1. Lecture 4: Basics of Macroeconomics - II
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
South Class Room #600
January 20, 2007

2. Saving, Investment and the Financial System
Chapter 26
Saving, Investment
and the Financial System

4. Tax Cuts have Eased the Oil Price Shock This Time
Source: Prof. Larry J. Kimbell, Nov. 2004

5. Savings And National Income Math
GDP (as the sum of expenditures) has been defined as:
Y = C + I + G + NX
In a closed economy:
Y = C + I + G
Rearranging terms gives:
Y - C - G = I
The left-hand side, which is the nation's income (GDP) leftover after consumption and government spending, is defined as National Savings. Since Y - C - G is defined as being equal to "S":
S = I

6. Continued..
This relationship must hold for the economy as a whole (when the economy is closed). Now, with
S = Y - C - G
Add and subtract the government's tax revenue (T) to the right-hand side
S = Y - C - G + T - T
Then rearrange terms on the right hand side to get
S = (Y - T - C) + (T - G)

7. Continued..
This expression breaks down national savings into two components: private savings and public savings.
Private savings (Y - T - C) is the income left in the economy after taxes and consumption have each been paid for.
Public savings (T - G) is equal to the taxes collected by the government, minus government spending. This is also an expression for the government surplus/deficit (surplus if T > G, deficit if T < G).

8. Market For Loanable Funds
Interest
Rate
Supply
Demand 5%
$1,200
Loanable Funds
(in billions of dollars)

9. Increase in Supply of Loanable Funds
Policy 1: Saving Incentives
Interest
Supply, S1 S2
Rate
Demand
1. Tax incentives for
saving increase the
supply of loanable
fund
s . . . 5%
$1,200 2.
. . . which
reduces the
equilibrium
interest rat
e . . . 4%
$1,600
Loanable Funds 3.
. . . and raises the equilibrium
quantity of loanable funds.
(in billions of dollars)

10. Increase in Demand of Loanable Funds
Policy 2: Investment Incentives
Interest
Rate
Supply D2
1. An investment
tax credit
increases the
demand for
loanable fund
s . . .
Demand, D1 6%
$1,400 2.
. . . which
raises the
equilibrium
interest rate . . . 5%
$1,200
Loanable Funds 3.
. . . and raises the equilibrium
quantity of loanable funds.
(in billions of dollars)

11. Effect Of A Government Budget Deficit
Policy 3: Budget Deficit
Interest S2
Supply, S1
Rate
Demand
1. A budget deficit
decreases the
supply of loanable
fund
s . . .
$800 6% 2.
. . . which
raises the
equilibrium
interest rat
e . . .
$1,200 5%
Loanable Funds 3.
. . . and reduces the equilibrium
quantity of loanable funds.
(in billions of dollars)

12. The U.S. Government Debt Percent of GDP 120 World War II 100 80 60
Revolutionary
War
Civil
War
World War I 40 20
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
Copyright©2004 South-Western

13. Unemployment & Its Natural Rate
Chapter 28
Unemployment & Its Natural Rate

14. Spanish labor supply increased by 12% in 1988 when taxes were cut
Article: Why do Americans Work More Than Europeans? WSJ; by: Edward Prescott
Americans aged 15-64, on a per-person basis, work 50% more than French. The French, for example, prefer leisure more than do Americans or on the other side of the coin, that Americans like to work more. This is silliness !!
Germans and Americans spend the same amount time working, but the proportion of taxable market time vs. nontaxable home work time is different
But marginal tax rates explain virtually all of this difference. Labor supply is not fixed. People be they European or American, respond to taxed on their income.
Spanish labor supply increased by 12% in 1988 when taxes were cut

15. Identifying Unemployment
Natural Rate of Unemployment
The natural rate of unemployment is unemployment that does not go away on its own even in the long run.
It is the amount of unemployment that the economy normally experiences.
Cyclical Unemployment
Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate.
It is associated with short-term ups and downs of the business cycle.

16. Unemployment Rate Since 1960
Percent of
Labor Force 10
Unemployment rate 8 6
Natural rate of
unemployment 4 2
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Copyright©2003 Southwestern/Thomson Learning

17. How Is Unemployment Measured?
Based on the answers to the survey questions, the Bureau of Labor Statistics (BLS) places each adult into one of three categories:
Employed
Unemployed
Not in the labor force
Labor Force
The labor force is the total number of workers, including both the employed and the unemployed.
The BLS defines the labor force as the sum of the employed and the unemployed.

18. Breakdown Of The Population In 2004
Adult
Population
(223.4 million)
Employed
(139.3 million)
Labor Force
(147.4 million)
Unemployed (8.1 million)
Not in labor force
(76.0 million)

19. Unemployment - What is it?
The unemployment rate is calculated as the percentage of the labor force that is unemployed.
Labor Force Participation Rate

20. Example
In 2001, million people were employed and 6.7 million people were unemployed.
Labor Force = = million
Unemployment Rate = (6.7 / 141.8) X 100
= 4.7 percent
Labor Force Participation Rate =
(141.8 / 211.9) X = 66.9 percent

21. The Labor-Market Experiences of Various Demographic Groups (2004)
Copyright©2004 South-Western

22. Figure 3 Labor Force Participation Rates for Men and Women Since 1950
Rate (in percent)
100
Men 80 60 40
Women 20
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005

23. Questions About Unemployment
Does the Unemployment Rate Measure What We Want It To?
How Long Are the Unemployed without Work?
Why Are There Always Some People Unemployed?

25. UPDATED: 9/20/2004
LOCATION: D:\AREMOS\Banks\Georgia\Graphs\Atlemploy\Cities
BANK: ATLNAICS (primary) and GACITY_E
GRAPH: allcityru

26. Article: The Double Benefit of Tax Cuts WSJ; by: Becker, Lazear & Murphy
The sum of present and future spending, discounted by the rate of interest on government bonds, must equal the sum of present and discounted future tax revenues - David Ricardo in 19th century
Typically, economists take government spending as given by the needs of society, and assume that taxes adjust to this spending. Yet empirical evidence suggest that spending often adjusts to available tax revenue rather than the other way around.
The Reagan tax cuts of the ’80s increased federal deficits and subsequent interest payments on the debt. The need to meet these interest payments helped pressure Congress and the Clinton administration to enact welfare reform, cut defense spending on Social Security and health.
Politics: Democrats are worried about the effects of deficits and a growing debt on future spending programs. Republicans appear to be favoring a fiscal stimulus so it limits future spending on entitlement and other programs favored by Democrats
Starve the Beast: Tax cuts will keep government spending in check and will provide the incentives necessary to produce a highly skilled, productive work force that enables high economic growth and rising standards of living (the WSJ/Conservative agenda)

27. Article: The $366 Billion Outrage Fortune Magazine; by: Janice Revell
Pension plans of 16 million state and local government workers are taking up a huge share of the budgets. In the 90’s elected officials allowed workers to dramatically spike their pre-retirement compensation, to retire on more than 100% of their pay, and to draw both their salaries and pensions, with guaranteed market returns, simultaneously.
San Diego deferred retirement option plan, or DROP allows pension, deposited into a special account earn a guaranteed 8% annual rate of interest, plus a 2% annual cost-of-living adjustment. When the employee actually decides to retire he can either collect the amount that has accumulated in his special pension account or let it keep compounding at that generous rate or return indefinitely.
Result:
The pension fund is short by billions and counting ($366 Billion so far!). The generosity of the plan means workers (e.g. in Houston 44% of the city workforce) can quit without taking a major financial hit => early retirement by qualified employees.
Solution:
Raise property tax (is happening)
Cut in city services (is happening)
Cut benefits (?)

28. Chapter 29
The Monetary System

29. Money–What is it and what does it do?
Money is the set of assets in an economy that people regularly use to buy goods and services from one another
Medium of Exchange –what sellers accept from buyers as payment for goods and services. Eliminates inefficiencies of barter.
Unit of Account – When there is one unit of account, like the ($) in the United States, you don't have to think in relative terms when valuing goods and services.
Store of Value – people have the option to hold money over time as one way of storing their assets. Money is an important store of value, because it is the most liquid asset in the economy

30. Types of Money
Commodity Money money that takes the form of a commodity with intrinsic value.
Fiat Money money without intrinsic value that is used as money because of government decree  

31. How to Measure Money
Money Stock: The quantity of money circulating in the economy
Q: Suppose you want to know the size of the U.S. money stock. What should you count as money?
A: Currency and demand deposits, and a few other items (detailed below) but not credit cards.
Currency - the paper bills and coins in the hands of the public
Demand Deposits - balances in bank accounts that depositors can access on demand by writing a check (or by using a debit card)

32. Two Measures of the Money Stock for the U.S. Economy (2004)
Billions
of Dollars M2
$6,398 •
Savings deposits
Small time deposits
Money market
mutual funds
A few minor categories
($5,035 billion) M1
$1,363 •
Currency
($699 billion)
Demand deposits
Traveler ’
s checks
Other checkable deposits
($664 billion) •
Everything in M1
($1,363 billion)

33. Continued… Q: How is the U.S. money stock measured and reported?
A: Two most important measures – M1 and M2
M1 = Currency, Traveler's checks, Demand Deposits and Other Checkable Deposits
Here is a breakdown of M1 for 1996: Item$ (Billions) % of total
$ %
Currency
Traveler's Checks
Demand Deposits
Other Checkable Deposits
M2 = Everything in M1 plus Savings deposits, Small Time Deposits, Money Market Mutual Funds and a few minor categories. M2 for 1996 was $ billion.  

34. Banks & Money Supply Q: How do banks operate?
A: Banks accept deposits from people. That money is in an account until the depositor makes a withdrawal or writes a check on their account.
Q: Do banks keep all of your money in their vault?
A: No. Our banking system is called fractional reserve banking. Bankers understand that it is not necessary to keep 100 percent of a depositors money on hand at all times. As a result, bankers take some of your money and loan it out to other people.

35. Continued..
Fractional reserve banking - a banking system in which banks hold only a fraction of deposits as reserves
Reserve ratio - the fraction of deposits that banks hold as reserves. Minimum reserve ratios are set by the Fed.

36. Money Creation with Fractional-Reserve Banking
When a bank makes a loan from its reserves, the money supply increases.
The money supply is affected by the amount deposited in banks and the amount that banks loan.
Deposits into a bank are recorded as both assets and liabilities.
The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.
Loans become an asset to the bank.

37. Money Creation with Fractional-Reserve Banking
This T-Account shows a bank that…
accepts deposits,
keeps a portion as reserves,
and lends out the rest.
It assumes a reserve ratio of 10%.
Assets
Liabilities
First National Bank
Reserves
$10.00
Loans
$90.00
Deposits
$100.00
Total Assets
Total Liabilities

38. Money Creation with Fractional-Reserve Banking
When one bank loans money, that money is generally deposited into another bank.
This creates more deposits and more reserves to be lent out.
When a bank makes a loan from its reserves, the money supply increases.

39. The Money Multiplier
Suppose that the Fed requires banks to keep 20 percent of their demand deposits on reserve.  
Q: What happens when somebody brings in $100 and deposits it in a bank?
A: The bank is required to keep $20 (20 percent) on reserve.
Q: What does the bank do with the remaining $80?
A: The bank will turn around and lend it to somebody else, earning interest income for the bank.
Q: What did that $80 loan do to the size of the money supply?
A: The money supply increased by $80 when the loan was made. Here's how:

40. Continued…
When the first depositor arrived with $100 in cash, the money supply included that $100 of currency in the depositor's wallet
After the deposit, the currency was in the bank vault and not circulating (so out of the money supply)
However, demand deposits increased by $100, so the money supply was unchanged (currency fell by $100, deposits increased by $100)
When the bank made the $80 loan, $80 in currency reentered the money supply
Added to the $100 demand deposit, that original $100 has grown to $180.

41. Continued…
Now suppose that the person who received the $80 loan deposits that money into their checking account.
Q: What does the bank have to do with the $80?
A: Keep 20 percent on reserve (20 percent of $80 = $16).
Q: What does the second bank do with the remaining $64?
A: They can lend that out to somebody else

42. The Money Multiplier Money Supply = $190.00! First National Bank
Assets
Liabilities
First National Bank
Reserves
$10.00
Loans
$90.00
Deposits
$100.00
Total Assets
Total Liabilities
Second National Bank
Assets
Liabilities
Reserves
$9.00
Loans
$81.00
Deposits
$90.00
Total Assets
$90.00
Total Liabilities
$90.00
Money Supply = $190.00!

43. Money Multiplier Q: How far does this process of money creation go?
A: The process of bank money creation continues until there are no more excess reserves to be lent out.
Money multiplier - the amount of money the banking system generates with each dollar of reserves. The money multiplier is the reciprocal of the reserve ratio:
M = 1/R
With a reserve requirement, R = 20% or 1/5,
The multiplier is 5. Therefore, the original $100 deposit will eventually turn into $500 of deposits.  
Q: The banking system can create money, but can it also create real wealth?
A: No. Each loan has two parts. Recall that the first $80 loan generated $80 in new money. At the same time, that $80 loan also created a new $80 liability for the person borrowing the money. The banking system cannot create real wealth.

44. The Federal Reserve System
The Federal Reserve (Fed) serves as the nation’s central bank.
It is designed to oversee the banking system.
It regulates the quantity of money in the economy.
The primary elements in the Federal Reserve System:
1) The Board of Governors
2) The Regional Federal Reserve Banks
3) The Federal Open Market Committee

45. The Federal Reserve System
Copyright©2003 Southwestern/Thomson Learning

46. The Fed’s Organization
The Federal Open Market Committee (FOMC)
Serves as the main policy-making organ of the Federal Reserve System.
Meets approximately every six weeks to review the economy.
The FOMC is made up of the following voting members:
The chairman and the other six members of the Board of Governors.
The president of the Federal Reserve Bank of New York.
The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis).

47. The Fed’s Tools of Monetary Control
The Fed has three tools in its monetary toolbox:
Open-market operations
Changing the reserve requirement
Changing the discount rate

48. The Fed’s Tools of Monetary Control
Open-Market Operations
The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:
When the Fed buys bonds, the money supply is increased. Here is why: The Fed pays for the bonds it buys with money that was not currently a part of the money supply, hence, when the Fed buys bonds it simply increases the total amount of money in circulation.
When the Fed sells bonds, the money supply is decreased. Here is why: The Fed sells bonds in the market and receives cash in return for the bonds it sells. Once the Fed receives the cash, this cash is taken out of circulation – therefore, the size of the money supply is decreased.

49. The Fed’s Tools of Monetary Control
Reserve Requirements
The Fed also influences the money supply with reserve requirements.
Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.

50. The Fed’s Tools of Monetary Control
Changing the Discount Rate
The discount rate is the interest rate the Fed charges banks for loans.
Increasing the discount rate decreases the money supply.
Decreasing the discount rate increases the money supply.

51. Problems in Controlling the Money Supply
The Fed must wrestle with two problems that arise due to fractional-reserve banking.
The Fed does not control the amount of money that households choose to hold as deposits in banks.
The Fed does not control the amount of money that bankers choose to lend.

52. Money Growth and Inflation
Chapter 30
Money Growth and Inflation

53. The Classical Theory of Inflation
Inflation is an increase in the overall level of prices.
Hyperinflation is an extraordinarily high rate of inflation.
Historical Aspects
Over the past 60 years, prices have risen on average about 5 percent per year.
In the 1970s prices rose by 7 percent per year.
During the 1990s, prices rose at an average rate of 2 percent per year.
Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century.
Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.

54. The Classical Theory of Inflation
Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.
When the overall price level rises, the value of money falls.

55. Money Supply, Money Demand and Monetary Equilibrium
The money supply is a policy variable that is controlled by the Fed.
Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied.
Money demand has several determinants, including interest rates and the average level of prices in the economy.
People hold money because it is the medium of exchange.
The amount of money people choose to hold depends on the prices of goods and services.
In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.
Bullet 2: Mankiw has removed the word, “directly”

56. Money Supply, Money Demand, and the Equilibrium Price Level
Value of
Price
Money,
Quantity fixed
by the Fed
Money supply 1 / P
Level, P
(High) 1
Money
demand 1
(Low) 3 /
1.33 4 A 1 / 2 2
Equilibrium
value of
money
Equilibrium
price level 1 / 4 4
(Low)
(High)
Quantity of
Money
Copyright © South-Western

57. Figure 2 The Effects of Monetary Injection
Value of
Price
Money, M1
MS1 M2
MS2 1 / P
Level, P
(High) 1
Money
demand 1
(Low)
1. An increase
in the money
supply . . . 3 /
1.33 4
decreases
the value of
mone
y . . . 3.
. . . and
increases
the price
level. A 1 / 2 2 B 1 / 4 4
(Low)
(High)
Quantity of
Money
Copyright © South-Western

58. The Classical Theory of Inflation
The Quantity Theory of Money
How the price level is determined and why it might change over time is called the quantity theory of money.
The quantity of money available in the economy determines the value of money.
The primary cause of inflation is the growth in the quantity of money.

59. The Classical Dichotomy and Monetary Neutrality
Nominal variables are variables measured in monetary units.
Real variables are variables measured in physical units.
According to Hume and others, real economic variables do not change with changes in the money supply.
According to the classical dichotomy, different forces influence real and nominal variables.
Changes in the money supply affect nominal variables but not real variables.
The irrelevance of monetary changes for real variables is called monetary neutrality.

60. Velocity and the Quantity Equation
The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.
V = (P  Y)/M
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
Rewriting the equation gives the quantity equation:
M  V = P  Y

61. Velocity & Quantity Equation
Velocity ( V ) = Nominal GDP/ Money Supply = ( P x Y ) / M
Example: V = ($10 x 100 ) / $ 50
= 20

62. Velocity & Quantity Equation
The quantity equation relates the quantity of money (M) to the nominal value of output (P  Y).
The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:
the price level must rise,
the quantity of output must rise, or
the velocity of money must fall.

63. Nominal GDP, the Quantity of Money, and the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP M2
1,500
1,000
500
Velocity
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005

64. Velocity and the Quantity Equation
The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money
The velocity of money is relatively stable over time.
When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y).
Because money is neutral, money does not affect output.

67. The Inflation Tax
When the government raises revenue by printing money, it is said to levy an inflation tax.
An inflation tax is like a tax on everyone who holds money.
The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate.

68. The Nominal Interest Rate and the Inflation Rate
Percent
(per year) 15 12
Nominal interest rate 9 6
Inflation 3
1960
1965
1970
1975
1980
1985
1990
1995
2000

69. Costs of Inflation
Shoeleather Costs – resources wasted when inflation encourages people to reduce their holdings of money.
Menu Costs – the costs involved in actually changing prices around the economy.
Relative Price Variability and the Misallocation of Resources – If firms only occasionally change their prices (like once per year), then they have to guess at the future level of inflation. Their prices will be too high early in the year and too low late in the year, resulting in sales that are artificially low early in the year and artificially high late in the year.
Inflation-Induced Tax Distortions – Taxes like capital gains and interest income taxes are imposed on the nominal value of assets or on interest income. From studying real versus nominal interest rates, you know that part of the nominal interest rate exists to compensate people for the effects of inflation. The higher is the rate of inflation, the higher is this distortion caused by these taxes.

70. Continued..
Confusion and Inconvenience – Money, being the economy's unit of account, is used to quote prices for goods and services throughout the economy. Confusion and inconvenience arise as a cost of inflation because inflation makes valuing dollars over time difficult. Many important items in the economy are measured over time (like the value of a firm, for instance), and inflation creates difficulties in the valuation of assets or debts that occur over time.
Arbitrary Redistributions of Wealth – "Inflation is good for borrowers and bad for lenders" is a common phrase that rings out in economics principles courses. Here's a personal example for you to consider (and a personal example for your website author as well). When you graduate from college, you will likely owe money on student loans that you took out during your college years. Between the time you borrowed the money and the time when you repay the loan, you will be better off if inflation is high.