7.

Reconciling AD/AS with Keynesian Cross the various C + I and 45 degree line
intersections, if multiplied by the appropriate price level will yield one point on the
aggregate demand curve. Shifts in aggregate demand can be shown with holding the
price level constant and showing increases or decreases in C + I in the Keynesian
Cross model. Both models can be used to analyze essentially the same
macroeconomic events.

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 7. Fiscal Policy

Lecture Notes

1. Discretionary Fiscal Policy - involves government expenditures and/or taxes to

stabilize the economy.

a. Employment Act of 1946 - formalized the government's responsibility in

promoting economic stability.

b. simplifying assumptions for the analyses presented here:

1. exogenous I & X,

2. G does initially impact private decisions,

3. all taxes are personal taxes,

4. some exogenous taxes collected,

5. no monetary effects, fixed initial price level, and

6. fiscal policy impacts only demand side.

2. Changes in Government Expenditures - can be made for several reasons:

a. Stabilization of the economy,

1. To close a recessionary gap the government must spend an amount

that time the multiplier will equal the total gap.

2. To close an inflationary gap the government must cut expenditures by

an amount that times the multiplier will equal the inflationary gap.

b. Political goals, and

c. Provision of necessary goods & services.

26
 An increased government expenditure of $20 billion results in an increase in GDP
of $80 billion with an MPC of .75, hence a multiplier of 4.

3. Taxation effects both consumption and savings.

a. If the government uses a lump sum tax increase to reduce an inflationary gap
the reduction in GDP occurs thusly:

1. The lump sum tax must be multiplied by the MPC to obtain the
reduction in consumption;

2. The reduction in consumption is then multiplied by the multiplier.

b. A decrease in taxes works the same way, the total impact is the lump sum
reduction times the MPC to obtain the increase in consumption, which is, in turn,
multiplied by the multiplier to obtain the full impact on GDP.

c. A short-cut method with taxes is to calculate the multiplier, as you would with
an increase in government expenditures and deduct one from it.

4. The balanced budget multiplier is always one.

a. Occurs when the amount of government expenditures goes up by the same

amount that a lump sum tax is increased.

b. That is because only the initial expenditure increases GDP and the remaining
multiplier effect is offset by taxation.

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5. Tax structure refers to the burden of the tax:

a. progressive is where the effective tax rate increases with ability to pay,

b. regressive is where the effective tax rate increases as ability to pay

decreases,

c. proportional is where a fixed proportion of ability to pay is taken in taxes.

6. Automatic stabilizers help to smooth business cycles without further legislative

action:

a. Progressive income taxes,

b. Unemployment compensation,

c. Government entitlement programs

7. Fiscal Lag - there are numerous lags involved with the implementation of fiscal
policy. It is not uncommon for fiscal policy to take 2 or 3 years to have a noticeable
effect, after Congress begins to enact fiscal measures.

a. Recognition lag - how long to start to react.

b. Administrative lag - how long to have legislation enacted & implemented.

c. Operational lag - how long it takes to have effects in economy.

8. Politics and Fiscal Policy.

a. Public choice economists claim that politicians maximize their own utility by
legislative action.

b. Log-rolling and negotiations results in many bills that impose costs.

9. Government deficits and crowding - out. It is alleged that private spending is

displaced when the government borrows to finance spending:

a. Ricardian Equivalence - deficit financing same effect on GDP as increased

tax.

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10. Open economy problems. Because there is a foreign sector that impacts GDP
there are potential problems for fiscal policy arising from foreign sources.

a. increased interest - net export effect

1. An increase in the interest rate domestically will attract foreign capital,

but this increases the demand for dollars which increases their value and
thereby reduces exports, hence GDP.

b. foreign shocks - in addition to currency exchange rates.

1. Oil crises increased costs of production in the U.S.

29
 8. Economic Growth

Lecture Notes

1. Economic growth is defined in one of two ways, as a total (hence GDP) or as a per
capita (hence GDP per capita). Each of these definitions has its uses. The second
definition is of the greatest importance in defining the standard of living in a country.

a. The following production possibilities frontier shows economic growth in a

simple two commodity economy.

b. The assumptions underpinning the production possibilities model is that there

are only two commodities produced, there is a fixed technology and number of
resources, and these resources are used in an economically efficient manner.

2. Developing economies are classified into two categories:

a. middle-income countries $760 to $9300 per capita GDP in 2000

b. low-income countries those below $760 per capita GDP in 2000.

30
 1. The majority of Latin countries are middle-income countries and the
majority of sub-Saharan African countries and South-Asian countries are
low income countries. The industrial, high income countries are the U.S.,
Canada, Australia, New Zealand, Japan, and Western Europe.

c. Growth-paths are the historical tracing of how an economy moved from

being less developed to a developed economy. The prerequisites to
economic growth, which include:

(1) Establishing and implementing domestic rules of law,

(2) Opening the economy to international trade,

(3) Controlling population growth,

(4) Encouraging foreign direct investment,

(5) Building human capital,

(6) Reasonable monetary institutions and markets,

(7) Minimizing the role of the military both domestically and internationally,
and

(8) Encouraging the growth of the private sector relative to the public
sector.

31
 d. Aggregate demand, aggregate supply over time shows accelerating economic
growth.

1. The following graph translates the AS/AD model into the secular trend.

2. In Indonesia, India, and several middle-eastern and African countries

there are significant problems with corruption, and capital flight. It is
nearly impossible to attract capital to a developing nation, if the

government is corrupt and there is little in the way of political stability or

the rule of law. In the late 1990s there were stories coming out of
Indonesia where high government officials were leaving the country with
several suitcases of U.S. dollars – classic capital flight.

e. Economic growth is a long-term secular trend.

3. The accumulation of capital in the United States was both domestic capital, and the
attraction of foreign capital.

a. Political instability in Europe

b. U.S. natural resources

c. Rule of law and political stability

d. Innovation

32
4. The Asian Tiger economies, China, Taiwan, Indonesia, South Korea, Malaysia, the
Philippines, and Thailand all experienced very substantial growth.

a. Much of this growth depended on two things, low wage labor for
manufacturing, particularly in the electronics industry, and exports.

5. The majority of the world’s population lives in low-income countries.

a. Indebted,

1. Help here is important

b. Population outgrowing the economy,

c. Narcotic effect of foreign aid

d. Brain Drain

e. Political instability

1. Arms trade

f. Capital Flight

g. International Trade

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 9. Money and Banking

Lecture Notes

1. Functions of Money - there are three functions of money:

a. Medium of exchange - accepted as "legal tender" or something of general and

specified value.

1. Use avoids reliance on barter.

2. Barter requires a coincidence of wants and severely complicates a

market economy.

b. Measure of value - permits value to be stated in terms of a standard and

universally understood standard.

c. Store of value - can be saved with little risk, chance of spoilage and virtually
no cost and later exchanged for commodities without these positive storage
characteristics.

2. Supply of money

a. There are numerous definitions of money M1 through M3 most commonly

used.

1. M1 is currency + checkable deposits

2. M2 is M1 + noncheckable savings account, time deposits of less

$100,000, Money Market Deposit Accounts, and Money Market Mutual
Funds.

3. M3 is M2 + large time deposit (larger than $100,000).

3. Near Money - are items that fulfill portions of the requirements of the functions of
money.

34
 a. Credit cards - fulfill exchange function, but are not a measure of value and if
there is a credit line, can be used to store value.

b. Other forms of near money:

1. Precious metals - store of value, but not easily exchanged

2. Stocks and Bonds - earnings instruments, but can be used as store of

value.

c. Implications for near money - stability, spending habits & policy

4. What gives money value

a. No more gold standard

1. Nixon eliminated gold standard

b. The Value of money depends upon:

1. acceptability for payment,

2. because the government claims it is legal tender, and

3. its relative scarcity.

5. Value of dollar = D = 1/P

6. Demand for Money - three components of money demand:

a. Transactions demand

b. Asset demand

c. Total demand

35
 The money supply curve is vertical because the supply of money is exogenously
determined by the Federal Reserve. The money demand curve slopes downward and
to the right. The intersection of the money demand and money supply curves
represents equilibrium in the money market and determines the interest rate (price of
money).

7. Money market

a. With bonds that pay a specified interest payment per quarter then:

1. interest rate and value of bond inversely related

8. U.S. Financial System

a. FDIC - Federal Deposit Insurance Corporation - guarantees bank deposits.

b. Federal Reserve System - is comprised of member banks. The Board of

Governors and Chairman are nominated by the President of United States. The
structure of the system is:

1. Board of Governors

2. Open Market Committee

3. Federal Advisory Council

4. 12 regions

36
 c. Functions

1. Set reserves requirements,

2. Check clearing services,

3. Fiscal agents for U.S. government,

4. Supervision of banks,

5. Control money supply through FOMC,

9. Moral hazard - insuring reduces insured's incentive to assure risk does not happen

37
 10. Multiple Expansion of Money

Lecture Notes

1. Balance sheet (T accounts -- assets = liabilities + net worth)

a. is nothing more than a convenient reporting tool.

2. Fractional Reserve Requirements

a. Goldsmiths used to issue paper money receipts, backed by stocks of gold.

The stocks of gold acted as a reserve to assure payment if the paper claims were
presented for payment.

1. Genghis Khan first issued paper money in the thirteenth century - it

was backed by nothing except the Khan's authority.

b. The U.S. did not have a central banking system from the 1820 through 1914.
In the early part of this century several financial panics pointed to the need for a
central banking and financial regulation.

1. States and private companies used to issue paper money.

2. In the early days of U.S. history Spanish silver coins were widely
circulated in the U.S.

3. The first U.S. paper money was issued during the Civil War (The
Greenback Act), which included fractional currency (paper dimes &
nickels!).

c. Today, the Federal Reserve requires banks to keep a portion of its deposits
as reserves.

1. purposes to keep banks solvent & prevent financial panics

3. RRR (Required Reserve Ratio) and multiple expansion of money supply through T
accounts

a. How reserves are kept

38
 1. Loans from Fed - discount rate at which Fed loans reserves to
members

2. Vault cash

3. Deposits with Fed

4. Fed funds rate - the rate at which members loan each other reserves

b. RRR = Required reserve/demand deposit liabilities

c. actual, required, and excess reserves

4. Money created through deposit/loan redepositing

a. Money is created by a bank receiving a deposit, and then loaning that non-
reserve portion of the deposit, which is deposited and loans made against those
deposits.

1. If the required reserve ratio is .10, then a bank must retain 10% of each
deposit as a reserve and can loan 90% of the deposit; the multiple
expansion of money, assuming a required reserve ratio of .10, is
therefore:

Deposit Loan

$10.00 9.00
9.00 8.10
8.10 7.29
. .
. .
_______ _______
$ 100.00 $90.00

Total new money is the initial deposit of $10 + $90 of multiple expansion for a
total of $100.00 in new money.

5. Money multiplier Mm = 1/RRR

a. Is the short-hand method of calculating the entries in banks' T accounts and

shows how much an initial injection of money into the system generates in total
money supply.

39
b. With a required reserve ratio of .05 the money multiplier is 20 & with a
required reserve ratio of .20 the money multiplier is 5.

c. the Federal Reserve needs to inject only that fraction of money that time the
multiplier will increase the money supply to the desired levels.

40
 11. Federal Reserve and Monetary Policy

Lecture Notes

1. Monetary policy, defined and objectives

a. Monetary policy is carried out by the Federal Reserve System and is focused
on controlling the money supply.

b. The fundamental objective of monetary policy is to assist the economy in

attaining a full employment, non-inflationary equilibrium.

2. Tools of Monetary Policy

a. Open Market Operations is the selling and buying of U.S. treasury obligations
in the open market.

b. Expansionary monetary policy involves the buying of bonds.

1. The Fed buying bonds, it puts money into the hands of those who had
held bonds.

c. Contractionary monetary policy involves the selling of bonds.

1. The Fed sells bonds it removes money from the system and replaces it
with bonds.

3. Required Reserve Ratio - the Fed can raise or lower the required reserve ratio.

a. Increasing the required reserve ratio, reduces the money multiplier, hence
reduces the amount by which multiple expansions of the money supply can
occur.

1. decreasing the required reserve ratio increases the money multiplier,

and permits more multiple expansion of the money supply.

4. The Discount Rate is the rate at which the Fed will loan reserves to member banks
for short periods of time.

41
5. Velocity of Money - is how often the money supply turns-over.

a. The quantity theory of money is: MV = PQ

1. This equation has velocity (V) which is nearly constant and output (Q)
which grows slowly, so what happens to the money supply (M) should be
directly reflect in the price level (P).

6. Target Dilemma in Monetary Policy

a. Interest rates and the business cycle may present a dilemma. Expansionary
monetary policy may result in higher interest rates which dampen expansionary
policies.

b. Fiscal and monetary policies may also be contradictory.

7. Easy Money - lowering interest rates, expanding money supply.

a. mitigate recession and stimulate growth.

8. Tight Money - increasing interest rates, contracting money supply.

a. mitigate inflation and slow growth.

9. Monetary rules - Milton Friedman

a. Discretionary monetary policy often misses targets in U.S. monetary history

b. Suspicion of Fed and FOMC – perhaps overblown

42
 12. Economic Stability and Policy

Lecture Notes

1. Inflation, Unemployment and Economic Policy

a. The misery index is the inflation rate plus the unemployment rate.

2. The Phillips Curve is a statistical relation between unemployment and inflation

named for A. W. Phillips who examined the relation in the United Kingdom and
published his results in 1958. (Actually Irving Fisher had done earlier work on the
subject in 1926).

a. Short run trade-off

Often used to support activitist role for government, however, the short-run trade-
off view of the Phillips curve demonstrates that there is a cruel choice between
increased inflation or increased unemployment, but low inflation and unemployment
together are not possible.

b. Long run Phillips Curve is alleged to be vertical at the natural rate of

unemployment.

43
 This long-run view of the Phillips Curve is also called the Natural Rate
Hypothesis. It is based on the idea that people constantly adapt to current economic
conditions and that their expectations are subject to "adaptive" revisions almost
constantly. If this is the case, then business and consumers cannot be fooled into
thinking that there is a reason for unemployment to cure inflation or vice versa.

c. Possible positive sloping has hypothesized by Milton Friedman. Friedman

was of the opinion that the may be a transitional Phillips curve while people adapt
both their expectations and institutions to new economic realities. The positively
sloped Phillips curve is show in the following picture:

The positively sloped transitional Phillips Curve is consistent with the

observations of the early 1980s when both high rates of unemployment existed together
with high rates of inflation -- a condition called stagflation.

44
 d. Cruel choices only exist in the case of the short-run trade-off view of the
Phillips Curve. However, there maybe a "Lady and Tiger Dilemma" for policy
makers relying on the Phillips Curve to make policy decisions.

3. Rational expectations is a theory that businesses and consumers will be able to

accurately forecast prices (and other relevant economic variables). If the accuracy of
consumers' and business expectations permit them to behave as though they know
what will happen, then it is argued that only a vertical Phillips Curve is possible, as long
as political and economic institutions remain stable.

4. Market policies are concerned with correcting specific observed economic woes.

a. Equity policies are designed to assure "a social safety net" at the minimum
and at the liberal extreme to redistribute income.

1. The Lorenz Curve and Gini Coefficients are used to measure income
distribution in economies.

The Lorenz curve maps the distribution of income among across the population.
The 45 degree line shows what the distribution of income would be if income was
uniformly distributed across the population. However, the Lorenz curve drops down
below the 45 degree line showing that poorer people receive less than rich people.

The Gini coefficient is the percentage of the triangle mapped out by the 45
degree line, the indicator line from the top of the 45 degree line to the percentage of
income axis, and the percentage of income axis that is accounted for by the area
between the Lorenz curve and the 45 degree line. If the Gini coefficient is near zero,

45
income is close to uniformly distributed; if is near 1 then income is mal-distributed.

b. Productivity is also the subject of specific policies. The Investment Tax

Credit, WIN program, and various state and federal training programs are
focused increasing productivity.

c. Trade barriers have been reduced through NAFTA and GATT in hopes of
fostering more U.S. exports.

5. Wage-Price Policies

a. Attempts have been made to directly control inflation through price controls,
this seemed to work reasonably well during World War II. Carter tried voluntary
guidelines that failed, and Nixon tried controls that simply were a disaster.

6. Supply Side Economics of the Reagan Administration were based on the theory that
stimulating the economy would prevent deficits as government spending for the military
was increased. This failed theory was based on something called the Laffer Curve.

a. Laffer Curve (named for Arthur Laffer) is a relation between tax rates and tax
receipts. Laffer's idea was rather simple, he posited that there was optimal tax
rate, above which receipt went down and below which receipts went down. The
Laffer curve is shown below:

The Laffer Curve shows that the same tax receipts will be collected at the rates
labelled both "too high" and "too low." What the supply-siders thought was that tax

46
rates were too high and that a reduction in tax rates would permit them to slide down
and to the right on the Laffer Curve and collect more revenue. In other words, they
thought the tax rate was above the optimal. We got a big tax rate reduction and found,
unfortunately, that we were below the optimal and tax revenues fell, while we
dramatically increased the budget. In other words, record-breaking deficits and debt.

b. There were other tenets of the supply-side view of the world. These
economists thought there was too much government regulation. After Jimmy
Carter de-regulated trucking and airlines, there was much rhetoric and little
action to de-regulate other aspects of American economic life.

7. Unfortunately, the realities of American economic policy is that politics is often main
motivation for policy.

a. Tax cuts are popular, tax increases are not.

b. Deficits are a natural propensity for politicians unwilling to cut pork from their
own districts and unwilling to increase taxes.

8. Politics - economics provides a scientific approach to understanding, politics is the

“art of the possible” what is good economically maybe horrible politically and vice versa

a. Public choice literature

1. Politicians act in self-interest just like the rest of us

47
 13. Epilogue

Lecture Notes

1. Why study Macroeconomics:

a. Knowledge is prerequisite for democracy

1. Founding fathers thought that knowledge was what prevented

despotism – Jefferson and the free Press

b. Business conditions

1. Environment in which business is conducted, importance cannot be

minimized in a practical sense.

2. Becoming more important as economy becomes more global –

exchange rates, reasons for shifting fortunes etc.

c. Self-preservation – very powerful incentives

1. Individual economic planning – 401K, investments, etc.

2. Understanding markets requires understanding the environment in

which they work – full circle to a and b above

2. Futurism, macroeconomic variables are powerful determinants of the future well-

being of societies and people.

a. Commodities - Oil (energy in general); metals; natural resources; etc.

b. Climate changes impacting markets and whole areas

c. Technological changes - products and processes available today which didn’t

exist 10 years ago

d. Political and institutional changes - terrorism, foreign policy etc.

e. Unanticipated issues and reactions – the historical record shows that much of
this shapes what the modern world is.

48
3. Economics as a career

a. Economics majors, areas in which they work, one of fastest growing majors in
U.S. universities

b. Graduate training almost required today - economic foundations in business,

law, teaching, etc.

c. Not dependent on institutional arrangements

49