1. Agenda, 11.7.12 Check 30/31 Review LPM & LFM Budget Balance Interest Rates & Monetary Policy Read: 32/33 (Unit 5 guide posted)

2. Review Draw a Liquidity Preference Model What causes shifts? Draw a Loanable Funds Market Model What causes shifts? Fisher Effect = inflation does not effect S/D of Loanable Funds, Nominal interest rate just rises that much (because real = nominal – interest rate)

3. Budget Balance Savings of Govt = Taxes – Govt Spending – Transfers Deficit versus surplus Business Cycle affects deficits and surpluses During recessions, larger deficit, during expansion, smaller deficit or even surplus Automatic stabilizers cause this To measure budget balance without business cycle use cyclically adjusted budget balance What would balance be if rGDP = potential output If there is a recess. Gap, would + tax revenue, lower transfers If there is an expan. Gap, would – tax revenue, raise transfers

4. Long range debt Budget balance – is it important? Is a deficit bad? IT DEPENDS Long Range: we measure in fiscal years (Oct to Sept) Debt Rolls over Measured in public debt & total debt Govt pays interest on debt, can borrow to cover debt Govt could default on debt (Argentina) Debt/GDP ratio – you want a low ratio, you want your GDP to grow more than your debt Implicit Liabilities = spending promises US has Medicare, Medicaid, Social Security Govt will owe that in future

5. Monetary Policy/Interest Rate Fed sets target federal funds rate (6 week period) How do they get the rate there? OMO usually (rarely dw or RR) Interest Rate change affects AD – how? Fed increases MS, lowers interest rate, more investment spending, higher real GDP, higher consumer spending, leads to higher Agg Demand Will contract with inflationary gap (contrationary monetary policies) Higher interest rates = less inflation

6. Monetary Policy/Interest Rate Taylor Rule says you should consider FFR = 1 + (1.5X inflation rate) + (.5Xoutput gap) Some countries set inflation target rate US does not but we stay in a safe range

7. Agenda, 11.9.12 Check 32/33 Practice FRQ Prices/Output in the Long Run Inflation HW: Module 34

8. Practice Pg 314, #2

9. Module 32 How an increase in the money supply affects the short run and the long run Short run: increase in MS increases AD which pushes price levels up Long run: SRAS eventually adjusts (rise in nominal wages after the “Sticky wages” unstick) and back to LRE but with a higher agg price level (And the opposite happens with decrease in MS)

10. Module 32 Monetary Neutrality: Change in money supply leads to proportional change in price level in the long run So if MS rises by 5%, agg price levels rise by 5% too Economists concern themselves with the short run affects of MS though

11. Module 32 Money Supply/Interest Rate in LR Money Supply increases, Interest Rate lowers Interest Rate lower equals more AD, which raises price levels Higher price levels lead to more money demanded Interest rate ends up back where it was

12. Module 33 Nominal MS (M) versus the real quantity of money (M//P) Classical Model of Price Level: Ignore transition period of increased AD and think of price level rising automatically Assumes Real GDP never changes in response to the change in money supply Doesn’t work in periods of low inflation Is applicable in periods of high inflation (quicker adjustment of wages and prices)

13. Module 33 Inflation Tax When governments prints own money it drives inflation up (increased MS = increased APL) Reduces the purchasing power of the people’s money Inflation tax = reduction in the value of the money held by the public Inflation tax is = to rate of inflation

14. Module 33 Hyperinflation: Seignorage is the revenue generated by government’s right to print money Measure the effect of seignorage by measuring real seignorage (revenue created by printing money divided by price level) Inflation spirals out of control as more money is printed to cover printed money

15. Module 33 Moderate Inflation: Cost push: Cost of integral good goes up Demand Pull: Agg demand leads to higher prices of goods when it outpaces agg supply Politics and Inflation: Policies that help economy can lead to inflation Policies to reduce inflation (deflation) can lead to depressed economies Short term gains are appealing to politicians

16. Module 33 Unemployment and Output Gap: Output gap = difference between Real GDP and potential output If Output gap is positive (inflationary gap), unemployment will be lower than natural rate Output gap negative (recessionary gap), unemployment will be higher than natural rate

17. Agenda, 11.13.12 Check M34 Practice: Pg 330, Free Response Questions Video: Phillips Curve Key Concepts: M34 HW: 35/36 Thursday: Discuss 35/36, Distribute Review Materials ***Model UN Friday = questions in Y block Thurs

18. Module 34 Phillips Curve: http://www.youtube.com/watch?v=jFKZqi1Bl-k http://www.youtube.com/watch?v=jFKZqi1Bl-k Basic idea: lower unemployment leads to higher inflation (caused by changes in AD/AS curves) Phillips Curve represents inflation rate (change in agg price level) & unemployment rate SHORT RUN (SRPC) is a negative relationship LONG RUN (LRPC) shows no relationship (vertical line) Expectations about future & supply shocks affect SRPC (positive/negative)

19. Module 34 SRPC will raise with expected inflation (and lower with expected disinflation) Idea = accelerating inflation Won’t accelerate at NAIRU (natural rate hypothesis) NAIRU = nonaccelerating inflation rate of unemployment NAIRU = LRPC Unemployment below NAIRU will mean + change in inflation rate, below NAIRU means – change in inflation rate NAIRU is estimated by economists

20. Module 34 Disinflation = contractionary policies to slow inflation Lowers Real GDP, can hurt economy but is necessary Less effect if the central bank states intentions Deflation is one result – dollar has higher value in the future Leads to lower agg. demand = debt deflation (cycle of further deflation) Deflation affects nominal interest rates (Fisher Effect) Zero bound IR = won’t go below zero = liquidity trap – when conventional monetary policies can’t be used because of a zero bound IR

21. Practice FRQ on 341