Macroeconomics

8-29-07
Monetary Policy -
The graphs of prime, discount, and FFR are highly correlated
The federal funds rate is the most important of the three rates
The Fed sets a target for the FFR – the rate moves all day long
The rate is based the amount of excess reserves in the system

Legal reserves – cash, reserves at the Federal Reserve

Government Security – T bill, T note, T bond

FDIC – Federal deposit insurance corporation

Required reserves are a percentage of demand, savings, and time deposits

Legal reserves – required reserves = excess reserves
Excess reserves influence the Federal Funds Rate

What does the Fed do to make us stay close to the FFR target?
Buy and sell government securities – to manipulate the amount of excess reserves and
thus the Federal Funds Rate

Manipulation of the money supply

• Open Market Operations – the buying and selling of government securities
• Changing the Discount Rate
• Change the reserve requirement

Open Market Operations fine tune the money supply

Moral suasion – Fed persuading the banks to borrow
A half a percent change in the Discount Rate is a big drop for the Fed
Fiscal Policy – The use of government spending and taxation to manipulate the economy

Prime Rate changes when the discount rate changes

National debt takes money away from the investment sector therefore raising interest
rates

Currently there is a high demand for government securities

Poor countries
 • Enclave – developed countries go into undeveloped countries and target only the
part of the undeveloped country that has a resource valuable to the developed
country
• Capital – human and otherwise

GDP – Gross domestic product – The value of all final goods and services in a country.
GNP – Gross national product – The total value of all final goods and services produced
by a country

First oil price shock was in 1973

Second oil price shock – 1979
Recession in 1981-2

Ways to measure inflation

• CPI – consumer price index
• Producer Price index
• GDP deflator

Paul Volcker – chairman of the fed between 1979-1988

Homework – look up the national debt; read first ten pages in Ch. 2

8-31-07
The Dow Jones Industrial Average – a composite of 30 blue chip companies that
symbolize the NYSE as a whole

S&P 500 - market of 500 highly competitive large companies – Standard and Poors

NASDAQ – a market of smaller technological companies

Fed rate cut – FFR

Macroeconomy – affects politics

• Unemployment and Inflation in election years; added together is the misery index
(1980) Carter vs. Reagan

Economic Models –
• irrelevant details are stripped away

Supply and Demand –

• shows how various events affect price and quantity of cars
 • assumes the market is competitive; each buyer and seller is too small to affect the
market price

Variables –
• Qd – quantity of cars that buyers demand
• Qs – quantity that producers supply
• P – price of new cars
• Y – aggregate income
• Ps – price of steel (input)

Demand equation – Qd = D(P,Y)

Quantity demanded is a function of price and income

D(P,Y) = 60 – 10p + 2Y
Demand curve because of the negative Y – inverse relationship

Change in Qd – change is only effected by change in price

Change in Demand – shift of demand curve

Import tariff on Toyotas – leftward shift on the supply curve

Endogenous – variable output of the model

Exogenous – given input for the model

Endogenous variables for supply and demand – Quantity and Price

For each new model we need to keep track of

• Its assumptions
• Which are exogenous and endogenous
• The questions it can answer and those it can’t

Classical – Adam Smith – laissez faire

Keynesian – 30’s – The General Theory – “In the long run we’re all dead.” – short run
person – prices are sticky and the economy doesn’t quickly adjust

Sticky reasons
• Most labor contracts set wages for three years
• Magazines tend to change their prices every 3-4 years

Supply and demand in the labor market –

Surplus of products from the setting of a price floor
• Keynesian – lay people off and we may enter into a recession
• Classical – do nothing

Consumer confidence – last month dropped

Wealth effect – how much you will purchase based on how wealthy you feel

Long run: prices flexible, markets clear, economy behaves differently

Two sector circular flow diagram

Components of GDP –
• C spending – consumer (70%)
• I spending – Investment (17%)
• G spending – government (20%)
• Nx – exports – imports

C spending – largest
• Durable goods
• Nondurable goods
• Services

Which is more representative of durable goods – more elastic

81-82 worst recession since the Great Depression

92 – Ross Perot

Homework – find out for Monday who we owe our national debt to; find the misery
index from 1980 until now; problem number 4 on pp. 15; Graph Y = 1/2X + 3 and Y =
-2X + 8 and then solve for equilibrium; read at least halfway through chapter 2

Today – 7.5%
1976 election: Carter and Ford (incumbent): 7.7% + 5.75% = 13.5%
1980 election: Reagan and Carter (incumbent): 7.1% + 13.5% = 20.6%
1984 election: Mondale and Reagan (incumbent): 7.5% + 4.3% = 11.8%
1988 election: Dukaucus and Bush (incumbent): under 10%
1992 election: Clinton and Bush (incumbent): 10.6%
1996 election: Dole and Clinton (incumbent): 6.3%
2000 election: Gore (incumbent) and Bush: 7.7%
2004 election: Bush (incumbent) and Kerry: 8.1%

9-03-07
Equities – stocks, ownership of a company
Bond – debt-issue
What is the relationship in Bond prices and bond interest rates?
There is an inverse relationship between the price and interest rates of bands.
Bonds are existing bonds (already issued)
6% interest rate
Interest rate goes up to 8%
EXAM – Why are banks not borrowing from the discount window right now?
Markets are calmed

Investment Spending (17%)

• business fixed investment (spending on plant and equipment)
• Residential fixed investment – housing
• Inventory investment

Planned inventory is 10 mil

Ending inventory of 12 Million
Unplanned of 2 million
• Classical – lower the price and sell the chairs
• Keynesian – people get laid off until inventory corrects itself

Investment spending is the most volatile type of spending

Stock is measured at a point in time

• Capital stock

Flow – measures something over a period of time

• Investment

Wealth = assets – liabilities

Government Spending –
• Payment made by the government to consumers for which consumers do nothing
at that time.

FICA – 6.2% goes to Social Security

We are currently taking more money in than we are taking out
In about 2012 we will start taking out more than we put in
In about 2040 SSI will be bankrupt
The SSI trust fund is all government securities

Fixing SSI
• Increase the taxes
• Delay collection age
• Lower the benefits – COLA (cost of living adjustment)

If we lower the COLA by 1% that would make everything by several decades

When it began the SSI tax was .5% up to $2000
There is a limit on SSI tax $93,000

Bonds
• Corporate
 • Municipal Bonds (tax exempt)
• Treasury – Bill, notes, bond

How do you make money off of stocks?

Increase in value of stock – capital gains
Dividends

Homework – check the FFR against the Discount rate; lookup for 2006 our trade deficit;
finish chapter 2

Deficit - $565 Brillion

FFR – 4.9%; Discount 5.75%

9-5-07
12% of subprimes are defaulting
The other group that invested in housing to flip it is defaulting

Excess inventory – unplanned inventory

Unplanned inventory is a form of investment

Nominal Verses Real

Nominal – the face value of something
Real – adjusted for inflation

Nominal GDP can change due to:

• Changes in prices
• Changes in quantity produced

The GDP went down in the 1930s during the Great Depression because there were fewer
goods produced and then sold at lower prices.

The Great Depression was our last period of substantial deflation.

Changes in real GDP can only be changes by changes in quantities

GDP Deflator = 100 x Nominal DGP/Real GDP

CPI – consumer price index

CPI measures a certain basket of goods while the GDP measures the inflation of all goods
Adjusts for COLA’s

Government likes to use is the GDP deflator

CPI
• Survey consumers on the typical basket of consumer goods
 • Every month collect data on the prices of all items in the basket
• CPI in any month equals 100 x Cost of basket in that month/Cost of basket in base
month

Substitution bias – CPI overstates inflation because it does not account for substitution
Introduction of new goods – the CPI does not take into account the affect of new goods
impact on the quality of life
Unmeasured changes in quality – better products for same price are not taking into
account

Generally speaking, most economists say that the CPI is about 1% too high

Prices of Capital Goods

• Included in GDP deflator
• Excluded from CPI

Price of imported consumer goods

• Included in CPI
• Excluded from GDP deflator

Basket of goods
• CPI – fixed
• GDP deflator – changes every year

Homework – pp. 40 questions 5 and question 6; read chapter 3

Laspeyres – fixed basket

Paasche – changing basket

5.) See Excel for Numbers; Yes, Personal Consumption is the highest component of
GDP in all three years, GPDI staid relatively equivalent in all three years, Government
purchases rose only slightly, and National Defense purchases staid almost equal.
However, state and local purchases increased from 1950 as well as imports. Also, net
exports when further and further negative as time progressed with the exception of 1950.

6.) a) See Excel for numbers.

b) They have increased by $10,000 for cars and $10 for bread. With a Laspeyres
measurement prices have gone up 20% and with a Paasche measurement they have gone
up 52%. The difference is that with the CPI (Laspeyres) we use a fixed basket of goods
that take into account a fairly even distribution of price change. However the GDP
deflator allows the basket to change and include all goods thereby reflecting the change
differently.

c) CPI, because it is more likely to reflect the actual change in COLA than the GDP
deflator.
9-7-07
Libor – London’s FFR
Categories of the Population
• Employed
• Unemployed
o Must be capable of work
o Must be willing to work
o Must be looking for work
o Must be without work
• Labor Force
• Not in the Labor Force
• Discouraged workers

Unemployment Rate – percentage of the labor force that is unemployed

Labor force participation rate – the fraction of the adult population that participates in the
labor force (below 16 is not a part of the labor force)

U.S. adult population by group, June 2006

Employed – 144.4 Million
Unemployed – 7 Million
Total Adult – 228.8
Million
Total population – 300
Million

Labor Force – 151.4

Not in the labor force –
77.4
Labor force participation
rate – 66%
Unemployment rate –
4.6%

Full Employment – 4%

Will always have frictional unemployment – when you are unable to synchronize job
endings and job beginnings
Structural unemployment – unemployment due to mismatching of jobs available and
workers skills

Work – leisure trade off

K = capital (plant and equipment)

L = Labor (the physical and mental efforts of workers; human capital)
Production Function Y = F(K,L)
o Shows how much output an economy with K units of capital and L units of labor
o Reflects the economy’s level of technology
o Exhibits constant returns to scale – if both inputs go up by the same factor the
output goes up by the same factor

Law of diminishing returns – for every input eventually your output levels off
Decreasing returns to scale – if you increase both inputs by the same percentage the
output changes by a lesser percentage
Diseconomies of scale – related to size and output

Marginal – additional, change, delta, slope, 1st derivative

EXAM:
Returns to scale - Y1 = F(K1, L1)
If both inputs increase by z
If constant Y2 = zY1
If increasing Y2 > zY1
If decreasing Y2 < zY1

Example:
F(K,L) = square root of KL
F(zK, zL) = Square root of (zK, zL)

Numbers are K = 10 and L = 20

Homework – F(K,L) = K2 + L2, Square root K + square root L

1.) 500 – 2000 (Increasing returns to scale)

2.) 7.6 – 10.8 (Decreasing returns to scale)

9-10-07
Constant returns to scale
• Technology is fixed
• Economy’s supply of capital and labor are fixed

Output is determined by the fixed factor supplies and the fixed state of technology:
Y=F(K,L) (with lines over everything but F)

Factor prices – what you pay for factors of production

• Wage – price of L
• Rental Rate – price of K

W = nominal wage
R = nominal rental rate
P = price of output
W/P = real wage
R/P = real rental rate

Factor prices are determined by supply and demand

Demand for Labor

• Assume markets are competitive
• A firm hires each unit of labor if the cost does not exceed the benefit
Cost = real wage
Benefit = marginal product of labor

Produce where MC = MR

MPL – marginal product of labor = the extra output the firm can produce using an
additional unit of labor (holding other inputs fixed)

MPL = F(K,L+1) – F(K,L)

A firm hires labor until MPL = W/P

Classical very supply side – work on Investment, cut taxes to investors (trickle down)
• John-Baptist Say – classical economist – supply creates its own demand
Neoclassical – 1870s with marginalists – supply and demand
Demand side economics – Keynesian – says to concentrate on Consumer, increase public
spending

Wages are set by addition to output

Trophy wage – a super-high wage for performance incentive

Law of diminishing marginal utility – each additional unit of a good gives you less
pleasure

Homework – redo to percentage with 2000 basket; read 4 pages; write about the
Subprime mortgage industry, regular mortgages, what effect has it had on stocks, bonds,
internationally (four sources, source at end of the paper) due Monday

9-12-07
Paper – Volatility, credit crunch, foreign markets

REIT sector – packaged debt in real estate

Hedge funds – historically not been used for common investors; historically a type of
insurance; today hedge funds deal in the futures markets (currencies, interest rates)
Institutions – large investors (Pension funds, insurance groups); they buy blocs of stock

Labor’s input in the GDP had been constant over time

Alpha = capital’s total share of total income

Capital income = alpha Y
Labor Income = (1 – alpha)Y
Y = AKalphaL (1-alpha) – cobb-douglas function – Production possibilities
Consumption is a function of disposable income
C = C(Y – T)

The slope of the consumption function is the marginal propensity to consume

We want to find when the economy is in equilibrium

Investment function is I = I(r)

r = real interest rate
i = nominal interest rate
The real interest rate is the cost of borrowing as well as the opportunity cost of using
one’s own funds to finance investment spending.

Retained earnings = after tax income – dividends

Government Spending – government spending on goods and services

G excludes transfer payments
Assume T and G are both exogenous

Aggregate Demand = C(Y-T) + I(r) + G

Aggregate Supply – Y = F(K,L)
Equilibrium – Y = C(Y-T) + I(r) + G

Loanable funds market – supply and demand model for our financial system
One assets –
• Demand for funds – investment
• Supply of funds – savings

Commercial banks – financial intermediary that brings these two groups together
Price of funds is the real interest rate

Investment function is also the demand curve for loanable funds

Supply of loanable funds – comes from the savings of

When were hula hoops in use – 1958

The government may also contribute to savings

Private savings = (Y-T) – C

Public Savings = T – G
National savings is private and public together
Y = 100 C = 60 G = 20 T = 10

In the early 1990s about 18 cents of every tax dollar went to pay interest on the debt.
Now it’s only 9.

Homework – add 10 I to the graph in notebook; how much was the interest on the
national debt last year
Interest on the National Debt in 2006 - $405,872,109,315.83

9-14-07
Loanable Funds Supply Curve
Multiplier Process – increases an input to the economy and the whole economy increases
Reaganomics – supply side economics
• Increase defense spending
• Big tax cuts

1980 – The highest marginal tax rate was 70%; when he left the highest marginal tax rate
was 28%

The crowding out effect – when government policy crowds out private investment

When we go into debt we sell government securities which we buy with higher interest
rates; in order to get people to buy government securities they raise the interest rate and
when the interest rises investment spending goes down; government spending crowded
out investment spending

Classical economists – total crowding out effect – if G increases X then I decreases X

Things that shift the investment function

• Change in technology
o To take advantage of an increases in technology companies have to invest:
1990’s
• Tax laws that affect investment
o Investment tax credit – a tax credit on investment (you get to take that
much off)
• Subsidies
o Government support to businesses

Classical = flexible
Homework – Send notes to Tyler Current; assume that the number is still too low,
increases G to 20; pp. 73-4 3-1, 3-7; read chapter 4

9-17-09
Functions of money
• Medium of exchange
• Store of value
• Unit of account

C–C
C–M–C
M – C – M` (Karl Marx) – Money to commodity to more money – middle C is labor
power

C = Commodity
M = Money

Monetary policy – the use of Federal Reserve tools to manipulate the economy

Money supply is the quantity of money in the economy

M1 – the most liquid form of money
• Currency
• Depositable Accounts
• Traveler’s checks

M2 – second most liquid

• M1
• small time deposits
• savings deposits
• money market mutual funds (short term investments like t-bills)
• money market deposit accounts

Classical theory
Concept of velocity – the turnover of money during a given year

The equation of exchange

MV = PY
It’s an identity

Money x Velocity = Price Level x Transactions (goods and services)

M/P = real money balances (the purchasing power of money)
Money supply divided by prices

(M/P)d = kY
K = how much money people wish to hold for each dollar of income (exogenous)
K = 1/V

Quantity Theory of Money

Start with the equation of exchange
Assumes V is constant and exogenous

Inflation = change in M over M minus the change in Y over Y

Hence, the Quantity Theory predicts a one-for-one relation between changes in the
money growth rate and changes in the inflation rate.

Milton Friedman – “Inflation is always and everywhere a monetary phenomenon.”

Chicago School of Economics, very conservative, classical

Empirical Research – number research to prove a theory

Seigniorage – when you spend money without raising taxes or issuing bond

Inflation Tax – printing money to raise revenue, inflation is like a tax on people who hold
money

Real interest rate adjusted for inflations

r = i – pi
The Fisher effect i = r + pi

Homework – finish correct terms on reserve in notebook; look at footnotes in the book
and put down three papers that you would be interested in doing (author, title of the
article, and where it is in the book); finish chapter 4

9-19-07
Lowering of the rate is being called a moral hazard – encouraging risky behavior by
removing the consequences from a bad choice

Could the real interest rate be negative – yes

The quantity theory of money – depends only on real income

The reasons we have money is transaction purposes
Another determinant in money demand is the nominal interest rate

Transaction demand for money – classical

Precautionary demand for money – Keynesian

Speculative demand for money – Keynesian

People use money to invest and attempt to earn a return on their money

You either hold money or bonds:

If the interest rate is very high the demand for money is extremely low because you could
make so much by investing it

When the rate is high you hold on to bonds because their value will go up
You don’t want to hold bonds at a low rate because the rate will go up and its value will
go down

Homework - pp. 73 3-1, 3-7; read 10 pages into ch. 5

9-21-07

Options backdating - changing the date on an option so that the books look different

Gold soars on inflation fears - gold is a store of value that will not fluctuate with
inflation

Hyperinflation – more than 50% inflation a month

Money ceases to function as a store of value
Inflation is always and everywhere a monetary phenomenon.
Classical dichotomy – nominal variables don’t affect real
Neutrality of money – changes in the money supply do not affect real variables

C = C(Y-T)
Y = C(T-T) + I + G
Private Savings = (Y-T) - C
Public Savings = T – G

In an open economy
• spending does not need to equal output
• saving need not equal investment

NX = EX – IM = Y – (C + I + G)
Twin deficits – government deficit and trade deficit

Net capital outflow = S – I

If S>I a country is a net lender

The exogenous world interest rate determines investment

Three experiments on the exam

• fiscal policy at home
• fiscal policy abroad
• an increases in investment demand

Homework – look up the inflation level in early Germany, Hungary, Yugoslavia; finish
chapter 5

Germany –
July 1922 = 1
January 1924 (18 months later) = 750,000,000,000

Yugoslavia –
January 1993 = 1
January 1994 = 600,000,000,000,000

Hungary –
June 1945 = 1
June 1946 = 828,000,000,000,000,000,000,000,000