipated Policy: If workers (and other input owners) know an increase in the money supply is about to take place and they know when it is going to occur, and then they will insist on nominal wages and prices for their inputs that move upward with the higher price level.
10192.    The Policy Irrelevance Proposition: The idea that a fully anticipated monetary policy is irrelevant in determining the levels of real variables in either the short-run or long-run and that even an unanticipated one has no effect in the long-run. When the money supply changes in an anticipated way, the short-run aggregate supply curve shifts to reflect the change. For example, the SRAS will shift upward simultaneously with an anticipated increase in aggregate demand. The only effect of an increase in money supply is a rise in price level.
10203.    What Must People Know? Economic participants do not have to have perfect information. Even if they are not perfect at forecasting the future, they are likely to know a lot. The policy irrelevance proposition really assumes only that people do not consistently make the same mistakes in forecasting the future.
10214.    What Happens if People Don’t Know Everything? Monetary policy can have an effect on real variables in the short-run only if the policy is unsystematic and unanticipated or if people make forecasting errors. In the long-run this effect will disappear because people will figure out what is going on and revise their expectations.
1022B.    The Policy Dilemma: The rational expectations model suggests that only “mistakes” can have real effects. If the Fed always does what it intends and its actions are always correctly anticipated, monetary policy will affect only price level and nominal input prices. If so, the Fed is effectively precluded from utilizing monetary policy to lower unemployment or raise the level of real GDP.
1023IV.    Another Challenge to Policy Activism: Real Business Cycles: When confronted with the policy irrelevance proposition, some economists began to reexamine the first principles of macroeconomics with fully flexible wages and prices.
1024A.    The Distinction Between Real and Monetary Shocks: Real business cycle theorists argue that real forces help explain economic fluctuations. A real shock affects long-run and short-run aggregate supply, not aggregate demand.
1025B.    The Impact on the Labor Market: A rise in the price level due to a real shock pushes the real wage rate downward and firms reduce the amount of labor inputs they are using. The real wage rate falls and the level of employment declines. In the long-run, some workers willing to continue to work at lower wages in the short-run, will retire, work part-time, or drop out of the labor force. The SRAS curve will decrease which puts additional upward pressure on the price level and downward pressure on real GDP.
1026C.    Generalizing the Theory: Real business cycle theory examines real disturbances such as technological change and shifts in the composition of the labor force. To the extent that real shocks account for the business cycle, there is little role for policy activism.
1027V.    Modern Approaches to Rationalizing Active Policymaking: New Keynesians drop the assumptions of pure competition and flexible prices. It emphasizes the possibility that optimal performance by an economy may require activist intervention by relevant fiscal and monetary authorities because of “sticky” wages and prices assumed by Keynes.
1028A.    Small Menu Costs and Sticky Prices: The idea that it is costly for firms to change prices in response to demand changes, because of the cost of negotiating contracts, printing price lists, etc. Costs associated with changing prices are called menu costs. New Keynesians argue that much of the economy is imperfectly competitive and this helps account for sticky prices.
1029B.    Real GDP and the Price Level in a Sticky-Price Economy: According to the New Keynesians, sticky prices strengthen the argument for active policymaking as a means of preventing substantial short-run swings in real GDP and as a consequence, employment.
1030    
1031        
1032            
1033             1.    New             Keynesian Inflation Dynamics: Sticky prices imply a horizontal             aggregate supply curve in the short-run. Thus changes in aggregate             demand will result in similar changes in real GDP. In the long-run             the economy will return to its original level.
1034         
1035    
10362.    Why Active Policymaking Can Pay Off When Wages and Prices Are Sticky: Active policymaking can stabilize real GDP and employment in the short-run.
1037C.    An Alternative New Keynesian Scenario: Bounded Rationality: The idea that people cannot examine every possible choice available to them, so they use rules of thumb to adjust wages and prices. Wages and prices are thus not fully flexible in the short-run but they are not completely rigid either. Incomplete adjustment of prices provides a rationale for active policymaking to stabilize the economy.
1038
1039    Chapter     18 – Policies and Prospects for Global Economic Growth
1040     
1041    Outline
1042
1043I.    Labor Resources and Economic Growth: Important determinants of economic growth are growth of labor and capital and the rate of increase of labor and capital productivity. This section examines the conditions necessary for population growth to be translated into economic growth.
1044A.    Basic Arithmetic of Population Growth and Economic Growth: The growth rate of per capita real GDP is equal to the rate of growth of real GDP minus the population growth rate.
10451.    How Population Growth Can Contribute to Economic Growth: Immigration can increase real GDP faster than population if they increase the labor force participation rate. It is possible for higher birth rates to lead to an increase in the labor force and an increase real GDP per capita in the long-run. If population growth is accompanied by an increase in the labor force participation rate, then the rate of economic growth will increase.
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1047
10482.    Whether Population Growth Hinders or Contributes to Economic Growth Depends on Where You Live: There are countries such as Saudi Arabia where rapidly increasing population leads to lower per capita real GDP and others such as Hong Kong that have experienced high rates of growth of per capita real GDP.
1049B.    The Role of Economic Freedom: Economic freedom is expressed as the rights to own private property and to exchange goods, services, and financial assets with minimal government interference. In general the higher is the level of economic freedom, the higher is per capita real GDP and growth rates.
1050C.    The Role of Political Freedom: Political freedom is the right to openly support and democratically select national leaders. It seems less important than economic freedom in explaining economic growth. In fact there is some evidence that greater democracy in a nation reduces economic growth rates because of successful attempts to restrict competition by producers. In general though as countries achieve high standards of living through consistent growth they tend to become more democratic over time. This suggests that there is a positive relationship between economic freedom and economic growth.
1051II.    Capital Goods and Economic Growth: In general capital is necessary for economic growth. In many developing countries one of the most significant problems they face that retards economic growth is dead capital, which is any capital resource that lacks clear title of ownership. Because people have difficulties exchanging, insuring, and legally protecting their rights to it, it is not readily allocated to its most productive use.
1052A.    Dead Capital and Inefficient Production: Because people who unofficially own capital goods are commonly constrained in using them efficiently, large amounts of capital goods are not employed in their highest valued use.
1053B.    Dead Capital and Economic Growth: In developing countries the existence of dead capital reduces the rate of return on investment thus reducing the incentive to invest in new capital goods. This reduces investment. Since economic growth depends in part on investment, the result is a decrease in the rate of economic growth.
10541.    Government Inefficiencies, Investment, and Growth: A major factor that contributes to dead capital and resulting lower rates of investment in less developed countries is inefficient government regulation. Economies of countries with less efficient governments tend to grow more slowly. The reason is that capital is difficult to direct to its most efficient uses.
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1057III.    Private International Financial Flows as a Source of Global Growth: One approach to promoting greater economic growth in developing countries is to rely on private markets to direct capital goods to their best uses.
1058A.    Private Investment in Developing Nations: Net private international flows of funds to developing countries have averaged over $100 billion per year since 1995 (equal to about10 percent of annual net investment in the U.S.). There are three sources of foreign funds for capital goods. These are bank loans, portfolio investment—the purchase of less than 10 percent of the shares of ownership in a company in another nation—and direct foreign investment. Direct foreign investment is the acquisition of a more than 10 percent share of a firm’s ownership.
1059B.    Obstacles to International Investment: The major problems of financial markets in developing countries are related to the problem of asymmetric information.
10601.    Asymmetric Information as a Barrier to Financing Global Growth: The problem here is that institutions that make loans or investors who hold stocks and bonds have less information than those who seek to use the funds. Adverse selection arises when those who wish to obtain funds for the least worthy projects are among those who wish to borrow or issue bonds or stocks. If lenders and investors have trouble identifying these higher-risk persons, they may be less willing channel funds to even creditworthy borrowers. Moral hazard exists when recipients of funds engage in riskier behavior after getting the funds. These asymmetric information problems are great enough in some countries as to form a significant obstacle to economic growth.
10612.    Incomplete Information and International Financial Crises: An international financial crisis exists when there is a rapid withdrawal of foreign investments and loans from a nation. These happen because less sophisticated investors and banks follow the example of larger, more sophisticated investors and institutions in withdrawing funds when risks in a foreign country or group of foreign countries exist.
1062IV.    International Institutions and Policies for Global Growth: Since 1945 the world’s governments have taken an active role in supplementing private markets through the World Bank and the International Monetary Fund.
1063A.    The World Bank: A multinational agency that specializes in making loans to about 100 developing nations in an effort to promote their long-term growth and development. The bank mainly finances projects such as irrigation systems and road improvements.
1064B.    The International Monetary Fund: The IMF is an international organization that aims to promote world economic growth through more financial stability. Each nation that joins the IMF deposits funds to an account called its quota subscription and these are measured in special drawing rights from a pool of funds held by the IMF. The IMF currently makes both short-term and long-term loans to help finance growth or to provide assistance to countries that are having trouble paying off their debts.
1065C.    The World Bank and the IMF: Part of the Solution or Part of the Problem?: In recent years economists have questioned IMF and World Bank policymaking.
10661.    Does the World Bank Really Have a Mission Anymore?: While the World Bank’s mission is to make loans to developing nations that fund projects incapable of attracting private investors for funding, it makes many of its loans to countries that have little trouble attracting private investment. Some countries such as China are inappropriate recipients for World Bank loans.
10672.    Asymmetric Information and the World Bank and the IMF: Lending policies of both organizations can make the adverse selection problem worse.
10683.    Rethinking Long-Term Development Lending: Many economists argue that promoting market reforms by governments in developing countries would have much higher payoffs in promoting development. The major issue is whether the lending should be for specific projects or more for financing the market reforms by government.
10694.    Alternative Institutional Structures for Limiting Financial Crises: Proposals range from eliminating the IMF and the World Bank and replacing them with alternative organizational forms to simply having the IMF and World Bank more carefully monitor borrowers. Almost all economists agree that improved accounting standards for international borrowers are needed.
10705.    Time to Replace the World Bank and the IMF?: There has been a discussion of either reforming the World Bank and IMF to eliminating them. There is no agreement about what to replace them with.
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1110    Chapter     19 – Comparative Advantage and the Open Economy
1111     
1112    Outline
1113
1114I.    The Worldwide Importance of International Trade: World trade has increased to more than 26 times what it was in1950. World GDP has only increased by a factor of 9. Imports as a percentage of GDP for the United States has increased from 4 percent in 1950 to almost 17 percent today.
1115
1116
1117II.    Why We Trade: Comparative Advantage and Mutual Gains from Exchange
1118A.    The Output Gains from Specialization: If specialization and trade occurs along lines of comparative advantage, then production increases above what would be otherwise possible.
1119B.    Specialization Among Nations: A two country numerical example is presented.
11201.    Production and Consumption Capabilities in a Two-Country, Two-Good World:
1121
1122
11232.    Comparative Advantage: Comparative advantage is the ability to produce a good or service at a lower opportunity cost than can other producers.
11243.    Production Without Trade: An example    of pre-trade production possibilities is presented.
11254.    Specialization in Production: Each country completely specializes in the product in which it has comparative advantage.
11265.    Consumption with Specialization and Trade: The basis for trade is explained in terms of opportunity cost ratios in the two countries and an example of trade is worked out .
11276.    Gains from Trade: The gains from trade are shown for each country.
11287.    Specialization Is the Key: Trade along lines of comparative advantage allows increases in production and consumption. Specialization along lines of comparative advantage allows nations to produce more efficiently and worldwide production capabilities to increase. Then consumption can increase above what was possible before specialization and trade.
1129C.    Other Benefits from International Trade: The Transmission of Ideas: Ideas are transmitted through international trade. These ideas may be in the form of intellectual property, new goods and services, and new processes.
1130III.    The Relationship Between Imports and Exports: In the long-run, imports are paid for by exports. This is because foreigners want something in exchange for the goods that are shipped to the United States. Any restriction of imports ultimately reduces exports, because restrictions on imports lead to a reduction in employment in the export industries.
1131IV.    International Competitiveness: This term is hard to define precisely because countries do not compete, businesses within each country compete with businesses in other countries. Based on an international study, the United States leads the world in measures of competitiveness.
1132V.    Arguments Against Free Trade: Arguments against free trade point out the costs of trade. They do not consider the benefits of possible alternatives for reducing costs while still reaping benefits.
1133A.    The Infant Industry Argument: The argument that tariffs should be imposed to protect an industry that is trying to get started from import competition. After the industry becomes technologically efficient, the tariff can be lifted.
1134B.    Countering Foreign Subsidies and Dumping: When a foreign government subsidizes its producers, our producers claim they cannot compete fairly with these subsidized foreigners. To the extent that such subsidies fluctuate, one can argue that unrestricted free trade will seriously disrupt domestic producers. Occasionally, dumping takes place. Dumping is the selling of a good or service abroad at a price below its cost of production or below the price charged in the home market. This disrupts international trade and may impair commercial well–being at home.
1135C.    Protecting Domestic Jobs: The most often used argument against free trade is that unrestrained competition from other countries will eliminate U.S. jobs because other countries have lower-cost labor and less restrictive environmental standards.
1136D.    Emerging Arguments Against Free Trade: The environmental concerns that there can be undesirable effects, e.g., genetic engineering, should lead to trade restrictions. Another is the national defense argument that certain technologies should not be exported.
1137VI.    Ways to Restrict Foreign Trade
1138A.    Quotas: Quotas are government-imposed restrictions on the quantity of a specific good that another country is allowed to sell in the United States. Quotas restrict imports. These restrictions are usually applied to a specific country or countries.
11391.    Voluntary Quotas: A voluntary restraint agreement (VRA) in which a country agrees to voluntarily restrict its exports to the United States. The opposite is a voluntary import expansion agreement (VIE) in which a foreign country agrees to voluntarily increase its imports from the United States. Neither a VRA nor a VIE has the force of law.
1140B.    Tariffs: A tariff is a tax on imported goods. A protective tariff is such that no similar tax is applied to identical domestic goods.
11411.    Tariffs in the United States: Tariffs on all imported goods have varied widely. The highest tariff rates in 20th century occurred with the passage of the Smoot-Hawley tariff in 1930.
11422.    Current Tariff Laws: The Trade Expansion Act of 1962 permitted the president to reduce tariffs by up to 50 percent. The Trade Reform Act of 1974 and the Trade and Tariff Act of 1984 allowed the president to reduce tariffs further and resulted in the lowest tariff rates ever. All of these trade agreement obligations of the United States are carried out under General Agreement on Tariffs and Trade (GATT), an international agreement formed in 1947 to further world trade by reducing barriers and tariffs.
1143VII.    International Trade Organizations: Widespread efforts to reduce tariffs around the world have led to a growth of international trade organizations.
1144A.    The World Trade Organization (WTO): The successor organization to GATT handles all trade disputes among its 117 member nations. In addition, the WTO agreement will lead to a 40 percent reduction in tariffs worldwide, protection of intellectual property rights, local content laws will be eliminated, and U.S. service suppliers will be subject to the same rules as foreign suppliers in their countries.
1145B.    Regional Trade Agreements: Other international trade organizations such as the EU and NAFTA known as regional trade blocs also exist. These trade blocs are groups of nations that grant members special trade privileges.