Unemployment Defined as that percentage of the labor force looking for work but unable to obtain it Types: Frictional-searching for jobs or waiting to take jobs Structural-changes in demand for types of labor. Obsolescence or geographic Cyclical-business cycle downturn

Full Employment Defined as the total of frictional and structural unemployment in an economy Also called the full employment rate of unemployment or the natural rate of unemployment This rate changes as the economy changes and is tied to the cultural , legal, and demographic characteristics of a population

Cost of unemployment Okun’s Law: For every 1% over the natural rate of unemployment there will be a 2% gap between actual and potential GDP

Inflation Inflation defined: a general rise in PRICE LEVEL over time, usually a one year period. Measured using price indices The Rule of 70 applies here as well

Demand Pull Inflation Spending increases faster than production Dollars chase product driving up the price level This can pull the economy into a spiral of inflation The three ranges of inflation on the AS curve are the horizontal, intermediate, and vertical

Cost Push Inflation Supply side inflation This occurs when a “shock” to prices of resources occurs; Results in a per unit production cost rise The AS curve will move to the left increasing price level and decreasing output levels Different fiscal and monetary policies will be needed to deal with each inflation

Effects of inflation Redistributes income Fixed income groups are harmed Savers can be hurt if inflation is unanticipated Debtors may be helped by paying back debt in nominal currency with a lower value, but lenders will suffer by not receiving the full value of what was lent.

Anticipated/Unanticipated Anticipated inflation is expected Lenders and others may add an “inflation premium” to interest rates Unanticipated inflation is not expected The real interest rate is the nominal interest rate minus the inflation premium Ex: inflation is 5% and anticipated; you pay 10% interest. The real interest rate is 5%

Aggregate Demand A curve showing the amount of output demanded at all price level of an economy AD has an inverse relationship to the price level This occurs due to three effects: A. Real balances effect B. Interest rate effect C. Foreign purchases effect

Determinants of AD Changes in consumer wealth Changes in consumer expectations Household indebtedness Taxes Changes in Investment Real interest rates Expected return: future business conditions, technology, capacity, taxes

Determinants of AD Changes in government purchasing will affect AD Changes in net exports An increase in exports will generally increase AD while an increase in imports will be more likely to decrease it. This is because changes in exports and imports are sensitive to the depreciation or appreciation of the dollar and government fiscal and monetary policies.

Aggregate Supply Aggregate supply is a curve showing the level of output by producers at all price levels It may be viewed as having three components: a horizontal component where price level is stable, an intermediate component where price level rises to near full employment levels, and a vertical component indicating full output has been achieved and inflation is in control

Determinants of AS Changes in input prices that change the per unit cost of production. These may include: Availability of resources Prices of resources particularly imported ones Market power or monopoly Changes in productivity can also affect AS Productivity is the amount of output per input measured in some unit.

Determinants of AS Finally, changes in taxes or subsidies and in the regulatory environment for business can be a factor in determining the amount of AS supplied

Equilibrium of AD and AS Equilibrium occurs where the AD curve and AS curve intersect. This may be at any point. Shifts in AD and less commonly shifts in AS will change this point. Shifts of the AD curve in the horizontal range of the AS curve will result in real output gains with little price level change. AD movements to the right in the intermediate range will cause real output increases as well as price level increases

Equilibrium continued AD shifts to the right in the vertical range of the AS curve will only result in price level change and no change in real output. The GDP multiplier must always be applied to shifts in the AD curve regardless of direction of movement. In the intermediate range the multiplier effect is weakened by price level change resulting in less increase or more decrease. In the horizontal range the full force of the multiplier will be felt. In the vertical range the multiplier will be nil.

Some Price level issues Although models show decreases in price level as AD decreases real world scenarios will most likely not show this. This is because price level is sticky. Prices do not fall easily and usually only in the most severe depression conditions do quantitative changes in price level occur.

Aggregate Supply Shifts Shifts in aggregate supply are harder to reconcile with modeling However, if cost push inflation occurs the AS curve will most likely shift left increasing price level and decreasing real output Productivity gains should push the AS curve right, with the best result being an increase in real output and a decrease in price level.

Fiscal Policy The Employment Act of 1946 Government to stabilize the economy Created Council of Economic Advisors Created Joint Economic Committee of Congress

Types of Fiscal Policy There are two types of fiscal policy Automatic and discretionary Discretionary fiscal policy is the deliberate manipulation of taxes and government spending by Congress to alter real domestic output, control inflation, and stimulate economic growth. These changes are at the discretion of the Congress and must be enacted specifically.

Types of Fiscal Policy Automatic Fiscal Policy is that which is built into the system in the form of progressive income taxes and transfer payments

APC and MPC The concepts of average propensity to consume and marginal propensity to consume are important in fiscal policy because the MPC/MPS formula will help to determine the GDP multiplier which is applied to all changes in aggregate demand accruing to fiscal policy. Review MPC/MPS and APC/APS. We don’t have time to go into it fully here.

Expansionary Discretionary Fiscal Policy If AD has fallen, that is there is a decrease in total spending in the economy so that the economy is no longer at FE, expansionary policy may be enacted by the government. Expansionary policy may call for an increase in government spending or a decrease in consumer and business taxes or some combination of all of these. Effectiveness will depend greatly on the scope and timing of the policy

Expansionary continued IF Govt Spending↑ then that amount times the multiplier ( which is 1/MPS) would equal the increase in AD incurred by this policy change If Taxes ↓, then that amount times the MPC times the tax multiplier( 1/MPS-1) would equal the increase in C incurred in AD by this policy. Remember for taxation you must always consider the marginality of income.

Expansionary Policy continued If expansionary policy is put in place and the government’s budget was balanced prior to the policy, a budget deficit should be incurred.

Contractionary Discretionary Fiscal Policy Contractionary Fiscal policy is a deliberate action on the part of the government designed to reduce AD due to inflationary pressures in the economy. Generally this would be demand pull inflation.

How it works IF it is determined that inflation is an issue, the government may reduce its spending, raise taxes or do some combination of the two. If the government choose to reduce spending, then the amount of spending cut times the multiplier would be taken from AD moving the AD curve left and lowering overall AD.

How it works continued IF the government decides to raise taxes (whether on consumer or business is actually unimportant) then the amount of taxes raised times the MPC times the multiplier would reduce AD moving the AD curve to the left reducing overall spending. Theses measure could also be combined to do the same thing.

Contractionary Discretionary cont. Such policies should result in a budget surplus for the government as increased taxes, reduced spending, or both pull money into the government and reduce individual and business spending.

Financing Deficits Deficits can be financed by borrowing. This may result in a crowding out of private investment, and increase in interest rates, and an offset of the expansionary policy. Deficits can be financed by creating money. Surpluses can be dealt with in two ways. Reduce debt (but you may fan inflation) or Impound the surplus and not spend it.

Components of Built in Stability Because taxes and transfer payments change with the economy, movements of AD into recession or into inflation bring the automatic stabilizers into play. Taxes automatically rise as income increases and fall as income decreases offsetting changes in total spending Transfer payments automatically fall as income rises and rise as income falls offsetting changes in total spending.

Responsiveness to Automatic Stability The more progressive the tax structure of an economy the more “stability” automatic stabilizers will have. The less progressive the tax system the less it will have. Economies with large entitlement programs tied to economic cycles will also have stronger automatic stability.

Evaluating Fiscal Policy Built in stability means that deficits will rise with declines in AD and surpluses will be created with increases in AD. So if there is a deficit due to this CYCLICAL change there is no discretionary policy in effect. This is true for surpluses as well. TO understand if policy is in effect we must look to the concept of the full employment budget.

Full Employment Budget The full employment budget is a model that allows us to figure out what the government deficit or surplus would be with current taxation and spending at full employment. If the actual deficit or surplus is greater than that modeled full employment budget + or -, then some type of fiscal policy has been implemented. If the actual deficit or surplus is equal to the modeled deficit or surplus at full employment, no fiscal policy is in effect.

Problems, Limitations, Critiques Timing: Recognition, Administration, Operational Political Issues: a political business cycle State and local finances and policies Crowding out effect of borrowing Shocks or changes from outside the economy