U R I N GP R I C EL E V E L

. Price Inder: Aleragc lc-rel of priccs relatire to the

[.conomics: of hou' scarce resources are
The str"rd-v.- DEMAND averasL-ler,cl in a base time period. C clst of'a fireci basket )
. D e m a n d C u r y e ( S c h e d u l e ) :A c u r v e ( t a b l c )s h o w i n g
. : . . ' . . r 1 - ' t. lr n r ( ) n Sc o m p e t r n g u s e s . of'soods reportcd as a pcrcr-ntasc r)i'basc pcriocl cost. n
ho F-conomic Questions Include:
\\ r.rt l: produced'.)
t h e q u a n t i t i e so f a g o o d a c o n s u r r e ri s u ' i l l i n g a n d a b l c
to buy at alternative prices ,r.rir r'n constant tastcs.
. G D P P R I C E I N D E X : A r n e a s u l c o t ' c h a n s c - si n t h c
v
A v e r a q ep r i c e o 1 ' a l l g o o c l s a n c l s e l v i c e s
I il,,rr r: lt produced'.)
: \\:r,,lcls \\hat is produced'J
i n c o m e s r. e l a t c dp r i c e s .a n d n u r n b e ro f b L r y c r s .
. L a w o f D e m a n d : I n c r e a s ei n p r i c e( P ) c a u s e sd e c r e a s e
. C o n s u m e r P r i c e I n d e x ( C P I ) : A r r c a s u r c o f ' c h a n g e si n
the ar'eraqeprice' of Llrbalrconsuller goods ancl sc-n icc's. ffl
!
i n q u a n t i t y('Q ) d c r n a n d e d . . Producer Price Inder (PPI): .A nrL-asrlrL- o1'ehun-uc-s irr ill
t,R0I)T (--I-IO\ POSSIBILITY FRONTIER: . C h a n g e i n d e m a n d : C h a n g ei n t a s t e sp^ r i c c o f ' r c l a t c d
I : r , ' . r l l " r n a t r rc c o r " n b i n a t i o n so f f i n a l g o o d s a n d
..': . r!c: that could be produced in a given tinte period
goocls.ir.rcorne.increasein nutnber of bu'n'ers:alters
p l a n n c dc o n s u r n p t i o na t a l l p r i c e s .s h i f i i n g c u r v e t o
tlte arelagc pnce of'uoclrls borrglrt br ploclucer: (inclLrclcs
cnrcle nratcrials: intenrrediatc gr.rods:f inishccl goocls).
. Clost Of l.iring Adjustment (COt-A): ,\utomatic
7
, ' : : r . t l l . r r l i l a b l . - a n d l i r n i t e d r e s o u r c e sa n d t e c h n o l o g y . r i g l r t( i n c r c - a s co)r l e f i ( d e c r e a s e ) .
. C h a n g ei n q u a n t i t l ' d e m a n d e d :( - a t i s e db r t r * n I r r t c c
a c i j u s t m c n t st r f ' r n c o r r . r ct o t h c r a t c o l ' i n l l a t i o n . )
I l.i:lrrrlc-rrlpportunitV cost: Obtaining more production
ME A S U R IN GIN FLA TIO N
,; ',11s'g1r1rd rL-quiresa reduction in the production (lost c h a n g ea n d r e s u l t si n m o r c n r c r .ar tl o n gc u r v e. . I n l l a t i o n : ( ' o n t i r t r r i n , gi n c r c a s c i n t h c a r c r a g c l e r c l o f '
, ' r n \ \ r t u l l l t \) o f ' o n e o r m o r e o t h e r g o o d s .
. R e l a t e d p r i c e s : I n c l r " r c lpcr i c e s o l c o t n p l e t n e n t so r
p r i eC . o l ' ! r r t t t l : l t l l t l : C tr i ec : r r re I ' l i l l ) e.
s u b s t i t u t eisn c l L r d i n g f u t u r cc o n s L r m p t i o n . . D e l l a t i o n : ( ' ( ) n t l n u l n u c l c c r e a s ei n t h e a r e r a g e l e i c ' l o f
- l . r ' , r t r l ' r n c r t - ' a s i n go p p o r t u n i t v c o s t m e a n s t h a t
.:.:.lilIltg llrore of a good requires giving up e\er
S U P PL Y
. S u p p h C u r v e :A c L r r v(et a b l c ) s h o w i nt gh eq u a n t i t i eosf a p r i c c s t r l ' s o o r l s u n d s ! - r \ i c c s ( n c _ g a t i r ei n f l a t i o n r a t c )
1 tfst h e a l t e n ] a t i V eg o o d .
. r : = J I J l 1 1 r ' r l . uO 0\ cr tllle .
gooda selleris rvillingandablcto sellat alterrtltirepriees . D i s i n l l a t i o n : F u l l u r gi n l l a t i o n r a t c . \ o t c t h a t p l i c c : u l c
: I nsidc frontier: Unemnloved resources at a givencostof productioncietenriinecl bv constantinput
still incrc-asins
: ri l l l c l ! ' r l C \) . prices.technologl,. andnurnbcrof sellers.
: t rpanding frontier: Increases in resources and . L a l l o f S u p p l y : I n c r e a s ci n p r i c e( P ) c a u s e sr r r c r e a si e u . lnflation rate: bciriccu tinre nerioti one and tinre
D D '' x 1oo
n c r i . t l t r i . i s .- . . -
' . ' . : r i r o l o s r c i i la d v a n c e s . q u a n t i t y( Q ) s L r p p l i e c l
. C h a n g e i n s u p p l y : C i h a n g er n c o s t o l ' p r o d u c t i o n . . Tr pes of l nl'lation
. t ..'.\)lrrrnl\ produccs only 2 goods (X.Y). Points on
'
J !-ir\c r.\.B.C.D) represent different cornbinatiotts
t e c h n o l o g vp. r i c c o f ' o t h e rp r o d u c e dc o o d s :n u m b e ro f I . S u p p l r s i c i er n f l a t r o n
s e l l e r sa l t e r sp l a n n e ds a l e sa t a l l p r i c e s .s h i f t i n gc u l v e a . w a g e - p u s h - $ a Q ci' n c r e a s el e a d st o p n c L 'l u c r e a s e
:::rc I goods $'hen all resources are used (full
t o r i g h t ( i n c r e a s eo) r l e f t ( d e c r e a s e ) . b . C ' o s t - p u s h i n c r c - a sicn n o n - l a b o rc o s t s l e a d st o
- : : . . , r r n r L ' n to f r e s o u r c e s ) .I f t h e a l l o c a t i o n i s i n s i d e t h e . C h a n g e i n q u a n t i t v s u p p l i e d : C ' a u s e db y o v rn p r i c . '
pncr- lllcrL-ASc
-..: .,'. : r ) r l l r - r C S O u r C e sa r e not used Or used
c h a n g ea n d r e s u l t si n m o v e r n c nat l o n - uc u r r e . L D e n t a n d - p u l li n t l a t i o n : , \ n r n c r e a s ien t h c p r i c el e rc l
: 1 , ' :!:a l c l t t l \ . M A R K E TE Q U I L I B R I U M i n i t i a t c db v c x c c s s i r ea g g r e g a t dcer.nand.
Good Y . E q u i l i b r i u m : I h e np r i c e p . M a c r o( ' o n s e q u e n c e o s1(' L n a n t i c r p a t e dI n) f l a t i o n :
i s e s t a b l i s h ew dhere L L,nccrtaintr'
q u a n t i t yc l e m a n d e1dP e )- SUPPLY 2 .S p e c u l a t i o n
q u a n t r t ys u p p l i e d1 Q e ) .
'"" Equilibrium
3 . N o n - p r o d u c t icr r n v c s t r n c n t s )
. Propertiesof Equilibrium: H€ A
MEASURING UNEMPLOYMENT
L P > P c .s u r p l u s . L a b o r l b r c e : [ : n r p l o v e do r ' [ , ' r r e m p l o v c c l U
2 . P < P c .s l r o r t a g e DEMAND . E m p l o l e d : \ \ ' o r k i n - ua n c ln o t l o o k i n g l b r r i o r k il
3.P-P., stable . f . l n e m p l o v e d :3 r ' c q u i r e l u e n ttsc l b e c a t e g o r i z e da s U
. Price C.lontrols:
I . ('cilin-qbclou cquilibriunr-. shorta-uc
L r n e n r p l u t , el c. ln. o 1u ' o r k i n s .l . a b l c1 ou o r k . - i . l o t t k i n g
llt
v
andblackrrrarkct fbr uork
u n e m p l o y m e n tt o t a l . . . ,
2 . l - ' l o o r a b o ie c q u i l i b n u n r - s u r p l u s a n c l c h c a t i n g . U)\ tr\'lPl.()\'\'l E\-I' rutc
( s e c r e st a l e -)s
ff i. "- r r 00
. l - r ' p e so f f n e n r p l o \m e n t :
. C h a n g e s I n E q u i l i b r i u m : F . c l L r i l i h r i upr n rice u'ill L Seasonal: [-lnetnplovr-il clrrrrng pcriocl. bctuce-n
changer,r'hener,'er the suppll,or clcnrandcurre shifts, a g r i c u l l u r a l s c i l s o n s .t o u r i s t s e a s o n s .s c h o t r lb r c a k s .c t c . )
I rplanation: This concavc production possibilrtics L F r i c t i o n a l : t , n c n r p l o v n r c l t t e 5 1 . r c o p I cl n o \ ! - b c t \ \ c c l t
' - : . i t , r r i ' I h a l a u c l f -i n c r e a s i n g o p p o r t u n i t y c o s t . jtlbs or irrto the labor rnur.kc't.
' -l Structural: \\'orkcrs llrid olf br cicclining inclu'lr.ics
I , --. . l 1 r $n t h c - c u l v e m e a n s t h i s e C o n o m V i s
- . : . . . : : : ! n r ( ) l ' co l X a n d l e s s o f Y . A t p o i n t A . t h e o r i l t c l e c l i n i t r gr e g i o n s o r b r j o b o t r s o l c s c r - ' r . r c c .
ME AS U R E SOF OU TP U T/IN C OME -l (lvclical: [-lnenrplovnrcntrlu.- tt., scncral cconor.riic
. - ' : r : . I r r . r r t l u c c sl J L r n i t so f Y a n d z e r o X . A t p o i n t . ( i r o s s d o m e s t i cp r o d u c t ( G D P ) : \ a l r . r eo f p r o d l l c t i o r l rcccssron.
:. , ' . . : r i . r r l \ A r L -n o \ \ p r o d u c e d . T o d o t h i s . I u n i t
u ' i t h i na c o u n t r \ " sb o u r t d a r i e s . . \ l a c r o c o n s e q u e n c e s o f u n e r r t p l o r m c n t : I L r s t( ) L r t p u t :
, ' f \ i r g i r t ' n u p T r ) p r o d u c c t h e n e x t 1 0 0 h o w c r ' e r .Y l . \ a l u e A d d e d C o n c e p t r a l r , r co f ' p r o d u c t i o nl c s s O k u n ' r L a u : l ( 'o i n c r c - a s c i l t t r n c r l l t l o r n t c l t t r a l c
" . :. . . : . . ' n . l r t r p : l i o n r L i t o l 0 m e a n i n g 3 u n i t s o f Y i s
r a l u e o f - r n a t c r i i li ln p u t ss u n r n ' r cacci r o s sl - i r r n s t ' t ' t l t t ct r ( i l ) P l r r I 5 ' ,
gr\t-n up (point C) Frnallv to produce an additional 2 . I n c o m e M e t h o d r . r ' a g e. rsn csl a l a r i c -.s r e n t i p r i i f r t s . SP[:C'lr\l- t'LASShS OF \\'ORKI ItS
. ::. \\l \. l0 units ofY has to be given up (point . i n t c r e s rt a c l i u s t m e u t s l. ['nderemploved: Pr'ople sccking tir]l-tint.' plitl
l) r
' - t . , , n r c \ r ' n r ) r -acn d m o r c
! - x p c n s i v ct o p r o d u c c t h c - 3 . E r p e n d i t u r e\ l e t h o d ( S u r n o f ' c x p c n c l i t r , r rocns f i n a l etttplovttre ttt uot-1. \\irrl'rrrg Lrrtlr piut-tlntc ()r
. . - - . . : : . 1r .r l \ g o o d sa n d s e r r i c e s-) P r i r a t cC ' o n s u u r p t i o( C n ' )- ( i r o s s c n r p l o v c d l r 1 - l t r l r s b t ' l o r i t h c r r er r p l t l r r ) i t r I p h u n t o n t
PrirateDouresticInvcstmc-nt (l) ' (iorernnlentPurchases u n c n t p l u r c c l) .
H( )\\ ( llol('ES.\RE \tADE:
( G ) . ' E r p o r t s( X ) - I r r p o r t s( \ , 1 ) ( C ' - l + ( i t X - M ) l. Laid-olT indiriduals rrith pronrise to be rehired:
\larkrt \lechanisnr:
\4arket deterrnined prices . RealGDP - CiDP PriceInder detlatedby thepriceindcr \ot looking lirr utrt'k bLtt pirlt rrl'rrnc-rnpltrrerl
. - .: ...ff lu:r': anci shortages. and o\\'ners allocatc . N e t D o m e s t i c P r o d u c t ( N D P ) . ( ; D P l e - s sc a p i t e l
' - . ..:.,'. ir, tlkc ad\ autaqe of hishest monetarv 1 - l o p t t l a l r oans i l n r ' \ t 'c p l r o n t t r t l t e r - u l c .
c o n s u n r p t i oanll o u ' a n c e - 1. D i s c o u r a g e d n o r k e r s : \ o t c o n : r r i c l c t i r n l a b o r t i t r ec
. \ a t i o n a l I n c o m e ( N l ) N D P - I n c l i r c cB t usincss'l-ares b c c u L t s tn' o t l o o k i n e l i r l u o r k I r k c l r t , r r c - ! ' n t c r '\ \ I t c l t
authority allocatcs t subsiclic-s labtlr nrarkct irnprorc:
. PersonalIncome (PI) ..Nl - (corporatetAxcsr rc-tainccl
market and c-amings t socialsecuritytaxes)+ translcrpavlrcnts )
goods ancl ' D i s p o s a b l eI n c o m e ( D I ) - P I - P c r s o n aTl a r c s fi
GDP Shortcomings: D c fi n i t i o n . { l f e r n a t i n gp c r i o d s o l ' e c o n u n r i cg r o n t h Y
The study of economic
n a t i o n a lp r o d u c t i o na n d t h e
1. Factorsor vzrriablcsnot
a. LJndcrground cconorny
a n d c o n t r a c t i o nA . s i n g l eb u s i n r s sc r c l e u o u l d h a r e
t h e s el b u r p a r f s : G D P
T
b. Improveclquality'
c . M o r e l c i s u r c . a l t h o r . r s hr r n p l y i n g f - c u c r h o u r s o t
I TroLrgh tll
t h c b e h a ri o r o f
o p e r a t i n gi n t h c
work. can lead to greaterproductirit1'.
2 . C c r t a i ng o o d sa n d s c r v i c e sc o n t r i b u t et o p e r s o n aol r
l. Rccovcn
-1.Pcak 7
propertyclestruction (e.-u.alcohol.tobacco.-9uns. etc ). -1R. ecession Time

. Gaps: Difference between spending at equilibnum
Circular Flow equilibrium: Spending: Output to meet GDP vs. full-employmentGDP.
Demand: Income L Recessionary Gap: Amount by which desired
spending at full employment falls short of full
CoNSUMPT|ON(C) & SAVINGS(S) employment output. This is represented by the
. CONSUMPTION:
difference betweenY I and Y*.
l . E q u a t i o n :C : a + M P C ( Y ) ; w h e r ea i s c o n s u m p t i o n 2.Inflationary Gap: Amount by which desiredspending
at 0 income, (also called autonomousconsumption) at fu1l employment exceeds full-employment output.
andY is personaldisposableincome This is representedby the differencebetweenY2 andY*.
2. MarginalPropensityto Consume(MPC)- (changein
C') . (change in Y) - fraction of an extra dollar of
incomethat is spent.
3 . A v e r a g eP r o p e n s i t yt o C o n s u m e( A P C ) : C ' Y :
fiaction of an averagedollar that is spent
. S A V I N G S : S a v i n g s ( S:) I n c o m e ( Y )- C o n s u m p t i o n ( C )
L E , q u a t i o nS: : - a + M P S ( Y )
Y1 Y-
2 . M a r g i n a lP r o p e n s i t yt o S a v e( M P S ) - ( c h a n g ei n S ) , ' (equilibrium)
(changein Y) : fractionof an extra dollar of income Expenditure Multiplier: The multiple by which an
that is saved. initial change in aggregatespending will alter total
3 . A v e r a g eP r o p e n s i t yt o S a v e( A P S ) - S , Y - f r a c t i o n cxpenditure after an infinite number of spending
c y c l e s : ( lt ( l - M P C ) )o r ( l i M P S ) .
of an averagedollar that is saved.
Simplified Example: Given MPC : 0.8; Deflationary
. MPC + MPS: I
Gap - $300 million; assume interest rates do not
.APC+APS:1 af-fectInvestment(l)
DOMESTTC
GROSSPRTVATE (l)
TNVESTMENT Question: How much of an increasein Investment(l) is
E x p e n d i t u r e so n o r p r o d u c t i o n o f n e w p l a n t a n d requiredto solvethe DeflationaryGap'?
Answer: I x rnultiplier- $300 m
e q u i p m e n(t c a p i t a l li n a g i v c n t r m e p e r i o d p l u s c h a n g e s I*x(l]MPS)-$:OOm
i n b u s i n e sisn r e n t o r i e s . l*-5300mxMPS
. Affccted by Expectations& interestrates (e.g. Crash I * : $ 3 0 0m x ( l - M P C )
makes many fearful about the future). I*-5300mx(0.2)
. Desired vs. Actual Investment I*-560m
l. I : desiredor plannedinvestment
2. Actual Investment- Savings
3 . U n i n t e n d e d I n v e s t m e n t : D e s i r e d I n v e s t m e n t<
Actual Investment
:1.Unintended Disinvestment- Desired Investment>
Actual Investment
E X P E ND IT U R E(G
GOVER NM E NT S )
Federal.state.and local governmentspending YY-
l-fr.J
. Two tvpes of G:
$ 3 0 0m i l
a. Direct purchasesby government.
Adjustmentto GAPS
b. Transfer paymentswhich redistributesincome from
1.KeynesianView: Governmentintervention
o n e g r o u pt o a n o t h e r . 2 . C l a s s i c aVl i e w : N o g o v e r n m e nitn t e r v e n t i o n
F OREIGNSE CT O R
L Exports (X ): Expenditures by foreigners on
domesticallyproducedgoods.
. Definition: The useof governmentspending(G) or taxes
2. Imports (M): Expendituresby domesticresidentson
(T) to changethe level of total spendingin the economl'.
goodsproducedin foreign countries.
TYPESOF FISCALPOLICY
K EYN ESI A NE Q UI LI B RIU M . Expansionarv Fiscal Policy: Increasesin government
A c h i e v e dw h e n : spendingor reduction in taxes. Bigger budget deficit
l. Output : Income (Y) -Aggregate expenditures(AE) (G>T). New Deal was expansionaryfiscal policy.
. Contractionarv Fiscal Policv: Decreases ln
From ( I ), we can get equilibriumlncomeor Output(Yx)
government spending or increases in taxes. Smaller
Y-AE
deficit or surolus (G<T).
Y-C-l+G+X-M
Y-a+MPC(Y)+I+G+X-M
Y-MP('(Y):a+l+G+X-M fiscal policy to
eliminate GDP
Y( l-MPC):a+l+G+X-M
gaps,called
Y * - [ ] , ' (1 - M P C ) ] [ a + l + 6 + a - Y 1
discretionary
2. Injectionsi LeakagesApproach
fiscal policy.
l - e a k a g e(sS + T + M ) : I n j e c t i o n s( l + G + X )
Exoenditures Fiscal Policv:
Govcrnment Y1 Y2
policy that oflsets shocksthat would createa business
cycle. The governmentusually engagesin fine-tuning
when it applies discretionary policy to bring the
economyback to full-employmentlevel.
. Automatic Fiscal Stabilizers: Built-in federal
expenditureor fixed tax ratesthat automaticallyresponds
countercyclicallyto changesin nationalincome.
. Ex. When income is high, spendingincreases,leadingto
inflationaryperiods;higher incomemeansincreasein tax
payments(T increase)but this will causea decrcasein
total expenditures. The expenditurecurve will drop, thus
lesseningthe inflationary gap.Also, with more people
employed,unemploymentcompensationwrll decreasc(G
decrease)also causinga decreasein total expendituresas
Govemmentspendslesson this item.
. PassiveDeficit: Deficit nortion due to the cconomv
o p e r a t i n gb e l o wp o t e n t i a il n c o m el e r e l .
. Classical: Belief that fiscal policy affectssupply side
of economv. Advocate tax cuts to stimulate labor
supply,productrvityand capitalaccumulation.
. Laffer Curve Hvpothesis: Cutting tax rates rvill
increasetax revenuesbecauseof supply side effects.
Most economists believe tax cuts ca arge budgct
deficits in 1980's.
. Structural Budget Deficit: Deficit that would occur at
full employment. Most economistsbelieve tax cuts
causedlargebudgetdeficits in thel980s.
W ITH FI SCALPO LI CY
E X P E R IE N C E
. Governmentshavecontinualexpansionaryfiscal policies
(budgetdeficits) becausethey are politically popular.
. Resultsand Effectiveness of the amount of fiscal
poficy expansion are slow to achieve and often too
late.
. Similar to consumption.imports can be modeled:\'l - nr -
MPM(Y) whereM - total inrporls.m - importswhenY (t
. MPM = marginap l r o p e n s i t yt o i m p o r t
. Import Multiplier:(l/(l-MPM))
Y2
AGGREGATE DEMAND: Total quantity of output
demandedat altcmativeprice levels in a given time pcriocl.
. Reasonswhy rt is downwardsloping:
l.Real balances effect: Price changesaffect the real
value of GDP.
2. Foreign trade elfect: Domesticprice increaselor.r'ers
exports (X) and increasesimports (M). Goods alc
more expensive here and cheaper abroad. Loucr
exports and higher imports lower expenditureson
l o c a lg o o d sa n d s e r v i c e s .
3. Interest-rate effect: Increase in prices causes an
increasein Money Demand. Increasein demanclfbr
money raisesinterestrates.which lower investments.
loweringtotal expenditures.
AE
C + | 1 + G + X 1 - M(1P 1 < P s i
AEr
C + 1 6 + G + X 6 - M 6( P 6 )
AEo
C + 1 2 + G + X 2 - M(2P 6 < P 2 i
AEz
w h e r e l 1 > 1 6 > 1x
21, >xo>x2M
, 2>Mo>Ml
Y z e z ) - Y o ( p o ) .Y r ( p r ) .
AGGREGATE SUPPLY: Total quantitv of olrtnur
p r o d u c e da l a l t e r n a t i v ep r i c c l e v e l si n a g i v c n t i m r ' p e ' r i t ' t l
. Short Run AggregateSupply (SRAS):
I . As price level rises,quantity of output risesas firnrs
seekhigher profits. In short run. pricesof inputs arc
fixed or sticky (e.g.wages).
2. As firms expandoutput even with fixed input priec'.
price level risesbecauseof diminishingreturns(nc-ri
labor lessproductive).
. ([-RAS):As price lercJ
L o n g R u n A g g r e g a t eS u p p l y
nses. no lncreaseln output becauselnput pnces nsc
proportionately.
NO PAYOFFTO CHANGINGAGGREGATE
D E M A N DI N T H E L O N GR U N
. l n c r e a s c i n a g g r e g a t ed e m a n d A D x t o A D 1 r x o r c :
economyto shortrun equilibriumfrom a to b aborc tirll
employmentbecausewagesare sticky.
As wagesadjust -' upward LR4S SRAS2
short run aggregate
supply gradually shifts
upward from b to c.
Short run equilibnum
output gradually falls Pe
t o l o n g r u ne q u i l i b r i u m
at full employmentY1
to Y1. In the long run
outputcannotbe raised
a b o v eY 1 a n d a t t e m p t s g
to do so mercly raise P.
RationalExpectations Economistsbelieveeconontvgoc\
directlyfrom original long run equilibriumto nevulong
run equilibriumif governmentpolicv is anticipatecl.
 r n?r{ ltilrr \t I I f [|rf r fi I ;l-
{ I I {fl lrl I
policy also dependson three Lump-sum Tax MONEY: Anything generally accepted as a
The Consumption equation is transformed: C : a + medium of exchanse.
takes between the . Characteristics of-Good Money': Relativelyconstant
M P C ( Y - T ) ; C - a + M P C ( Y )- M P C ( T )
occurrence of the economic condition and policy and limited supply, difficult to counterfeit.divisible.
. The tax multiplier:
durable.small and oortable.
maker recognition of the situation.
Atequilibrium,Y:AE Ex. Gold becamethb most important form of monev in
2. Implementation Lag: If an act of congress
AssumingC is the only expenditureconsumption,Y - C lTth and l8th century.Problems: relativelyheavy.easy
required. it can take some time for congress to counterfeit, subject to fluctuations (when neu' -soldis
Y:a+MPC(Y) MPC(T)
debateand approvethe bill. discovered).Led to replacementof gold with paper
3. Effectiveness Lag: After the policy ls Y-MPC(Y)-a-MPC(T) money.Gold was depositedat the goldsmith.who issued
implemented"it can take time for the policy to Y(I-MPC):a MPC(T) receipts for the gold to the depositor.The depositor
have an impact on the economy (ex. in the late Y(MPS): a - MPC(T) would then issuethe receiptsas paymentfor goods and
'90s, services.The receipthad valuebecauseit was backedbr
Greenspantned to anticipate inflationary Y : a(1/MPS) (MPC/MPSXT)
tendencies by tightening the money supply This impliesthe Tax multiplier - MPC/MPS or MPC/( l- the gold on deposit.
. Usesof Money:
fincreasinginterestrates]aheadof time). MPC). 1. Medium of exchange
D IF F ER EN TIA LE FFE C T OF IN C R E A S IN G 2. Storeof value
IAND G 3. Unit of account
. Types of Money
If T and G are increasedby the same amount. the net
Accumulateddebt of the federalgovernmenl. l. Commodity money: Value as commodity - r'alueas
. Debt Service:the interestrequiredto be paid eachyear eflect on Y is the increasein G. money
on outstandingdebt (currentdeficit & debt) Explanation: The effect of each component on Y is 2. Fiat mone]-:Money declaredby governmentas legal
. Transferresourcesfrom bond holders to tax payers.No basedon their respectivemultipliers.Assumingall other tender.Value as commodity < value as monev
. Monev Supply
net change. componentsare unchanged:
. Future generationstransferresourcesfiom tax payersto L B a s i c M o n e y S u p p l y ( M 1 ) : c u r r e n c yh e l d b 1 ' t h e
A Y : ( 1 / (l - M P C ) ) G - ( M P C / (l - M P C ) )T
public outsidebanks (checkingaccounts)+ balances
bond holders. AssumingS40-G:T, in demanddepositsincludingtravelerschecks
. External Debt: U.S. government debt (Treasury
A Y : ( l / ( 1 - M P C ) )$ ' 1 0- ( M P C / ( l - M P C ) )$ / 1 0 2 . M 2 - M l + s s 1 ' 1 n gasc c o u n t s+ s m a l l t i m ed e p o s i t s{ <
bonds) held by foreign households,businessesand A Y : $ 4 0 [ (r / ( l - M P C ) ) - ( M P C / (l - M P C ) ) ] $100.ooo)
governments.Imposesa burden on future generations.
A Y - $ 4 0 [ (r - M P C ) | ( l - M P C ) ]) 3 . M 3 - M 2 + l a r g et i m e d e p o s i t s( > - $ 1 0 0 . 0 0 0 )
. Crowding out investment leads to slower growth for 4.L - the broadest definition of money supplr.
AY - $40il1 consisting of all short-term (matures less than or
future generations.
W h e r eA : c h a n g e equalto I year) financial assets.L refersto liquiditl.
5 .C r e d i t C a r d i s n o t m o n e y : M o n e y i s a f i n a n c i a l
asset belonging to individuals and a liabilitr to
banks.Credit card is a savingsitem made arailablu- tcr
1.Accurate measureof variables:The governmentcan . r e d i ti s n o t a n a s s e t .
b e b o r r o w e dC
only estimate the sizes of MPC. MPM and other . When investment depends on income, an attempt to
B A N K IN G
exogenousvariables. increase saving can result in reduced savings. . Financial lntermediar.v-: Banks lunction rs an
2. Govemment is not able to changeG or T quickly. as it . Individuals intermediarybetweenlenders& borrowersby holding
who save more can cause income to
is often subjectto legislationas well as checksand depositsand making loans.
balancesbetweenthe Executiveand Legislativebodies. decrease, leading to a decrease in overall savings (S). . Bank Reserves:Vault cash and deposits at Federal
3. Financingdeficits can haveoffsettingeffects. AggregateExpenditures Reserve.called federal funds. In general.reservesis the
. Crowding out: Classicaleconomistsbelievethat amount of casha bank keepson hand to manageinflou s
when government finances a deficit. the and outflows. Banks lend each other excessfunds at the
expansionaryicontractionary eft-ectsare not fully federalfunds interestrate. Somereservesare requiredbr
realized.If governmentsellsbondsto financean central bank as a ratio (proportion)of depositsa. a
erpansionary fiscal policy. it is taking away reserve against cash withdrawals. Erpected rule: the
funds fiom a possible private investment ([) more liquid the asset.the hi-eherthe reserl'erequirement.
undertaking.Thereforeincreasein G is offset by . Money Creation:
a d e c r e a s ien I . L How banks create money: Banks create demand
-1.Fiscal policv can conflict u'ith other goals. Ex. deposits,part of the money supply.when makin-ebank
Def'lationarygap and large public debt. Solving the loans.
clet)ationary gapmay requirean increasein G. Increasing 2. Money multiplier:the amount(dollars)of moneythatthe
(i hou'ever.further raises the budget deflcit (G<T) bankingsystemcan createfrom $l of ercessresenes.
3. Maximum money creation:
increasingpublic debt as filnds are borowed. Classical View: The lnterestRate a. Assumes public depositsall money received and
financial market works : doesnot add to cashleakage.
s m o o r h l y .I n re s t m e n t a n d * b. Assumesbanks lend or snendall excessreser\es.
savings will always be n* c. Formula:
C l a s s i c a l T h e o r l ' : ( P r o p o n e n t :A d a m S m i t h . e t c . ) equal.Interestrateschange l increse i n c r e a s ei n
\\'ases and prices are flexible. The economy self- ^
to ensurethis equality in money requiredreserveratio" excessreserves
adiusts to deviations frorn its long term grou'th trend. : 4.Complex Money Multiplier: Measure of monev
nrinirnumgovernmentinterventionrequired.Persistent K e 1n e s i a n v i e u : S a ri n g s
createdper dollar depositedin the banking svstem
u n e m p l o y m e n tr e q u i r e s s u p p l y s i d e p o l i c i e s e . g . and investments are often when peoplehold cash;
deregulationand tax cuts.Politicalconservatives. unequal with the monetary sectornot working correctly. Formula: [( l+c)/(r+c)]x increasein excessresen'esu'herer
( ' l a s s i c a lE q u i l i b r i u m : The -realsectoris affected.AD does not equalAS. The : requiredreserveratio: c :9/o of withdrar.l'als not redeposited
Prices LRAS imbalance affects the real sector (due mostly to the E x . r : 0 . 0 2 ; c : 0 . 4 ; i n c r e a s ei n e r c e s s r e s e r v e so f
SRAS multiplier effects). The savings curve is viewed as $ 1 , 0 0 0m o n e ys u p p l yw i l l i n c r e a s eb y S 3 3 3 3 . 3 3 .
vertical and unafl'ected by interest rate changes.
Discretionaryfiscal policy needsto be implementedto
increase/decrease savings:
Person borrows $2,000, r:0.1, e0.,1
Bank Bank keeps Bank Loans Demand Person
AD Gets (Resen'e (excessreser\'€ Deposits keeps
Ratio: l0%o) 90o ) (60oh of 10o
GDP
loan is
redeposited)
I rplanation: Short run equilibrium occurs u'here the sr.200.00 s800.00
\:trrt-Run Aggregate Supply curve (SRAS) intersects
\ruregate Demand (AD). This is temporary.The s r .200.00 s 120.00 s r .080.00 s6.18.00 s-l-r 00
L-conolnywill self-adtustso that both curves will
intersect on the Long-Run Aggregate Supply
T L R A S ) t h u s a c h i e v i n ge c o n o m i c s t a b i l i t y w i t h
tirll emnlovment. 5349.92 53,1.99 S3l,+.91 S188.96 Sll-s.97
Kernesian Theory: (Proponent: British economist John $r 8 8 . 9 6 Sr 8 . 9 0 S1 7 0 . 0 6 S1 0 2 . 0 . r 5 6 8 . 0 2
When investmentsdecrease.the interest rate will not
\l.rrnard Keynes) Wages and prices are sticky (slow to
adjust quickly to n I to bring the economy to St 0 2 . 0 1 St u . 2 0 S eI x 4
-:t.ilrsL-). Prirate demand is inherently unstable, thus
: rqLrrring active government intervention. Persistent equilibrium. Instead the multiplier processwill occur
requires demand side policies. e.g. increases
..:rcrl1.rIcrvrncnt and will shift the S curve to S1 and be back in
tr,\ Cnllnc'nt spending and tax cuts. Political liberals. equilibriumat n* before interestratesevendrop to nl. TOTAL monev created will be: $6.840
 N , li n c r e a s e- ( Q ' \ ' ) P i n c r e a s e
'l'his
i s c a l l c c l t h eQ U A N T I T Y T H E O R Y O F M O N E Y .
S a v i n g sa n d l - o a n s( S & [ - s ) h e l d a n d i n v c s t e ds a v i t r g s C o m b i n a t i o no f h i g h a n d a c c e l e r a t i nign f l a t i o na n d h i ' l h
INTERESTRATES:
( back to the cornrnunity. unemployment.
l. Norninal
tJp to 1980.they rcgulatedby thegovernment: allorved Classicalerplanationof stagflatron:If the governr.nL-nr
"r'ere
private.residentialntofigages. 2. Real - Noninal interest - eroected inflation rate
to investonl1,in safb.
7 . 1982 cleregulationsignalec'l the end fbr S&L stabilit,.,''.
ill S & l . s s t a r t e di n v e s t i n gi n r i s k y h i g h - y i c l d b u t l o u ' -
KE YN ES IA NV IE W
. Monetarl' Policl': Userl to fight rccessionand inflation,
wantsto r-naintain or get close to the 1.9 unemplolrncrrt
rate.it rvill increaseG or lessenT (movementup SRP( ; r
U gradejunk bondsand ccxnmercialreal L'state. but mav neeclto be supplemented by fiscal policy to fight to a higher inflation rate. Howeveronce again the
ll . S & L s d i t l n ' th a v cm a n a g e m e ncta p a b i l i t yt o h a n d l ct h e recession and by inconrespolicl,to fight inflatron.
. Kevues nronetary prescription cln thc cconomy:
econonryil'ill be pushedtoward the naturalrate of'
|l g r o w i n gb a d l o a n s . unenrployment accorrplishedby an SRPCI that sits
. [-].S. has guaranteeddeposits ot' f inancial
^ Because including(S&l.s).it spenthundr-eds of billions
l. ContractionarJ- Monetarl, policl': Monev Supply r o r h en g h t o f S R P C ] .
U of institutions c l e c r e a s e- > i n t e r e s t r a t e i n c r e a s e- > I n v e s t m e n t INFLATION: Can be subject to Adaptive Expectatron.
dollars. With the complerity o1' sorne o1' the deals. decrease-t' ( lltcome:Output) decreasc
( accurategovernlnentbailoLrtcost\\'asdif icult to deterntine. 2.Expansionarv N'Ionetarv policr,: Money Supply
expectations ofthe future based on what has happenecl rn

i n c r c a s e - , , i n t e r e s t r a l e d e c r e a s e- > I n v e s t m e n t thepast).
increase-.:'( lncome:Output) increase' Sustained h i g h i n f l a t i o n :A c c o m p a n i e db y M S i n c r e a : e
Notc: lt is inportant that nronctary policyurakersare and c'xpectations of inflation.
The FED is the United Statcs' Ccntral Bank lt
a\l'arcof'thu-curre-lrtcondition of the real sectorand the D i s t r i b u t i o n a lE f f e c t s o f I n f l a t i o n :
s u p e r v i s e st h e f i n a n c i a l s y s t c r n .
. Structure: Tu,el'n'e regional Fedcral Reservc banks cll'cctiveness lag of' n'ronctarl,policv. L lndir,idualswho can get higherrvagesand sell goodslt
. K e t , n e s i a sr rt i n r u l u s
super\ isecl by a Board ot' (ioverrrors in Washingtorr higherprices,can still keepjobs and continueto sanr
nonrinated to fired ternrs subjcct to senate approval. I . lntcrcsl ralcs - price paid fbr thc use of lloney
r e \ r e n u ef r o m s a l e s . w i l l b e n e f i t f r o n r s L r s l a i n c t l
. F u n c t i o n : C ' o n s r e s s{ a v e t h c -F E D 6 c r p l i c i t f u n c t i o n s . 2 S p e n c l i n (gI r r v e s t n r e n t s )
-j I iqLridityTrap. The' portion of thc- rloney-denrand inflation. Indexing wages (such as cLln-cltt\ociitl
I . ( o n c l t r c tr n o n c t a r v p o l i c , r ,('r t t o s l i r n p o r t a r t t f u u c t i o n ) .
2 . S u p el r i s c a n c l r e g r i l a t e l - i n a n c i a l i n s t i t u t i o n s c u l r e t l r a t i s h o l r z o n t a l :p e o p l ea r e w i l l i n g t o h o l d security payments)to inflation pre\ents or rccluec.
. i . S c r r c -a s l c n t l e r o f l a s t r e s ( ) r tt o f i n a n c i a l i n s t t t u t i o r t s . u n l i n r r t e da l n o u n t so 1 ' m o n e ya t s o m e ( l c l w ) i n t e r e s t the bad efl'ects of inflation. Their rcal rnconre
; 1 .P r o r i d c b a n k i n s s e r v i c e s t o t h e L i . S . ( l o v e r r t n r c ' u t . ratc. N'lonctary, policf is ineffectivc. becortresindependentor is lcss affectedbr int'latitrrr
5 . I s s t t ec o r n a n d c u r r c n c v .
M O NET A R IS TP E R S P E C TIV E 2. Bonclholders:The reall'alucof bondsclropu ilh intlatr,'n
6. Pror ide firrancial ,.:r'r iecs to eouiuicte iul banks. savitrgs
a n d l o a n a s s ( ) iea t i o n s .s a r i n - { s b a n k s . a n d c r e c l i tr r n i o n s .
(M | L T O NFR TE D MA N 'V
StE W ) if rtotninal intercst rates are unchangecl.Thc'rc-ti'r'r'
. \lO\F,'I.\RY . \Jonetan policr can control inflation.
POLI('\': Polici that afTcctsthc economv bondholders'wealth stafusdependson hori tirstnonrrr.,.r
. Inerease uronev suppll at a steady rate eqrral to grorvth
t l r r o r r r : l. tl r r r r t s:e i l t r t t , r r t c \r u p l ; l \ l n d a r r r i l a h l ee l e i l i t . interestratesadjustto expectations of inliation.
. F'ederal ()pr:n \larket Committee (F'O\lC ): (tl cet.lrtrlnr'.
( onroosctl of 7 rrrr'nrbers of the Boalcl of (iovelnors . [)o not attclnpt 1o f ine tune nlone], grou'th. FIGHTINGSTAGFLATION:
a n d 5 l r c r l c l a l R e s c r r e B a n k p r c - s i d e n t s .l t i s t h c c h i e f ' l. Classical: Run a recessior.t. This squL-r./..
polio-uraking bodv ot'thc FED. i n f l a t i o n a r y e x p e c t a t i o n so u t o f t h e e c o n o n t r
'fools.
. N4onc-tan'
I n fl a t i o n
l. Reserve Requirenrent (r'atio): Prollortion ot
Inflation and unemploymentrelationship:Thc thcory-- Rate
clenosrtsthat ur.lst be held as rcscrvcs.
u'hcn uncnlllovmcnt is lou'.peoplehavejobs. peoplehave
2. Discount Rate: Ratc-of intercst charged br, the Federal
wagcs. purchirsc's are made. clerrrandincreases.plices
( Reservc Lranksfitt' lencling fcservcs to privale banks.
incrcasc.lcadingto an increasein inflation rates.When

z
3.Open l\Iarket Operations: Fedcral Rcscrve
unenrpkiy'ment is high. people are laid of}. rro income.
purchases and salcs oi'goverurnent bonds fbr thc
-fhis denanclis lou,.pricesdecrease. then inflationratesdrop.
p u r p o s r -o f a l t e r i n g b a n k r e s e r r . e s . is most ofien
Shortrun Phillips Curve (SRPC): Graphical
Ill used by the Fed in contrtrlling monr-y srrpply.
. Tight rnonev policv: (lou'ers N{S) reprc-sentationof the negative relationship betwecn

n
I
I . IIigh reservelcquirerncnts
2 . t l i g h d r s c o L r n tr a t e
irrflation and ur.rernplovrnent
I n fl a t i o n
Rate
rate.

SRPC2
i 3 . C ) o e nn r a r k e t s a l e s
U . E a s i ' l n ( ) n e l p o l i c l ' : l i r r c r c a s c sI \ ' l S )
I. I-ou fescf\e reottirenrerrts u.=5.5 6.5
( 2. [-ou rliscount rate Jb lowcr the inflation rate fl'om a. (3oo). cla\\l!.r,.
3. f)pen urarket purcltasc-s '.
prescribe a planned rcccssiol.t. L.ouerin-g uronc\ .r.1p1r
. Dernand fbr \4ouey,: The quantitics of'nronel' people are
il'illins ancl ablc to holcl at allcnrati','e intcr-cstr;rlc-(S). lvill raise interest rates. lou,ering inr c:tnt.-nl .l:rt
19 5 4 19 6 2
l . T r a n s a c t i o n s d e m a n d : \ 4 o n c v h el d f i r r t h e D u r t r o s e contribute to more unemplovment. rll\ln-! lit-
o f r t t a l ' i l t r c i c t r J r t r t t t i t t ' k c tp t t r el t l r e s . unemploytnent rate to 6.5 but lo'"1'erin-u
inllatrtrn ttr I -
2. Precautionarl' demand: N'{onev lrelcl fbr unexpected S R P ( - r s h i f t s t o S R P C r a n d s e t t l e sa t t h c n a r u n r l r . r r c , , :
m a r k e t t r a n s a c t i o n so r e n r e r g e r r c i e s . N o t e . I I n t r l l t ) 6 f i . t l r c d o un u ' a r c l - s l o p i nPgh i l l i p s c u r v e
-l.Speculative demand: Monev helii firr speculatilc
was appal'cntln the eally '70s it appearedto breakd0u,n. uncmployrnent - 5.5 at d.
purposcs. fir later l'inancialopportuuitics. \\'lre-nrrucrnploynrcnt uas high, inflation u,asalso high. 2 . K e y n e s i a n : I n d u c i n g a r e c e s s i o n i s c o n t r o r c r ' \ l . r l. r : r r :

CON TROV E RS I E/SI S S U ES L O N G R U NP H I L L I P SC U R V E : u n p o p u l a r . M S c l e c r c a s ei s i n e f f i c i c n t .

. S h o u l c l c c n t r a l b a n k s o n l y ' s e t r ) r o n e t a l ' \p o l r c l t o k c c p l . lrr tltc lofle run. $ ltctt ,-i,^r.^ Kevnesian Solution: Supplcmcntarr polrcr e. r l i i , :
inllation lou'l e.rpcctatrtirrs r]f irrflatiorr are HlrT'o" incomes policy.
. Shouldlrollctall policv be usedto stiruulitlca u eak cuorroun".) l n c t . c h a r t - g c su l r ' \ p c c t l l t i ( ) n
. Should ccntral banks crintrol thc rnoncv sr4rplvor iuterert lltcjs.'
l l n-p' C a . L ) i r e c tp r e s s u r ci s p u t o n i n d i ri d u a l st o
I t l t tc t r , r t l l i ' r ' t t r t t l r e l c r c l r r l ' | i
. Ilou sl-rotrldnronev be rneasurerl'.) rirtcrrrplovnrent, 41 u ' a g e sa n d p r i c e s o 1 'g o o d s . ( c r . u a g c -
| un"n,-
. T h e i r t : l ) ' s t o n t r o l ( ) l l n r o n c ) s r r p 1 . r l r . : p e c r f - i c a lol vn t h c I l - h . - I o n g R u r r I ' h i l l r p s( ' u r r r ' 2 1 ployment c o n t r o l s )T. h i s h e l p sl o u ' e re x p e c t a t i t ' ntsr 1
I
ct'tcctivcucss of expiirr.iortarr' policr'. clepc-ntlstrn tl.rc ( l . l t l j ' ( ' ) r r - p r e s c n t -tsh r - \ i t r r a t i ( ) n I Rate b . W i t h l o v v e re x p e c t a t i o no f i n f l a t i o nS R P (
]
r o b u s t n c s so l ' t h c c s t i n r a t e ( e l l ) a r a l r ) c t e i ' -" o o l t l r c l t r a n u ' h c n a el r r a l r n f l a t i o n c c l u a l s t h e l e f i r . l ' i t h o u tc a u s i n c a r e c e s s i o n , [ . r l l .
borro'nlcrsl<cc'pas cash and is nol redeposited. e - r p e c t c di n l l a t i o n . when LRP(' is reached.

l*l
-1.F.conorrtvis irble to atljust concctlv ttr thc inflation rate.

I n fl a t r o n

lllllruil
MONETARYBASE
. \/arrltcashplusbankresen'es at the lil-.1)l'lrc Ft:l) directl_v
controlsthe MonetaryBascand not N4one1SL4rplruireir --'sRPC3
thc uncertaintyof the c paral)rete-r anc'lrvhetirerbanksle-nd
( or.rteractlv ail. less.ol rlore thartits cxcessrcser\/es. "-- sRPC2
LASSICALVIEW
, C'lassicalthcodsts bcliclc that nrorrctarv ptilicr, cannot be
{ useclto solve problerrrsol-ittr,rtitc,.tLrtptit.irntl c:nrployrnent GREDITS:
A u t h o r : J o h nC . M i j a r e sP h . D
tll (rcal sector).Classical monetary policy is bcst exemplified
through the FQLJATION OF IlXC'tlAN(iE:
MV PQ u'herc
SRPCl
D e s i g n :A n d r eD . B r i s s o nL a y o u t :C h r i s t i a n
P R I C E : U . S .$ 4 . 9 5C A N $ 7 5 0
Ortrz
I
tl N { ' n r o n e vs u p p l i '
t
n V r,'e'locitl'
P nlrce level
At SR['( l. actualinflationis at J.8. (actualr,rnentployntent
rate is l 9;, houever.expcctcdinflationrate is only 1.6. quickstudy.com
U Q
- outputor (iDP (full ernplovrnerrt) Bccauseo1' the' discrepancl,,prices furrher increaseand ISBN 157aaab31-5
. In classical theory. r'elocity is firecl, ancl thc ecorlorny unerrploynrentincreascsalso.representing a shrft in SRPC

llnti
,llilIilffil|[[
( o p e r a t e si n i i r l l e r n p l o y n r e n t i n t h e l o n g n r n . T h i s m e a n s to SRP('1*'hich bringsactualand expectedinflatronratc ttt
that \/anti Q are fixed and any change ir.rrr.ronc'vsLrpplv c'qualat point b. resultingin unenrplovntcntratein the lon-u
will only'be inflaticlnarv in the long run. lt has no ef'fect nrn.l-he siriftin-qof the SRPC'to the right represents a lnove
on real econontic variables: lo\\'ardstaqfltrtion.