Performance and Policy Real GDP Corrects for price changes Nominal GDP Uses current prices Unemployment Actively seeking employment Inflation Increase in overall level of prices

Expenditures Approach Four components of GDP: Consumer Spending- 70% of U.S. GDP Purchases of final goods/services by private individuals. Ex: A burrito, car insurance Gross Investment- 15% of U.S. GDP Businesses spending on tools, equipment, construction, R&D, changing inventories, depreciation Ex: Walmart buys self checkout machines 3. Government Spending- 20% of U.S. GDP Ex: School, tanks, but NOT transfer payments 4. Net Exports- Exports (X) – Imports (M) Ex: Value of 3 Ford Focuses minus 2 Nissans GDP = C + Ig + G + Xn Copyright ACDC Leadership 2015

The Business Cycle Durable and nondurable industries Peak Peak Trend Peak Expansion Growth Level of Real Output Recession Expansion Trough Recession Trough Time Durable and nondurable industries affected differently

The PPC and the Business Cycle Max Capacity 0% Unemployment Real GDP Capital Goods Real GDP Consumer Goods Time 6+% Unemployment Full Employment 5% Unemployment 4-6% Unemployment Super low unemployment leads to inflation 4 Copyright ACDC Leadership 2015

Unemployment Types of unemployment Full employment redefined Frictional (search and wait) I Quit! --- You’re Fired! Structural (occupational and geographical) Cyclical Full employment redefined No cyclical unemployment Natural rate of unemployment Stay tuned Full employment rate

CPI CPI = x Consumer price index (CPI) Market basket 300 goods and services Typical urban consumer 2 year updates *****Base year used by Bureau of Labor Statistics is 1982-1984 (CPI1982-84 = 100) CPI Price of the Most Recent Market Basket in the Particular Year Price estimate of the Market Basket in Base Year = x 100

Rate of Inflation This year index – Last year index Last year index

Because people can either save or consume MPC + MPS = 1 Why is this true? Because people can either save or consume Copyright ACDC Leadership 2015

Calculating the Spending Multiplier If the MPC is .75 how much is the multiplier? Spending Multiplier OR If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP? How much will a decrease of $3 in spending decrease GDP? MPC = .5 the multiplier is 2 = Multiplier x Total change in GDP Initial Change in Spending 9 Copyright ACDC Leadership 2015

Use the AD and AS model to show an economy at full employment output LRAS Price Level AS PLe AD QY GDPR 10 Copyright ACDC Leadership 2015

#1. Assume there is an increase in consumer spending #1. Assume there is an increase in consumer spending. What happens to PL and output in the short-run? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 11 Copyright ACDC Leadership 2015

Example: Assume consumer spending falls. What happens to PL and Output? LRAS Price Level AS PL and Q will decrease PLe PL1 AD AD1 Q1 QY GDPR 12 Copyright ACDC Leadership 2015

Stagnate Economy + Inflation Still considered recessionary gap Example: If there is a negative “supply shock” of oil. What happens to PL and Output? LRAS Price Level AS1 AS Stagflation Stagnate Economy + Inflation PL1 PLe Still considered recessionary gap AD Q1 QY GDPR 13 Copyright ACDC Leadership 2015

If investment increases, what happens in the short-run and long-run? Capital Stock- Machinery and tools purchased by businesses that increase their output Price Level LRAS LRAS1 The PPC shifts outward since producers can make more AS AS1 Capital Goods PL1 PLe AD AD1 QY Q1 QY1 GDPR Consumer Goods 14 Copyright ACDC Leadership 2015

3 Functions of Money 1. A Medium of Exchange 2. A Unit of Account Money can easily be used to buy goods and services with no complications of barter system. 2. A Unit of Account Money measures the value of all goods and services. Money acts as a measurement of value. 1 goat = $50 = 5 chickens OR 1 chicken = $10 3. A Store of Value Money allows you to store purchasing power for the future. Copyright ACDC Leadership 2015

The Supply for Money This is called Monetary Policy. MS MD The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) What does the MS curve look like? Why? Interest Rate (ir) MS The FED can change the money supply. This is called Monetary Policy. 20% 5% 2% MD 200 Quantity of Money (billions of dollars) Copyright ACDC Leadership 2015

Increasing the Money Supply Interest Rate (ir) MS MS1 If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The surplus will cause the interest rate to fall to 2% 10% 5% 2% How does this affect AD? MD 200 250 Quantity of Money (billions of dollars) Increase money supply Decreases interest rate Increases investment Increases AD Copyright ACDC Leadership 2015

Decreasing the Money Supply Interest Rate (ir) MS1 MS If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause the interest rate to rise to 10% 10% 5% 2% How does this affect AD? MD 150 200 Quantity of Money (billions of dollars) Decrease money supply Increase interest rate Decrease investment Decrease AD 18 Copyright ACDC Leadership 2015

Tools of Monetary Policy Open Market Operations – WHAT IS IT? Buying and selling securities (mostly treasury bonds) Used to influence the money supply The reserve ratio – WHAT IS IT? Changes the money multiplier AND excess reserves The discount rate – WHAT IS IT? The Fed as lender of last resort Short term loans 33-19

Expansionary Monetary Policy Problem: unemployment and recession CAUSE-EFFECT CHAIN Fed buys bonds, lowers reserve ratio, or lowers the discount rate Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises 33-20

Quantity of Investment Interest Rate (i) S&D of Money Interest Rate (i) Investment Demand SM SM1 10% 5% 2% 10% 5% 2% DM DI 200 250 QuantityM Quantity of Investment AD/AS PL The FED increases the money supply to stimulate the economy… AS PL1 PLe Interest Rates Decreases Investment Increases AD, GDP and PL Increases AD AD1 Copyright ACDC Leadership 2015 Qe Q1 GDPR

Restrictive Monetary Policy Problem: inflation CAUSE-EFFECT CHAIN Fed sells bonds, increases reserve ratio, or increases the discount rate Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines 33-22

Quantity of Investment Interest Rate (i) S&D of Money Interest Rate (i) Investment Demand SM1 SM 10% 5% 2% 10% 5% 2% DM DI 175 200 QuantityM Quantity of Investment AD/AS PL The FED decreases the money supply to slow down the economy… AS PLe Interest Rates increase Investment decreases AD, GDP and PL decrease PL1 AD AD1 23 Copyright ACDC Leadership 2015 Q1 Qe GDPR

Loanable Funds Market Example: The Govt. increases deficit spending? Government borrows from private sector (issues bonds) increasing the demand for loanable funds Real Interest Rate SLenders Private investment crowded out What happens to private investment? Real interest rates increase causing crowding out!! r1 re D2 – priv.+gov. D1 - private QLoans Q1 Quantity of Loans 24 Copyright ACDC Leadership 2015

Expansionary Fiscal Policy (The GAS) Contractionary Fiscal Policy (The BRAKE) Laws that reduce inflation, decrease GDP (Close a Inflationary Gap) Decrease Government Spending Increase Taxes (Decreasing disposable income) Combinations of the Two Expansionary Fiscal Policy (The GAS) Laws that reduce unemployment and increase GDP (Close a Recessionary Gap) Increase Government Spending Decrease Taxes (Increasing disposable income) Combinations of the Two 25 Copyright ACDC Leadership 2015

Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .8) LRAS What type of gap? Contractionary or Expansionary needed? What are two options to fix the gap? What is the least amount of initial government spending to close gap? AS Price level P1 AD2 AD1 $10 Billion $50 $100 Real GDP (billions) Copyright ACDC Leadership 2015

Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .5) LRAS What type of gap? Contractionary or Expansionary needed? What are two options to fix the gap? How much needed to close gap? AS P2 Price level -$10 Billion AD1 AD $80 $100 Real GDP (billions) Copyright ACDC Leadership 2015

Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation When there is a recession, unemployment is high but inflation is low 5% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% SRPC 2% 9% Unemployment 28 Copyright ACDC Leadership 2015

Short Run vs. Long Run Long Run Phillips Curve In the long run there is no tradeoff between inflation and unemployment Long Run Phillips Curve Inflation 5% The LRPC is vertical at the Natural Rate of Unemployment 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% 2% 5% 9% Unemployment 29 Copyright ACDC Leadership 2015

The Long-Run Phillips Curve PCLR 3 6 9 12 15 PC3 b3 PC2 a3 Annual Rate of Inflation (Percent) b2 PC1 a2 c3 b1 a1 c2 3 4 5 6 Unemployment Rate (Percent) 35-30

Taxes and Aggregate Supply Supply-side economics Tax incentives to work Tax incentives to save and invest The Laffer curve 100 n Laffer Curve Tax Rate (Percent) m m Maximum Tax Revenue l Tax Revenue (Dollars) 35-31

Three Ranges of Aggregate Supply 1. Keynesian Range- Horizontal at low output 2. Intermediate Range- Upward sloping 3. Classical Range- Vertical at Physical Capacity AS Price level Classical Range Keynesian Range Intermediate Range Qf Real domestic output, GDP 32

Supply and Demand Analysis U.S. Domestic Aluminum Market (b) U.S. Export Supply and Import Demand Price (Per Pound; U.S. Dollars 1.50 1.25 1.00 .75 .50 50 75 100 125 150 Quantity of Aluminum (Millions of Pounds) Surplus = 100 1.50 1.25 1.00 .75 .50 50 100 Quantity of Aluminum (Millions of Pounds) Price (Per Pound; U.S. Dollars Sd c Surplus = 50 U.S. Export Supply b a U.S. Import Demand x Shortage = 50 y Shortage = 100 Dd 37-33

Supply and Demand Analysis Canada’s Domestic Aluminum Market (b) Canada’s Export Supply and Import Demand Price (Per Pound; U.S. Dollars 1.50 1.25 1.00 .75 .50 50 75 100 125 150 Quantity of Aluminum (Millions of Pounds) 1.50 1.25 1.00 .75 .50 50 100 Quantity of Aluminum (Millions of Pounds) Price (Per Pound; U.S. Dollars Surplus = 100 Sd s Surplus = 50 Canadian Export Supply r q Canadian Import Demand Shortage = 50 t Dd 37-34

International Equilibrium Import demand = Export supply 1.00 .75 .88 50 100 Quantity of Aluminum (Millions of Pounds) Price (Per Pound; U.S. Dollars U.S. Export Supply Canadian Export Supply e Equilibrium U.S. Import Demand Canadian Import Demand 37-35

Trade Barriers Economic Effects of a Tariff or Quota Free trade provides consumers with a higher quantity at a lower price! Quantity Price Sd Who/What benefits from the tariff? Who/What suffers? Sd + Q Pd Pt Pw What about a quota? Dd a b q c d 37-36

What happens if Europeans prefer vacationing in the United States? € Dollars $ Euros $ € S er1 S S1 ere ere D1 er1 D D Quantity of Dollars Quantity of Euros The Dollar APPRECIATES The Euro DEPRECIATES Copyright ACDC Leadership 2015