LECTURE NOTES ON

MACROECONOMIC PRINCIPLES

Peter N. Ireland
Department of Economics
Boston College

irelandp@bc.edu
http://www2.bc.edu/~irelandp/ec132.html

Copyright (c) 2009 by Peter N. Ireland. Redistribution is permitted for educational and research
purposes, so long as no changes are made. All copies much be provided free of charge and must include
this copyright notice.
Ch 23 Measuring a Nation’s Income
Introduction
Microeconomics studies how households and firms make decisions and how they interact in markets.

Macroeconomics studies the economy as a whole.

Some questions addressed by macroeconomics:

1. Why is average income high in some countries and low in others?

2. Why do prices rise rapidly in some periods and remain stable in others?
3. Why do production and employment expand in some years and contract in others?
4. What can the government do to promote rapid growth in income, stable prices (low inflation),
and high employment?

This chapter focuses on gross domestic product or GDP as a measure of economy‐wide well‐being.

Outline
1. Income and Expenditure
2. Measuring GDP
3. The Components of GDP
4. Real and Nominal GDP
5. GDP and Economic Well‐Being

Income and Expenditure

GDP measures two things at once:

1. The total income of everyone in the economy.

2. The total expenditure on the economy’s output of goods and services.

Why? Because for the economy as a whole, income must equal expenditure. “For every buyer there
must be a seller.”

The circular flow diagram (Figure 1) illustrates this:

‐ In markets for factors of production (inputs):

o Households sell or rent labor, land, and capital. Their income equals GDP.
o Firms buy or hire labor, land, and capital. Their wages, rent, and profit equal GDP.
‐ In markets for goods and services (outputs):
o Firms sell goods and services. Their revenue equals GDP.
o Households buy goods and services. Their expenditure equals GDP.
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This diagram ignores the financial sector, the government, and the foreign sector. Later we will expand
our analysis to include them, but without changing this basic result that for the economy as a whole,
income must equal expenditure.

Measuring GDP
GDP is the market value of all final goods and services produced within a country in a given period of
time.

GDP is the market value …

GDP measures all goods in terms of their market value, in the common unit of dollars.

“You can’t compare apples and oranges.” If an apple costs twice as much as an orange, then it
contributes twice as much to GDP.

Non‐market activities like leisure, housework, and child care don’t contribute to GDP.

… of all …
That last caveat notwithstanding, GDP tries to be comprehensive.

… final …
International Paper makes paper, which is used by Hallmark to make a greeting card.

In this example, paper is an intermediate good, since it is used as an input for producing yet another
good. The greeting card is a final good, since it is sold to and used by and end user.

Since the value of the final good reflects the value of the intermediate good, only the value of the final
good is included in GDP to avoid double counting.

… goods and services …

Goods include cars, food, clothing, etc.

Services include haircuts, medical care, etc.

… produced …
GDP only includes newly produced goods.

Buy a new car, that contributes to GDP. Buy a used car, that does not contribute to GDP.

… within a country …
US GDP counts all goods and services produced in the US.

A Canadian works in the US; her income counts in US GDP.

A US citizen works in Canada; his income does not count in US GDP.

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… in a given period of time.

Usually within a quarter (3 months) or a year.

The Components of GDP

GDP can be decomposed into four components: consumption, investment, government purchases, and
net exports.

Consumption
Consumption is spending by households on:

‐ Durable goods (cars, appliances).

‐ Nondurable goods (food).
‐ Services (haircuts).

Investment
Investment is spending by firms on goods that will be used in the future to produce more goods and
services:

‐ Capital equipment (machines and tools).

‐ Structures (factories, office buildings).
‐ Inventories (goods produced but not yet sold).

By convention, the purchase of a newly built house is a form of spending by households that is also
included in investment.

Note that inventory accumulation is counted as investment:

‐ If Ford builds a $50,000 car in 2008, but the car sits in inventory through the end of the year,
GDP and investment both rise by $50,000 in 2008.
‐ Then, if the car is sold in 2009, consumption rises by $50,000 but investment falls by $50,000,
since Ford’s inventory is depleted. GDP remains unchanged.
‐ The car adds to GDP during the year it is produced, not during the year it is sold.

Note that the term investment as it is used here has a different meaning from a household’s purchase of
a financial asset like a stock or a bond.

Government Purchases
Government spending includes:

‐ Purchases of goods and services by federal, state, and local governments.

‐ Salaries of government workers.
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Other forms of government disbursements, like social security payments, are called transfer payments
and are not counted in GDP.

Net Exports
Net exports equal:

‐ Exports: purchases of domestically (US) produced goods by foreigners.

‐ Minus imports: purchases of foreign goods by US households and firms.

Why are net exports included in GDP?

‐ Suppose that Boeing sells $100 million in airplanes to British Airways.

o Conceptually, we want to include this $100 million in US GDP, since the income is
earned by a US firm.
o And, consistent with this idea, the $100 million in exports get added to US GDP.
‐ But suppose that you spend $100,000 on a new Porsche.
o Conceptually, we would not want to include this $100,000 in US GDP, since the income
is earned by a German firm.
o And, consistent with this idea:
 US consumption rises by $100,000, adding $100,000 to GDP.
 But US imports rise, subtracting $100,000 from net exports and also from US
GDP.
 In the end, US GDP is left unchanged.
‐ One way of highlighting these ideas is to write out the national income accounting identity in
slightly more detail, separating out the contributions of exports and imports:

Table 1 shows the breakdown of GDP into its four major components for the US in 2004.

Some Examples
Now let’s ask what happens to GDP and its components when …

‐ Karen pays Doug $10 to mow the lawn.

o Consumption rises by $10.
o GDP rises by $10.
‐ Karen marries Doug – now he mows the lawn for free!
o Consumption falls by $10.
o GDP falls by $10.
‐ Sam the baker buys a $10 bag of flour.
o GDP does not change, since in this case the flour is an intermediate good.
‐ I buy a $10 bag of flour to bake cookies at home.
o GDP rises by $10, since in this case flour is a final good.
o Consumption rises by $10.
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‐ You spend $25,000 on a new car, built in the US.

o Consumption rises by $25,000.
o GDP rises by $25,000.
‐ You spend $25,000 on a new car, built in Japan.
o Consumption rises by $25,000.
o Net exports fall by $25,000.
o GDP is unchanged.
‐ You spend $10,000 on a used car.
o GDP is unchanged.
‐ General Motors manufactures $100 million worth of cars and sells them in Europe.
o Net exports rise by $100 million.
o GDP rises by $100 million.
‐ General Motors builds a new factory for $100 million.
o Investment rises by $100 million.
o GDP rises by $100 million.
‐ General Motors buys $10 million worth of computer equipment made in Japan.
o Investment rises by $10 million.
o Net exports fall by $10 million.
o GDP is unchanged.
‐ The Department of Defense buys $500 million of military equipment, manufactured in the US.
o Government purchases rise by $500 million.
o GDP rises by $500 million.
‐ The State of Massachusetts hires a new employee with a $35,000 salary.
o Government purchases rise by $35,000.
o GDP rises by $35,000.

Real and Nominal GDP

If GDP rises from one year to the next, then either:

1. The economy is producing more goods and services, or

2. Goods and services are selling at higher prices.

Since what people really care about is the total volume of available goods and services, and not so much
the prices at which these goods and services sell, we want to correct GDP for the effects of inflation,
that is, for rising prices.

Real GDP makes this correction, by valuing the goods and services produced this year at constant prices
that prevailed during a base year.

Nominal GDP does not make this correction. It values the goods and services produced this year at
current prices that prevail this year.

The numerical example from Table 2 illustrates the distinction between real and nominal GDP.
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The GDP deflator is then calculated as

100

Now let’s ask what happens when …

‐ The quantities of all goods and services produced rise, but prices stay the same.
o Real GDP rises.
o Nominal GDP rises by the same amount.
o The GDP deflator stays unchanged.
‐ The prices of all goods and services rise, but quantities produced stay the same.
o Real GDP says unchanged.
o Nominal GDP rises.
o The GDP deflator rises.

The percentage increase in the GDP deflator from one period to the next defines the rate of inflation.

Figure 2 shows the evolution of real GDP in the US since 1965:

‐ Real GDP grows over time: real GDP in 2004 was about 4 times its 1965 level.
‐ Growth is uneven. Periods in which GDP declines for more than two quarters in a row are called
recessions.

GDP and Economic Well­Being

GDP measures the level of income and expenditure in the economy.

Since most people would prefer more income and expenditure to less, GDP per person can serve as a
measure of economic well‐being.

But let’s remember that GDP is a measure based on market value and therefore does not include:

‐ Leisure.
‐ Childcare from a parent.
‐ Volunteer work.
‐ Environmental quality.
‐ Equity in the distribution of income and expenditure.

However, Table 3 reveals that despite these omissions, real GDP per person is highly correlated with
other measures of well‐being, including life expectancy and adult literacy rates.
Ch 24 Measuring the Cost of Living
Introduction
In 1931, the New York Yankees paid Babe Ruth an annual salary of $80,000.

In 2005, the New York Yankees paid Alex Rodriguez an annual salary of $26 million (and that amount
went up to $28 million in 2008).

But then again, in 1931 an ice cream cone cost a nickel and a movie ticket cost a quarter. More
generally, the cost of living has risen greatly since then.

This chapter focuses on the consumer price index or the CPI as a measure of the cost of living.

The inflation rate is the percentage rate of change in the CPI.

Once we understand how the CPI is constructed and how it has behaved in the US, we can return to the
question: who was really paid more, after adjusting for inflation, Ruth or Rodriguez?

Outline
1. The Consumer Price Index
A. How the CPI is Measured
B. Problems in Measuring the Cost of Living
C. The GDP Deflator and the CPI
2. Correcting Economic Variables for the Effects of Inflation
A. Dollar Figures at Different Points in Time
B. Indexation
C. Real and Nominal Interest Rates

The Consumer Price Index

The CPI is computed by the Bureau of Labor Statistics (BLS), a division of the Department of Labor, to
measure the overall cost of goods and services bought by a typical consumer.

How the CPI is Measured

Table 1 highlights the 5 steps involved in measuring the CPI:

1. Survey consumers to determine the relevant “basket of goods.”

2. Record the price of each good in each year.
3. Compute the cost of the basket in each year.
4. Choose a base year and compute the CPI for the current year:
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100

5. Compute the inflation rate as the percentage change in the CPI from one year to the next:

100

The example in Table 1 assumes, for simplicity, that the basket includes only two goods. Figure 1
illustrates in more detail what is really in the CPI basket.

In addition to the CPI, the BLS also computes the producer price index or the PPI, to measure the cost of
goods and services bought by the typical firm.

Problems in Measuring the Cost of Living

Three problems prevent the CPI from being a perfect measure of the cost of living:

1. Substitution bias.
2. The introduction of new goods.
3. Unmeasured quality change.

Substitution bias arises because in any give year the prices of some goods rise faster than others:

‐ The basket holds the quantity of each good purchased fixed.

‐ But, in fact, consumers tend to substitute less expensive goods for more expensive goods.

Does substitution bias cause the CPI to overstate or understand the true change in the cost of living?

To answer this question, return to the example from Table 1:

‐ There, the price of hot dogs rises at a faster rate than the price of hamburgers.
‐ The CPI holds the number of hot dogs and the number of hamburgers fixed.
‐ But, in reality, consumers are likely to buy more hamburgers and fewer hot dogs.
‐ Hence the true, changing basket of goods is less expensive than the fixed basket used in
computing the CPI.
‐ The CPI therefore overstates the true change in the cost of living.

When new goods are introduced, the true cost of achieving a given level of consumer satisfaction falls.
For example, which would you rather have?

‐ A $100 gift certificate for a small store, with a limited range of choices.
‐ Or a $90 gift certificate for a large store, with a wide variety of goods.
‐ The CPI does not account for these effects, so it again overtstates the true change in the cost of
living.

Unmeasured quality change: many types of goods improve in quality over time.
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‐ A new cellphone purchased today is a lot better than a cellphone purchased two or three years
ago, even if it sells at a higher price.
‐ The BLS tries to correct for this quality change.
‐ But to the extent that it underestimates the extent of quality change, it again overstates the
true change in the cost of living.

Many economists believe that the because of the combined effects of these three problems, the
inflation rate based on the CPI overstates the true increase in the cost of living by about 0.5 percentage
points per year. These effects are important, since for example, Social Security benefits get adjusted
upwards automatically in a way that is tied to the CPI inflation rate.

The GDP Deflator and the CPI

Usually, the GDP deflator and the CPI move together, as shown in Figure 2.

One difference, however, arises because:

‐ The GDP deflator reflects the prices of all goods produced domestically.
‐ Whereas the CPI reflects the prices of all goods consumed domestically.

So let’s ask: what happens when the price of an imported good rises?

‐ The CPI increases.

‐ But the GDP deflator does not.
‐ This effect is particularly important when the price of imported oil rises.

What happens when the price of a domestically‐produced capital (investment) good rises?

‐ The GDP deflator increases.

‐ But the CPI does not.

A second and more subtle difference arises because:

‐ The GDP deflator is based on the prices of goods as currently produced.

‐ Whereas the CPI is based on the prices of a fixed basket of goods.
‐ So differences arise when the prices of different goods are rising or falling at different rates.

Correcting Economic Variables for the Effects of Inflation

Dollar Figures at Different Points in Time
Let’s go back to the question from the beginning: after correcting for inflation, who was paid more, Ruth
($80,000) in 1931 or Rodriguez ($26 million) in 2005?

To answer this question, ask first: how many “baskets” of goods could Ruth buy in 1931?
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$80,000 1931
1931
1931

Now ask, how much would this same number of baskets have cost in 2005?

2005 1931
2005 1931
$80,000 1931
2005
1931

This last formula can be rewritten as:

2005 1931
2005
1931
$80,000 1931

But now it simplifies to:

2005
2005 1931 $80,000 1931
1931

This equation is true more generally:

It turns out that

1931 15.2

2005 195

And so, doing the math:

195
2005 $80,000 1931 $1,026,315.79
15.2

Even after adjusting for inflation, Rodriguez’s salary is much, much higher!

But, interestingly, President Herbert Hoover’s 1931 salary was $75,000. Let’s convert that into 2005
dollars in the same way:
195
2005 $75,000 1931 $962,171.05
15.2

After adjusting for inflation, Hoover’s salary is more than twice as large as the $400,000 earned in 2005
by President George W. Bush.

Table 2 does these calculations for box office receipts for movies released in different years.
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Indexation
Indexation refers to the automatic correction by law or contract of a dollar amount for the effects of
inflation.

As noted above, Social Security benefits are indexed, that is, adjusted every year based on the
percentage increase in the CPI.

Union contracts often specify indexed wages that increase each year based on the inflation rate. Such a
provision is often referred to as a cost‐of‐living allowance (COLA).

Real and Nominal Interest Rates

Since bank accounts, bonds, automobile loans, and mortgages all make or require dollar payments at
different points in time, the interest rates on these investments or loans must also be corrected for the
effects of inflation to gauge their true economic significance.

Suppose, for example, that you deposit $1,000 in a bank account that pays interest at a 10% annual rate:

‐ One year from now, you will have $1,100: your original $1,000 plus $100 interest.
‐ But let’s say that the inflation rate over the next year is 3%.
‐ You have 10% more dollars, but those dollars buy 3% less.
‐ Your “real” return is actually 10% ‐ 3% =7%.

In this example, the nominal interest rate, that is, the interest rate as it is usually reported without
correcting for inflation, is 10%.

But the real interest rate, corrected for the effects of inflation, is 7%.

In general:

Note that the real interest rate can even be negative: if the nominal interest rate on your bank account
is 10%, but the inflation rate turns about to be 12%, the real interest rate is 10%‐12%=‐2%.

Most frequently, prices rise over time, so that the inflation rate is positive. But sometimes, as in the US
economy during the Great Depression of the 1930s and in Japan during the last decade, prices actually
fall over time, so that the inflation rate is negative. These are periods of deflation as opposed to
inflation.

Which is bigger: the nominal interest rate or the real interest rate?

‐ Under inflation, the nominal interest rate is bigger than the real interest rate since the value of
dollars is falling over time.
‐ Under deflation, the real interest rate is bigger than the nominal interest rate since the value of
dollars is rising over time.
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Figure 3 shows the relationship between nominal and real interest rates in the US:

‐ During the 1970s, nominal interest rates were high but real interest rates were low. Why?
Because inflation was high.
‐ During the 1980s and 1990s, nominal interest rates were low but real interest rates were high.
Why? Because inflation was low.

This is an important lesson for personal finance and investing: when evaluating the payoff on an
investment or the interest rate on a loan, you need to make a judgment on what the inflation rate will
be over the lifetime of the investment or loan, to convert the nominal interest rate into a real interest
rate.
Ch 25 Production and Growth
Introduction
Real GDP per person in the United States, Japan, or Germany is about ten times larger than real GDP in
India, Indonesia, or Nigeria. Why?

In the US over the past century, real GDP per person has grown at an average annual rate of 2 percent.
This number may seem small, but it implies that the average real income doubles every 35 years, and
that average income in the US today, at the beginning of the 21st century, is more than seven times as
large as it was a century ago, at the beginning of the 20th century. Why?

In some East Asian countries, such as Singapore, South Korean, and Taiwan, real GDP per person has
grown at an average rate of 7 percent in recent decades. This implies that average real income doubles
every ten years. Yet there are other countries, especially in Africa, where GDP per person has not grown
at all. Why?

It is no exaggeration to say that these issues, explored in this chapter, are some of the most important in
all of economics.

Outline
1. Economic Growth Around the World
2. Productivity: Its Role and Determinants
A. Why Productivity is So Important
B. How Productivity is Determined
i. Physical Capital
ii. Human Capital
iii. Natural Resources
iv. Technological Knowledge
C. The Aggregate Production Function
3. Economic Growth and Public Policy

Economic Growth Around the World

Table 1 shows data on real GDP per person in 13 countries around the world:

1. Real GDP per person varies widely from country to country:

a. Income per person in the US is now about 7 times that in China and 13 times that in
India.
b. Average income in India today is less than average income in England in 1870.
2. In the US, real GDP per person has grown at an average annual rate of 1.82% since 1870.
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3. Japan’s real GDP per person has growth at an average annual rate of 2.79% since 1890:
a. In 1890, average income in Japan was similar to average income in Mexico and
Argentina.
b. Today, average income in Japan is similar to average income in Germany and the
United Kingdom.

Productivity: Its Role and Determinants

Why Productivity is So Important

Economists studying production and growth often like to start by thinking about Robinson Crusoe, a
sailor stranded on a desert island.

Everything Crusoe consumes, he must produce himself.

What determines Crusoe’s standard of living? His productivity, the quantity of goods and services
produced by each unit of labor input. Or, put even more simply: productivity measures output per
worker.

This seems obvious – it holds true almost by definition – when thinking about Crusoe, but it also holds
true when thinking about GDP – income or expenditure – per person in a real‐world economy.

How Productivity is Determined

What determines how many fish Crusoe eats?

His productivity: how many fish he catches.

But what determines his productivity?

1. How many fishing poles does he have?

2. How much training in fishing does he have?
3. How plentiful is the supply of fish near his island?
4. How effective is he in inventing new techniques for catching more fish?

Again, these basic principles extend to real‐world economies.

Physical Capital per Worker

Crusoe catches more fish if he has more fishing poles.

Workers are more productive when they have more tools.

Physical capital (or capital) is the stock of equipment and structures that are used to produce goods and
services.

A larger stock of physical capital per worker makes an economy more productive.

Recall that capital and labor are inputs or factors of production.

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But capital is a produced factor of production: an output of past production that has now become an
input to new production.

Human Capital per Worker

Crusoe catches more fish if he has had better training.

Human capital is the stock of knowledge and skills that workers acquire through education, training, and
experience.

A larger stock of human capital per worker makes an economy more productive.

Although human capital is less tangible than physical capital, we can still think of human capital is being
itself “produced” in schools, training programs, etc.

Natural Resources per Worker

Crusoe catches more fish if fish are more plentiful in the nearby waters.

Natural resources are the inputs to production that are provided by nature: land, water, mineral
deposits, etc.

Natural resources can be:

1. Renewable: forests.
2. Nonrenewable: oil.

A larger stock of natural resources per worker also tends to make an economy more productive.

Although some countries, such as Japan, can be quite productive without having access to a lot of
natural resources.

Technological Knowledge
Crusoe catches more fish if he is good at inventing new fishing techniques.

Technological knowledge refers to society’s understanding of the best ways to produce goods and
services.

Technological knowledge can be:

1. Common knowledge: Henry Ford introduced assembly lines in auto manufacturing, but
other companies in other industries followed suit.
2. Proprietary: a pharmaceutical company develops a new drug and patents it, and then has
exclusive rights to produce that drug for a period of time.

A larger stock of technological knowledge makes an economy more productive.

Technological knowledge and human capital are closely related, but ultimately distinct:

‐ Technological knowledge refers to society’s understanding of how the world works.

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‐ Human capital refers to each individual worker’s ability to use that technological knowledge.
‐ “Technological knowledge is reflected in textbooks, human capital is reflected in the amount of
time each worker has spent reading those textbooks.”

Summary
What determines Crusoe’s standard of living? What determines the US standard of living?

His productivity (output per worker). Our productivity (output per worker).

What determines Crusoe’s productivity? What determines US productivity?

Number of fishing poles. Amount of physical capital per worker.

Amount of training in fishing. Amount of human capital per worker.
Supply of fish. Amount of natural resources per worker.
Invention of new fishing techniques. Amount of technological knowledge.

The Aggregate Production Function

These determinants of productivity are often depicted mathematically using an aggregate production
function.

Let

Economists often assume that output is related to inputs via an aggregate production function of the
form

, , ,

This equation assumes that holding other inputs constant, an increase in the stock of technological
knowledge leads to a direct increase in output.

Economists also often assume that holding the stock of technological knowledge fixed, the production
function exhibits constant returns to scale; doubling L, K, H, and N all at once leads to a doubling of
output, so that

2 2 ,2 ,2 ,2
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Similarly, tripling L, K, H, and N all at once leads to a tripling of output, so that

3 3 ,2 ,2 ,2

Or, for any number x:

, , ,

Now set x = 1/L in this last equation to write

1, , ,

This last equation just restates in mathematical terms when we learned in words from Crusoe: that
productivity (output per worker) Y/L is determined by:

1. Physical capital per worker K/L.

2. Human capital per worker H/L.
3. Natural resources per worker N/L.
4. Technological knowledge A.

This production function also highlights that a decrease in natural resources per worker, due to the
depletion of nonrenewable resources, will tend to decrease productivity.

This last observation raises the question: can productivity‐driven economic growth continue indefinitely,
given that natural resources are ultimately limited?

Maybe, but evidence from history suggests not:

‐ Growth in the stock of technological knowledge makes production processes and goods
themselves more resource‐efficient.
‐ Prices of natural resources tend to be volatile, but also have tended remain stable or in some
cases even fall over long period of time.
‐ If we use the price of a good to measure its economic scarcity, the stable or falling historical
trend in natural resource prices suggest that while supplies may be falling, demands are
declining just as fast or even more rapidly.

Economic Growth and Public Policy

What can government policies do to increase productivity and thereby raise standards of living?

By adopting policies that lead to larger stocks of

1. Physical capital per person.

2. Human capital per person.
3. Technological knowledge.
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Saving and Investment

Since physical capital is a produced factor of production, a larger stock can be accumulated over time.

But this requires that people save and invest more and consume less today.

Chapter 26 takes a more detailed look at how financial markets coordinate saving and investment.

Diminishing Returns and the Catch­Up Effect

Diminishing returns refers to property whereby the benefit from an extra unit of input declines as the
quantity of the input increases.

Economists usually assume that capital accumulation is subject to diminishing returns, as illustrated in
Figure 1.

The diminishing returns assumption implies that higher savings leads in the long run to higher levels of
productivity and incomes but not to higher growth rates in these variables.

It also implies that poorer countries have more to gain, relatively speaking, from capital accumulation
than richer countries. There can be a catch‐up effect, according to which countries that start off poor
tend to grow more rapidly than countries that start off rich.

This catch‐up effect seems to have been particularly important in fast‐growing East Asian economies.

Investment from Abroad

A country’s capital stock can also be augmented by investment from abroad:

1. Foreign direct investment occurs when foreigners make capital investments that they own and
operate in the domestic economy.
2. Foreign portfolio investment occurs when foreigners lend money to domestic corporations that
use the funds to acquire more physical capital.

When foreigners invest in a country, they expect to earn a return. But the capital they supply makes
domestic workers more productive, increasing the workers’ incomes as well.

The World Bank raises funds in advanced countries and uses those funds to make loans in developing
countries.

Education
Like physical capital, human capital accumulation raises productivity.

But also like physical capital, human capital accumulation has a cost: when students are at school, they
forego the wages that they could earn by working instead.

Many economists believe that human capital is even more important than physical capital because of
positive externalities. Recall that an externality is the impact that one person’s actions have on the well‐
 7

being of bystanders. If an educated worker comes up with new and better ways of producing goods and
services, he or she adds to the stock of technological knowledge that is available to everyone.

Perhaps for this reason, governments are heavily involved in education.

Health and Nutrition

Although human capital is most often associated with education, it applies on an even more basic level
to the health of workers.

Economist Robert Fogel argues that improved nutrition and heath accounts for about 30 percent of the
growth in GDP per person in Britain between 1790 and 1980. During that time, the average caloric
intake in Great Britain rose by 26 percent and the height of the average man rose by 3.6 inches.

Property Rights and Political Stability

A key aspect of both physical and human capital accumulation is an intertemporal trade‐off:

‐ Physical capital: consume less and save more today to have more physical capital in the future.
‐ Human capital: attend school and forgo wages today to have more human capital in the future.

If people are to willingly accept these intertemporal trade‐offs, they need to be assured that they will be
able to enjoy the future benefits of today’s sacrifices.

This requires a stable political and judicial system that respects property rights, that is, the ability of
people to exercise authority over the resources that they own.

Free Trade
Free trade can help raise productivity by:

1. Allowing a country to specialize in goods that it can produce most efficiently.

2. Allowing a country to import foreign capital.

Research and Development

Research and development leads to increases in the stock of technological knowledge, hence to higher
productivity.

Like human capital accumulation, research and development activities yield positive externalities when
one person’s discoveries can be used by other people in other activities.

For this reason, the National Science Foundation and the National Institute of Health provide research
grants to scientists.

The federal government is also a big sponsor of higher education.

Population Growth
Our equation for productivity
 8

1, , ,

derived above from the aggregate production function, suggests that population growth (an increase in
the number of workers L), can decrease productivity by:

1. “Diluting” the stocks of physical and human capital.

2. Stretching natural resources too thin.

On the other hand, increases in population may make technological progress more rapid, since there are
more people around to discover and invent.

Which of these effects “wins out” in the end?

Again, it’s hard to say for sure, but evidence thus far has not supported the “Malthusian” (named after
British economist Thomas Robert Malthus, 1766‐1834) view that population growth will ultimately lead
to widespread poverty.

Summary
Our equation

1, , ,

suggests that productivity improvements can come through policies that work through several channels.

K/L H/L A

Saving and investment Education Research and development

Catch‐up effect Health and nutrition
Investment from abroad
Free trade

Property rights and political stability

Ch 26 Saving, Investment, and the
Financial System
Introduction
When a country saves a large fraction of its income, more resources are available for investment in
capital, and higher capital raises the economy’s productivity, raising living standards still further.

But within that country, at any given point in time, some people will want to save some of their income
for the future, while others will want to borrow to finance investments in physical capital.

How are savers and investors coordinated?

The financial system consists of those institutions in the economy that help to match one period’s
savings with another person’s investment.

This chapter:

1. Describes the variety of institutions that make up the financial system in the US today.
2. Describes the relationship between the financial system and these key macroeconomic
variables: saving and investment.
3. Develops a model that describes how the interest rate adjusts so as to equate the demand for
and supply of funds in the financial system and uses this model to show how various
government policies affect the interest rate, saving, and investment.

Outline
1. Financial Institutions in the US Economy
A. Financial Markets
i. Bond Market
ii. Stock Market
B. Financial Intermediaries
i. Banks
ii. Mutual Funds
2. Saving and Investment in the National Income Accounts
3. The Market For Loanable Funds
A. Supply and Demand for Loanable Funds
B. Public Policies and the Market for Loanable Funds

Financial Institutions in the US Economy

Savers spend less than they earn.
Financial Institutions in the US Economy
Financial Markets
Bonds (debt)
(Direct Finance)
Stocks (equity) Bonds and stocks

Funds Funds

Borrowers
B SSavers
1. Firms 1. Households
2. Governments 2. Firms
3. Households 3. Governments

Funds Funds

Financial Intermediaries
Bank Loans (Indirect Finance)
Bonds and stocks 1. Banks Bank Deposits
2. Mutual Funds Mutual Fund Shares
 2

Borrowers spend more than they earn.

The financial system moves funds from savers to borrowers.

Savers supply funds with the expectation that they will get those funds back with interest at a later date.

Borrowers demand funds with the expectation that they will have to repay those funds with interest at a
later date.

Financial institutions include:

1. Financial markets.
2. Financial intermediaries.

Financial Markets
Financial markets are institutions through which savers supply funds directly to borrowers. Hence,
borrowing and lending activity in financial markets is often referred to as direct finance.

The two most important financial markets in the US economy are:

1. The bond market.

2. The stock market.

The Bond Market

A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the
bond.

A bond typically specifies:

1. The date of maturity, when the principal or amount borrowed is to be repaid.

2. The rate of interest that will be paid periodically until the date of maturity.

Example: General Motors issues a $1000 bond with a maturity date of December 2028 and a 5% rate of
interest. This bond will make annual interest payments of $50 each year until the end 2028, when the
final interest payment is made and the $1000 returned.

Three characteristics of bonds:

1. The bond’s term is the length of time until the bond matures. Some bonds have short terms of
only a few months, other bonds have long terms of up to 30 years. Typically, longer term bond
pay higher interest rates than shorter terms bonds, to compensate bond holders for having to
wait longer to get their principal back.
2. The bond’s credit risk refers to the probability that the borrower will be unable to make interest
payments and/or repay principal. When this happens, the borrower is said to default by
entering bankruptcy. Typically, low risk bonds like those issued by the US Government pay
lower interest rates than higher risk bonds issued by corporations: borrowers receive a higher
 3

interest rate to compensate them for taking on more risk. Junk bonds, issued by financially
shaky corporations, pay the highest rates of interest.
3. Bonds also differ in the tax treatment of their interest payments. Municipal bonds, issued by
state and local governments, pay interest that is exempt from the federal income tax. Because
of this tax advantage, municipal bonds usually pay lower interest rates than bonds issued by
private corporations or even the US Government.

The Stock Market

A stock is a certificate that represents a claim to partial ownership in a firm and hence a share of the
profits that the firm makes. The firm pays out some of its profits as dividends to its stockholders.

Example: if a corporation issues 1,000,000 shares of stock, then each share represents a claim to
1/1,000,000 of the business.

From the borrower’s point of view, the sale of stock to raise money is called equity finance, while the
sale of bonds to raise money is called debt finance.

From the saver’s point of view:

‐ The advantage to buying a bond is that it pays a fixed rate of interest and returns the principal
for sure, except in the rare care of bankruptcy.
‐ The disadvantage to buying a bond is that its payments are fixed, even if the firm earns higher
and higher profits.
‐ The advantage to buying a stock is that its dividends, and therefore its price, will rise when the
firm earns higher profits.
‐ The disadvantage to buying a stock is that its dividends, and therefore its price, will fall when the
firm earns lower profits.

Although the US bond market is actually much larger than the US stock market, stock prices get more
attention. This is not surprising, in light of the consideration of bonds versus stocks from above, since
stock prices are more closely linked to firm profitability and hence to the health of the US economy.

Stock indexes, or averages of stock prices, like the Dow Jones Industrial Average (an average of stock
prices for 30 major US corporations) and the Standard & Poor’s 500 (an average of stock prices for 500
large US corporations) are closely followed by economists and financial market participants.

Financial Intermediaries
Financial intermediaries are institutions through which savers supply funds indirectly to borrowers.
Hence, borrowing and lending activity through financial intermediaries is often referred to as indirect
finance.

Two of the most important financial intermediaries in the US economy are:

1. Banks.
2. Mutual funds.
 4

Banks
Banks:

1. Accept deposits from savers.

2. Make loans to borrowers.

Banks cover their costs and make profits by charging a higher interest rate on their loans than they pay
on their deposits.

Banks are also special, in that they allow savers to write checks on some types of deposits. That is, bank
deposits serve as a medium of exchange as well as a store of value.

Mutual Funds
Mutual funds:

1. Sell shares to savers.

2. Use the proceeds to buy a collection or portfolio of stocks and/or bonds.

Why don’t savers just buy the stocks and bonds themselves?

Mutual funds help with diversification: by investing in many stocks and bonds, a sharp decline in the
price of any one stock or a default on any one bond becomes less important.

Mutual funds also allow savers to delegate stock and bond selection to a professional money manager.

Saving and Investment in the National Income Accounts

Recall that GDP can be broken down into four components: consumption, investment, government
purchases, and net exports:

This equation is an identity: it always holds true, given how the variables are defined.

A closed economy is one that does not trade with the rest of the world. An open economy is one that
does trade with the rest of the world.

For now, let’s simplify the analysis by considering a closed economy in which, by assumption, NX = 0 and
so

Again, this equation is an identity: it just says that each unit of output is either consumed, invested, or
purchased by the government.

Rearrange the equation as

 5

The amount on the left‐hand side equals national saving, the amount of income that is not consumed by
households or purchased by the government:

Therefore, in a closed economy, saving must always equal investment:

Next, let T denote the amount of tax revenue the government receives, net of transfer payments (like
Social Security) that it returns to households. Then the equation for national saving

can be rewritten as

Which divides national saving into two components:

Private saving is the income that households have left after paying for taxes and consumption.

Public saving is the amount of tax revenue that the government has left after paying for its purchases:

‐ If T ‐ G > 0, then the government is running a budget surplus, an excess of tax revenue over
government spending.
‐ If T – G < 0, then the government is running a budget deficit, a shortfall of tax revenue
compared to government spending.

Now suppose that:

‐ GDP equals $15 billion.

‐ Consumption equals $9 billion.
‐ Government purchases equal $1.5 billion.
‐ Tax revenue equal $1 billion.

Let’s assume that we’re in a closed economy, and find investment, national saving, private saving, and
public saving.

To find investment:

$15 9 1.5 $4.5

 6

To find saving:

$4.5

To find private saving:

$15 $1 $9 $5

To find public saving:

$1 1.5 $0.5

In this (unfortunately realistic) case, the government is running a budget deficit.

The Market for Loanable Funds

Something curious:

‐ In the first part of this chapter, we looked at how some people save by spending less than they
earn and how others borrow by spending more than they earn. What’s more, some borrowers
use the proceeds to invest, that is, to purchase capital goods. So for any one individual, saving
need not equal investment.
‐ In the second part of the chapter, however, we looked at how, for a closed economy as a whole,
saving must always equal investment.
‐ How can we reconcile what is possible at the level of each individual with what must hold true
for the economy as a whole?
‐ What mechanism coordinates individual decisions, so that saving always equals investment?

To answer these questions, we need to develop a model of what happens in the market for loanable
funds, that is, the market in which individual savers supply funds and individual borrowers demand
funds.

Supply and Demand for Loanable Funds

Like any other market, an analysis of the market for loanable funds revolves around supply and demand.

The supply of loanable funds comes from individuals who have saved and want to lend the funds out,
either directly in the stock and bond markets or indirectly through a bank or mutual fund.

When the interest rate rises, saving becomes more attractive, so the supply of loanable funds goes up.

Hence, in Figure 1, the supply curve for loanable funds slopes up.

The demand for loanable funds comes from individuals who need funds and want to invest (to purchase
a house, for example) and firms who need funds and want to invest (to purchase capital equipment, for
example).
 7

When the interest rate rises, borrowing becomes less attractive, so the demand for loanable funds goes
down.

Hence, in Figure 1, the supply curve for loanable funds slopes down.

The economy’s interest rate must adjust to balance the supply and demand for loanable funds. In Figure
1, this happens when the interest rate equals 5%.

What would happen if, instead, the interest rate was below its equilibrium level, say, at 3%? Then the
demand for loanable funds would exceed the supply. That is, too many people would want to borrow.
The resulting shortage of loanable funds would place upward pressure on the interest rate, encouraging
saving and discouraging borrowing until the interest rate returns to 5%.

What would happen if the interest rate was above its equilibrium level, say at 7%? Then the supply of
loanable funds would excend the demand. That is, too many people would want to save. The resulting
glut of loanable funds would place downward pressure on the interest rate, discouraging saving and
encouraging borrowing until the interest rate returns to 5%.

In this way, the “invisible hand” of the market for loanable funds coordinates the decisions of individuals
who want to save (and hence supply loanable funds) and individuals who want to invest (and hence
demand loanable funds).

With the loanable funds framework in hand, we can consider the impact of various government policies
on saving and investment by asking:

1. Does the policy shift the demand curve or the supply curve in the market for loanable funds?
2. Which way does the curve shift?
3. What happens to the equilibrium?

Policy 1: Saving Incentives

What happens if the government increases the amount of income that individuals can allocate to
Individual Retirement Accounts and other tax advantaged accounts?

This policy would increase the after‐tax interest return that individuals would receive on their saving.

1. It would therefore shift the supply curve for loanable funds.

2. Because savers would supply more loanable funds at any given interest rate, the supply curve
would shift to the right.
3. Hence, as shown in Figure 2, the equilibrium interest rate falls and the equilibrium quantity of
loanable funds rises.

Policy 2: Investment Incentives

Suppose that Congress institutes an investment tax credit, giving a tax advantage to any firm that builds
a new factory or purchases new capital equipment.

1. This policy would shift the demand curve for loanable funds.
 8

2. Because borrowers would demand more loanable funds at any given interest rate, the demand
curve would shift to the right.
3. Hence, as shown in Figure 3, the equilibrium interest rate rises and the equilibrium quantity of
loanable funds rises.

Policy 3: Government Budget Deficits and Surpluses

A budget deficit results when government spending exceeds tax revenue.

The government borrows by issuing bonds. The entire amount of government bonds outstanding,
representing the accumulation of past government deficits, is the government debt.

A budget surplus can be used to retire (repay) existing government debt.

If the government’s spending exactly equals tax revenue, then the government has a balanced budget.

Suppose that the government starts out with a balanced budget, but then either cuts taxes or raises
spending, so that it now runs a budget deficit.

1. Recall that national saving consists of private saving plus public saving. When the government’s
budget swings to a deficit, that subtracts from national saving, shifting the supply curve for
loanable funds.
2. The supply curve shifts to the left, since now there is a reduced supply of loanable funds at any
given interest rate.
3. Hence, as shown in Figure 4, the equilibrium interest rate rises and the equilibrium quantity of
loanable funds falls.

When the equilibrium interest rate rises, fewer families buy new homes and fewer firms buy new capital
equipment. This reduction in investment because of government borrowing is called crowding out.

The History of US Government Debt

Figure 5 shows the amount of US government debt outstanding, expressed as a fraction of GDP.

Historically, the level of government debt has risen during wars, when the government runs a deficit to
finance higher military spending.

But once the wars end, the government runs a budget surplus to pay down the debt.

An exception to this general pattern: government debt began rising again after President Reagan’s tax
cuts in 1981 and even now shows little sign of returning to zero.

Conclusion
This chapter shows how:

1. Financial institutions in the US economy allow some agents to save and others to borrow and
invest.
 9

2. In the economy as a whole, however, saving must equal investment.

3. The market for loanable funds coordinates individuals decisions so that saving and investment
are always equal in the aggregate.
Ch 28 Unemployment
Introduction
Like GDP, unemployment ranks high as an indicator of economic well being. This chapter starts by
describing how unemployment is measured and, related to this measurement issue, why unemployment
can sometimes be a misleading indicator of the true health of the economy.

Note, for instance, that there is unemployment even during normal or good economic times.

Partly for this reason, economists distinguish between two types of unemployment:

1. The natural rate of unemployment is the rate of unemployment that the economy experiences
even during normal times, that is, even when the economy is not in a recession.
2. Cyclical unemployment refers to the additional unemployment that occurs during recessions.

Alternatively, we can think about the natural rate of unemployment as the economy’s long‐run rate of
unemployment and cyclical unemployment as the shorter‐run fluctuations around the natural rate.

This chapter focuses mainly on the determinants of the natural rate of unemployment, leaving an
analysis of cyclical unemployment for later. In particular, the chapter continues by describing four types
of theories or sets of considerations that economists use to explain the economy’s natural rate of
unemployment: job search, minimum‐wage laws, unions, and efficiency wages.

Outline
1. Identifying Unemployment
2. Job Search
3. Minimum‐Wage Laws
4. Unions
5. Efficiency Wages

Identifying Unemployment
Data on unemployment in the US economy are assembled monthly by the Bureau of Labor Statistics
(BLS), which is part of the Department of Labor.

Each month, the BLS compiles these data from a survey of about 60,000 households called the Current
Population Survey.

Based on responses to survey questions, the BLS puts each adult aged 16 and over into one of three
categories:
 2

1. Employed. This category includes paid employees, both full‐time and part‐time, people who
worked in their own business, and those who were temporarily absent from work because of
illness or vacation.
2. Unemployed. This category includes people who were not employed, were available for work,
and had tried to find a job within the previous 4 weeks, as well as those who were temporarily
laid off and waiting to be recalled.
3. Not in the Labor Force. This category includes everyone else: students, homemakers, retired
people.

Figure 1 shows the breakdown of the US population in 2004 into these three categories.

The BLS then defines the labor force as the total number of workers, both employed and unemployed,

the unemployment rate as the percentage of the labor force that is employed,

100

and the labor force participation rate as the percentage of the total adult population that is in the labor
force,

100

Let’s use the numbers from Figure 1 to compute these statistics for 2004:

‐ Number of employed = 139.3 million.

‐ Number of unemployed = 8.1 million.
‐ Not in the labor force = 76.0 million.
‐ Labor force = 139.3 + 8.1 = 147.4 million.
‐ Unemployment rate = 8.1/147.7 x 100 = 5.5 percent.
‐ Labor force participation rate = (139.3+8.1)/(139.3+8.1+76) = 147.4/223.4 = 66 percent.

Table 1 shows how the unemployment and labor force participation rates varied across demographic
groups in 2004. Figure 3 shows how labor force participation rates have varied over time for men and
women.

What factors might explain women’s rising labor force participation? What factors might explain men’s
falling labor force participation?

Figure 2 shows how the unemployment rate fluctuates about a long‐run average, or natural, rate, of
slightly more than 5.2 percent.

Updating the data shown in Figure 2, the Congressional Budget Office now estimates the natural rate of
unemployment to be 4.8 percent.
 3

Even during good economic times, there is some unemployment in the US economy. It is this natural
rate of unemployment that the theories described in this chapter seek to explain.

The most difficult part of measuring the unemployment rate entails determining who is unemployed
versus who is out of the labor force:

Suppose an employed worked loses his or her job, and starts looking for a new one. What happens to
the unemployment rate? It rises, since the number of unemployed workers goes up while the labor
force stays the same.

But suppose that after awhile, that same person becomes a discouraged worker: someone who would
like to work but has given up looking for a job. Maybe that person decides to go back to school or maybe
he or she just stays at home and doesn’t bother looking for a job. Either way, the number of
unemployment workers goes down, and while the labor force goes down as well, the net effect is to
decrease the rate of unemployment.

Symmetrically, what happens if the economy starts to look better, so that a discouraged worked starts
to look for a job? Now the number of unemployed workers rises, and while the labor force also gets
bigger, the net effect is to increase the unemployment rate.

So changes in the unemployment rate don’t always accurately reflect whether economic conditions are
improving or deteriorating.

Another set of facts pertains to the duration of unemployment spells: most spells of unemployment are
short, even though most unemployment observed at any given point in time is long term.

How can both of these facts hold true? A simple example shows how:

‐ Suppose that 55 people each year are unemployed.

‐ Each week, one person loses his or her job, but finds a new job at the end of that week.
‐ But three workers lose their jobs at the beginning of the year and stay unemployment for the
full year.
‐ Then 52 out of 55 unemployment spells last only one week.
‐ But, at any given point in time, three out of the four unemployed workers has a spell that lasts
for one full year.

What explains the natural rate of unemployment? In other words, why are their unemployed workers
even during good times?

‐ One explanation is that it takes time for workers to find jobs that are best‐suited for them. This
type of unemployment is often called frictional unemployment.
‐ A second set of explanations focus on why there might not be enough jobs to employ everyone
who wants one. This type of unemployment is often called structural unemployment.
 4

‐ So the essence of frictional unemployment is that there are jobs out there, it just takes time and
effort for workers to find them. The essence of structural unemployment is that there are just
not enough jobs out there for everyone who wants one.

Job Search
Job search is the process by which workers find appropriate jobs given their tastes and skills.

The process of job search can explain why there is always some frictional unemployment:

‐ Suppose that Hewlett Packard takes market share away from Dell. Dell lays off workers; HP hires
new ones. In the interim there is a period of unemployment in the industry.
‐ Similarly, if the price of oil rises, energy exploration companies hire more workers, while auto
manufacturers and airlines lay off workers. Because of these sectoral shifts, unemployment
arises.

A certain amount of frictional unemployment is inevitable, simply because the economy is always
changing.

However, government training and re‐training programs can help reduce the amount of frictional
unemployment.

Through unemployment insurance programs, the government partially protects workers’ incomes when
they become unemployment.

Just like automobile and home‐owners insurance, unemployment insurance makes risk‐averse workers
better off.

But it can also lead to higher levels of frictional unemployment, by making it possible for unemployed
workers to search longer for the right job.

Minimum Wage Laws

Figure 4 illustrates how unemployment results from minimum wage laws.

This type of unemployment is structural as opposed to frictional, in that there are workers who want to
work at the minimum wage, but who will not be able to find those jobs even after extensive search.

This type of unemployment affects low‐wage workers, particularly teenagers.

But the same line of reasoning illustrated in Figure 4 implies that any factor or set of factors that raises
the actual wage above the equilibrium wage that would equate supply and demand will cause structural
unemployment.
 5

Unions and Collective Bargaining

A labor union is an association of workers that bargains with employers over wages, benefits, and
working conditions through a process of collective bargaining. If the two sides can’t agree, the union
can organize a strike, the organized withdrawal of labor from the firm.

In the 1940s and 1950s, about one third of US workers were unionized. Now, that number is only about
13 percent.

Studies show that through collective bargaining, unions can increase the wages that their members
receive by 10 to 20 percent.

The overall effects of unions on wages and unemployment therefore resemble the effects of minimum
wage laws:

‐ Insiders, or union members, benefit from the higher wages.

‐ But outsiders are hurt because at higher wages, fewer workers are hired.

The Theory of Efficiency Wages

Like minimum wage laws and union collective bargaining, the theory of efficiency wages explains
structural unemployment by appealing to wages that are above the level that equates supply and
demand.

But whereas the “above equilibrium” wage resulting from minimum wage laws comes from government
actions, and the above market equilibrium resulting from unions comes from workers’ collective action,
efficiency wage theory stresses that employers themselves might want to pay their workers above
equilibrium wages to raise worker productivity?

Why might an employer voluntarily want to pay above equilibrium wages? Why might higher wages
raise worker productivity?

1. Worker Health. Better paid workers will be healthier and therefore more productive. This factor
is probably not relevant in the United States, but certainly could be in developing countries.
2. Worker Turnover. It’s costly for the firm to hire and train new workers; hence it’s in a firm’s
interest to try to retain its existing workers. It can do this by paying them wages that are higher
than they can get elsewhere.
3. Worker Quality. Suppose that a firm wants to fill an open job and advertises a lower wage. Since
the only people who will apply are those who can’t earn a higher wage elsewhere, it runs the
risk of having to hire someone with less experience or lower skills. Conversely, by offering a
higher wage, the firm can attract even the very best applicants.
4. Worker Effort. If a firm’s workers are happy because they feel that they are well treated, they
will be willing to work harder. Also, if they know that they won’t be able to find as good a job
elsewhere, they will work harder to keep their existing job.
 6

In 1914, Henry Ford offered his workers $5 per day, about twice what they could get at other jobs.
Worker turnover and absenteeism fell. Ford called the decision to raise wages “one of the finest cost
cutting moves we ever made.”

Conclusion
After discussing how the unemployment rate is actually measured, this chapter goes on to identify a
number of explanations for the natural rate of unemployment, that is, the long‐run rate of
unemployment that prevails even outside of recessions.

These explanations fall under two broad headings: theories that explain frictional unemployment and
theories that explain structural unemployment.

Before closing, let’s ask:

1. The government raises the minimum wage. What does this do to the natural rate of
unemployment? Do these effects arise by changing the amount of frictional unemployment or
by changing the amount of structural unemployment?
2. The internet makes it easier for firms to advertise job openings and makes it easier for workers
to find job openings. What does this do to the natural rate of unemployment? Do these effects
arise by changing the amount of frictional unemployment or by changing the amount of
structural unemployment?
3. Unions in the US have become considerably weaker and less prevalent since the 1950s. What
did this do to the natural rate of unemployment? Did these effects arise by changing the amount
of frictional unemployment or by changing the amount of structural unemployment?
4. Music downloading puts traditional cd stores out of business. What does this do to the natural
rate of unemployment? Do these effects arise by changing the amount of frictional
unemployment or by changing the amount of structural unemployment?
Ch 29 The Monetary System
Introduction
In the absence of money, people would have to exchange goods and services through barter.

The problem with barter lies in finding a double coincidence of wants: a successful trade requires (i) you
to want what your trading partner has and (ii) your trading partner to want what you have.

Money overcomes this problem, since everyone will accept it in exchange for goods and services.

But how exactly is money defined? What are its functions? How does the government control the supply
of money? And what role do banks play in the money supply process?

These questions are the focus of this chapter.

The next chapter will then begin to relate changes in the supply of money to changes in other key
economic variables.

Outline
1. The Meaning of Money
2. The Federal Reserve System
3. Banks and the Money Supply
4. The Fed’s Tools of Monetary Control
5. Two Final Points
A. Bank Runs and the Money Supply
B. The Federal Funds Rate

The Meaning of Money

Sometimes people will say, “Bill Gates has a lot of money.” But what they really mean is that Bill Gates
has a lot of wealth.

Economists use the term “money” in a more specific sense, to refer to the set of assets that people use
regularly to buy goods and services from other people.

Functions of Money
1. Money is a medium of exchange, that is, an item that buyers give to sellers in exchange for
goods and services.
2. Money is a unit of account, that is, the units in which prices are measured.
3. Money is a store of value, that is, an object that people can use to carry wealth from the
present into the future.
 2

Closely associated with the concept of money is that of liquidity: the ease with which an asset can be
converted into the economy’s medium of exchange.

‐ By definition, money is the most liquid asset.

‐ Stocks and bonds are pretty easy to buy and sell. They are highly liquid assets.
‐ Houses, valuable paintings, and antiques take more time and effort to sell. They are less liquid.

Notice that the first two items on this list highlight a trade‐off. Money is the most liquid asset, but
currency does not pay interest. Bonds are less liquid, but pay interest. This trade‐off will become
important later on in our analysis of how changes in the money supply affect the economy as a whole.

Kinds of Money
Historically, gold or gold coins served as money. This type of money, that takes the form of a commodity
with intrinsic value, is called commodity money.

US dollar bills have value, but that value is not based on the intrinsic value of the paper and ink
themselves. Money without intrinsic value is called fiat money, since it is used as money because of
government decree.

Money in the US Economy

The money stock is the total quantity of money circulating in the economy.

Suppose we want to measure the money stock for the US. What assets would we include in our
measure?

1. Certainly currency, the paper bills and coins in the hands of the public.
2. Probably checks as well. Demand deposits is the official name given to bank deposits that
customers can access on demand by writing a check.
3. Maybe savings deposits. Banks won’t let customers write checks on savings deposits, but they
still can withdraw the funds anytime.
4. Maybe also money market mutual funds, some of which offer limited check‐writing privileges.
5. Maybe also time deposits (also called CD’s or certificates of deposit). Here, the funds can’t be
withdrawn without penalty for a fixed amount of time, but that amount of time tends to be
short – three to six months – so these assets, too, are fairly liquid.

Evidently, the choice of what to include is not entirely clear‐cut. For this reason, there are several official
measures of the US money stock. Two of the most widely used are:

‐ M1. Includes only those assets that are clearly used as a medium of exchange: currency,
demand deposits, traveler’s checks, and “other checkable deposits” which is the official term for
interest‐earning checking deposits.
‐ M2. Includes everything in M1, plus other highly liquid assets: savings deposits, money market
mutual funds, and small (under $100,000) time deposits.

Figure 1 shows some data on M1 and M2 in 2004. Which measure is bigger? Why?
 3

What about credit cards? Credit cards are clearly used to make purchases. Why aren’t they included in
M1? The reason is that credit cards are a means for deferring payments as opposed to making
payments. At the end of the month, when you pay your credit card bill with a check, you are using the
medium of change to finally pay for what you purchased earlier.

But while credit card balances are not included in M1, they clearly influence the level of M1. Before
credit cards use became widespread, people had to hold a lot more currency.

Here’s one other puzzle.

‐ In 2004 the stock of US currency in circulation was $699 billion.

‐ In 2004, there were 223 million adults in the US.
‐ $699 billion/223 people = $3,135 per person!
‐ A lot of this currency is held overseas, as a store of value in countries with unstable political or
economic systems.
‐ Undoubtedly, some of this currency is also held by drug dealers and other criminals.

The Federal Reserve System

The Federal Reserve (Fed) is the central bank of the US: the institution responsible for overseeing the
banking system and regulating the quantity of money in the economy.

The Federal Reserve System consists of:

‐ The Board of Governors in Washington DC

o Seven Board Members, called “Governors,” with 14‐year terms.
o Including the Chairperson of the Federal Reserve System: formerly Alan Greenspan and
now Ben Bernanke.
‐ Twelve Federal Reserve Banks
o Located in major cities, including Boston and New York.

As a central bank, the Fed has two jobs:

1. It regulates banks, assists in check processing (clearing), and acts as a bank for banks – taking
their deposits and, when other sources of credit dry up, making loans to banks. In this last role,
the Fed is said to be the lender of last resort.
2. It regulates the money supply: the quantity of money in the economy. That is, it conducts
monetary policy.

The monetary policymaking committee at the Fed is called the Federal Open Market Committee
(FOMC). The FOMC meets every six weeks and consists of the seven Governors plus the 12 Reserve Bank
Presidents. All seven Governors vote on Committee decisions; a rotating group of 5 Reserve Bank
Presidents vote as well, with the President of the New York Fed always a voting member.
 4

But exactly how does the Fed regulate the supply of money? By conducting open market operations,
that is, by buying and selling US Government bonds. Loosely speaking:

‐ The Fed increases the money supply by using newly‐created money to buy US Government
bonds held by private investors.
‐ And decreases the money supply by selling US Government Bonds to private investors.

Banks and the Money Supply

Because even the narrowest measure of money, M1, includes both currency and demand deposits,
banks play a key role, together with the Fed, in the money supply process. But how exactly do banks
participate in this process?

The Simple Case of 100 Percent Reserve Banking

Start by considering an economy without banks, where all money consists of currency.

Suppose for simplicity that the total quantity of currency in circulation is $100.

Now suppose that someone opens up a bank: call it the First National Bank.

But instead of making loans, all this bank does is to safeguard people’s money: it accepts deposits, and
keeps the currency in its vault until the depositor either asks for the currency back or writes a check
against his or her balance.

Deposits that the bank receives but does not loan out are called reserves. So this simple form of banking
without loans is called 100‐percent‐reserve banking, for the obviously reason that 100 percent of all
deposits are held as reserves.

We can use a T‐account (a simplified balance sheet), to show what happens if the entire $100 of
currency in circulation is deposited in the bank:

First National Bank

Assets Liabilities

Reserves $100 Deposits $100

What has happened to the M1 money supply as a result of this transaction?

‐ Nothing!
‐ Currency in circulation declines by $100.
‐ But demand deposits rise by $100.

This first example illustrates that in an economy with 100‐precent‐reserve banking, banks do not
influence the money supply.
 5

Money Creation with Fractional Reserve Banking

Now suppose that the managers of the First National Bank notice that not all of the bank’s depositors
ask for the money back on any given day. In fact, most customers are content to leave their money in
the bank. What if the bank lends out some of the money it receives from deposits?

Now we’ll consider a fractional‐reserve banking system, in which banks hold only a fraction of the funds
they receive from depositors as reserves.

The reserve ratio measures the fraction of deposits that banks hold as reserves.

Although banks want to lend funds out, in order to earn interest, they will always hold at least some
reserves:

‐ Partly because they are required to by law. The Fed sets a minimum reserve ratio that each bank
must maintain. Reserves held to satisfy this legal requirement are called required reserves.
‐ But banks will also hold excess reserves above what is legally required to cope with depositors’
requests for withdrawals.

Let’s suppose that First National Bank decides on a reserve ratio of 10 percent. Then it holds $10 (or 10
percent) of its deposits as reserves and lends the rest out. The T‐account now becomes

First National Bank

Assets Liabilities

Reserves $10 Deposits $100

Loans $90

What’s happened to the money supply as a result of this transaction?

‐ It has increased!
‐ Depositors still hold $100 in demand deposits.
‐ But now the people who receive the loans hold $90 in currency.
‐ The total money supply is $190.

This second example illustrates that in a fractional reserve system, banks can create money.

Notice, however, that while the money supply has gone up because of this transaction, people aren’t
really wealthier:

‐ The depositors have $100 in deposits, just as before.

‐ The borrowers have $90 in currency, but now they owe that $90 to the bank. So that balances
out too.

Another way to think about this is that people aren’t wealthier, but they are more liquid.
 6

The Money Multiplier

In an economy with a fractional reserve banking system, however, the action does not really stop at the
end of this second example.

Now the First National Bank’s borrower has $90 in currency. Presumably, that borrower wanted the
funds in order to buy something: a consumption good or an investment good.

But then the seller of this good gets the $90. Let’s suppose that he or she then takes that currency, and
deposits it in his or her bank: the Second National Bank.

If the Second National Bank also chooses a 10 percent reserve ratio, it will take the $90 in currency, hold
$9 (10 percent) as reserves, and lend the remaining $81 out. Its T‐account appears as

Second National Bank

Assets Liabilities

Reserves $9 Deposits $90

Loans $81

What does this do to the money supply?

‐ The First National Bank’s customers have $100 in deposits.

‐ The Second National Bank’s customers have $90 in deposits.
‐ The Second National Bank’s borrower has $81 in currency.
‐ Now the money supply is $100+90+81 = $271!

But now the Second National Bank’s borrower uses the $81 in currency to buy something. The seller
takes the $81 and deposits it in his or her account at the Third National Bank.

The Third National Bank, if it also chooses a 10 percent reserve ratio, holds $8.10 (10 percent) of the $81
as reserves, and lends the remaining $72.90 out. Its T‐account appears as

Third National Bank

Assets Liabilities

Reserves $8.10 Deposits $81

Loans $72.90

What’s the money supply now?

‐ The First National Bank’s customers have $100 in deposits.

‐ The Second National Bank’s customers have $90 in deposits.
‐ The Third National Bank’s customers have $81 in deposits.
‐ The Third National Bank’s borrower has $72.90 in currency.
‐ Now the money supply is $343.90.
 7

We could go on and on, repeating this forever. The Third National Bank’s borrower buys something, the
seller deposits the funds in the Fourth National Bank, which keeps 10 percent as reserves and lends the
rest out ….

But notice that in each step, the additions to the money supply get smaller and smaller. So eventually
the process will converge. Use a calculator or better yet a computer spreadsheet to do the endless
repetitions and what you will find is that when the banking system finally holds the entire $100 as
reserves, the money supply is $1000.

In this case, the money multiplier – the amount of money that the banking system generates per dollar
of reserves – is $1000/$100 = 10.

In this example, where all banks choose a reserve ratio of 10 percent, is it an accident that the money
multiplier is 10? No!

In general, if

R = the reserve ratio

then

1/R = the money multiplier

So if as in our example R = 0.10 or 10 percent, then the money multiplier is 1/R = 1/0.10 = 10.

To see why this reciprocal formula must be true, remember that the reserve ratio measures the fraction
of deposits that banks hold as reserves:

R = Reserves/Deposits

or

Deposits = (1/R) x Reserves

In our example, everyone deposits all of their money, so

Money Supply = Deposits = (1/R) x Reserves

But now remember that the money multiplier is defined as

Money Multiplier = Money Supply/Reserves = 1/R

This last set of calculations reveals two important assumptions that are built into our second example:

1. All banks have the same reserve ratio R.

2. All bank customers hold all of their money as deposits.
 8

What happens when the first assumption is violated, say because some banks choose to hold more
reserves?

‐ The money multiplier goes down, because when some banks hold more reserves, they make
smaller loans, so the process of monetary expansion is curtailed.

What happens when the second assumption is violated, say because some people choose to hold some
currency as well as deposits?

‐ Again, the money multiplier goes down, because when some people hold some currency, they
deposit less, and again the process of monetary expansion is curtailed.

The Fed’s Tools of Monetary Control

But, as long as banks do not hold all of their deposits as reserves, and as long as people don’t hold all of
their money as currency, the fractional reserve system allows banks to play a key role in the money
supply process.

The Fed must take banks’ role into account when making monetary policy decisions.

Open Market Operations

Recall that open market operations occur when the Fed buys or sells US Government bonds from or to
private investors.

When the Fed buys US Government bonds, each newly‐created dollar held as currency increases the
money supply by $1. But each newly‐created dollar held as a deposit increases the money supply by
even more, because of the money multiplier.

And when the Fed sells US Government bonds, if the seller pays for the bond with currency, the money
supply decreases by $1. But if the seller pays for the bond using funds from a bank deposit, the money
supply decreases by even more, as the process of multiple deposit creation works in reverse.

Open market operations are easy for the Fed to execute. There is a trading desk at the Federal Reserve
Bank of New York that links the Fed to the US Government bond market. The Fed can trade in this
market just like all other financial institutions and individual investors.

Open market operations can also be used to change the money supply by large or small amounts.

Because of these advantages, open market operations are the Fed’s most frequently‐used policy tool.

Reserve Requirements
Reserve requirements are the legally‐imposed minimum amount of reserves that banks must hold
against their deposits.

We’ve already seen that a higher reserve ratio leads to a smaller money multiplier.
 9

The same reasoning implies that when the Fed increases reserve requirements, the money supply will
fall.

But changes in reserve requirements disrupt bank business. To avoid these disruptions, the Fed rarely
uses changes in reserve requirements to affect the money supply.

The Discount Rate

The Fed also acts as a lender of last resort for banks that cannot obtain funds through other sources.

The discount rate is the interest rate that Fed charges on its loans to banks.

When the Fed makes a loan to a bank, in effect it lends newly‐created money to that bank. The bank has
more reserves, some of which it can lend out. Through the process of multiple deposit creation, the
money supply will rise.

Hence, when the Fed lowers the discount rate, inducing more banks to borrow from the Fed, the money
supply will rise.

But the Fed rarely uses discount lending to control the money supply. Instead, it uses its role as lender of
last resort to help banks when they are in financial trouble.

Problems in Controlling the Money Supply

All of this discussion highlights that the Fed cannot perfectly control the money supply.

It cannot control how much money people hold as currency as opposed to depositing in banks.

And it cannot control how much banks hold in reserves as opposed to making loans.

In practice, therefore, Federal Reserve analysts need to constantly monitor the behavior of banks and
their depositors, to keep the money supply on track.

Two Final Points

Bank Runs and the Money Supply

Note that in a fractional reserve banking system, if all depositors attempt to withdraw their money at
once, there will not be enough reserves to satisfy them all.

In a bank run or panic, depositors rush to withdraw their funds, not wanting to be the ones who lose
out.

This actually happened during the Great Depression of the 1930s. Many banks had to close until enough
loans were repaid to allow them to satisfy all of the withdrawal requests.
 10

The problems were magnified by the fact that this experience made people lost their trust in banks, and
hold more money as currency. The decline in the money multiplier then led to a large decline in the
money supply, which many economists blame for making the Depression more severe.

Today, the Federal Deposit Insurance Corporation guarantees the safety of most bank deposits. So it is
unlikely that bank runs or panics will happen again.

On the other hand, during the most recent financial crisis, events very similar to bank runs began
happening not to banks but to money market mutual funds; in response, the US Treasury moved last Fall
to extend deposit insurance temporarily to money market mutual funds as well.

The Federal Funds Rate

What’s the connection between this analysis of reserves, the money multiplier, and the money supply,
and the more common way of talking about monetary policy, where changes in Federal Reserve policy
are always described as changes in the federal funds rate?

The federal funds rate is the interest rate that banks charge each other on short‐term loans of reserves,
or federal funds.

Just like, previously, we traced out a downward‐sloping demand curve for loanable funds in the
economy as a whole, we can trace out a downward‐sloping demand curve for federal funds in the
interbank loan market.

In Graph 1, the Federal Reserve sets a target Res* for reserves, and conducts open market operations so
as to hit this target:

‐ In this case, the supply curve for reserves is vertical, or perfectly inelastic.
‐ The market for interbank loans then clears with the federal funds rate at FF*.
‐ If the federal funds rate were below FF*, the demand for loans of federal funds would be
greater than the supply. Upward pressure on the federal funds rate would result, until the funds
rate rises to FF*.
‐ If the federal funds rate were above FF*, the demand for loans of federal funds would be
smaller than the supply. Downward pressure on the federal funds rate would result, until the
funds rate falls to FF*.

Graph 1 illustrates the workings of monetary policy as we’ve envisioned it so far.

Alternatively, though, we could think of the Federal Reserve as setting a target FF* for the federal funds
rate:

‐ In this situation, illustrated in Graph 2, the supply curve for reserves becomes horizontal, or
perfectly elastic.
‐ The Federal Reserve must conduct open market operations so that it is supplying Res* in
reserves.
 11

Comparing Graphs 1 and 2 suggests that there’s not too much difference between these two monetary
policy strategies:

1. Setting a target Res* for reserves, and accepting the equilibrium funds rate FF*.
2. Setting a target FF* for the funds rate, and supplying Res* in reserves to hit that target.

Either way, the outcome is the same: reserves are Res* and the federal funds rate is FF*.

But things change when we allow the demand curve for reserves to shift.

Why might the demand curve for reserves shift?

‐ Perhaps banks’ lending opportunities change, so that they want to hold larger or smaller stocks
of reserves at any given interest rate.
‐ Perhaps depositors’ behavior changes, so that they provide banks with more or less currency to
hold as reserves.

In Graph 3, the Fed sets a target Res* for reserves, and the demand curve for reserves shifts. As a
consequence, the equilibrium funds rate rises from FF* to FF**.

This graph implies that if the demand curve for reserves were subject to ongoing shifts, a policy strategy
of targeting reserves would lead to volatility in the federal funds rate.

In Graph 4, the Fed sets a target FF* for the federal funds rate, and the demand curve for reserve shifts.
The Fed must conduct open market operations so that the equilibrium quantity of reserves rises from
Res* to Res**. But, by doing so, it can stabilize the funds rate in the face of ongoing shifts in the demand
for reserves.

In practice, the Federal Reserve conducts monetary policy by setting a target for the federal funds rate
as opposed to a target for reserves.

That is why changes in Federal Reserve policy are always described as changes in the federal funds rate
target.

But note that in order to implement a strategy of federal funds rate targeting, the Fed must constantly
be engaging in open market operations, adding or withdrawing reserves from the banking system to
stabilize the funds rate in the fact of shifts to the demand curve for reserves.

Why, in practice, does the Fed choose to conduct policy in this way, with a target for the funds rate as
opposed to a target for reserves?

1. It believes that the demand curve for reserves is unstable, exhibiting continual shifts. Thus, it
believes that a reserves‐targeting strategy would lead to excessive volatility in the federal funds
rate and possible instability in the banking system.
2. It also believes that instability in the federal funds rate would spill over into other financial
markets as well, leading to more volatile interest rates economy‐wide.
 12

Finally, Graph 5 illustrates what happens when the Fed raises its federal funds rate target. To raise the
target from FF* to FF**, the Fed must use open market operations to drain reserves from the banking
system, specifically, to lower the quantity of reserves from Res* to Res**. Through the money
multiplier, the money supply will also contract. Monetary policy becomes “tighter” or “more restrictive.”

Symmetrically, Graph 6 shows that when the Fed lowers its funds rate target, it must use open market
operations to add reserves to the bank system. And, through the money multiplier, the money supply
will also expand. Monetary policy becomes “looser” or “more accommodative.”

These last two graphs highlight how reserves, open market operations, the money multiplier, and the
money supply all continue to work just as in the textbook, even under the Fed’s current operation
procedures, which focus most of the immediate attention on the federal funds rate.
 Graph
G h 1:
1 When
Wh th the FFed
d sets
t a ttargett
Federal Res* for reserves, it must accept the
Funds Rate fed funds rate FF*.

Supply Curve
for Reserves

Equilibrium
Funds Rate FF* Demand Curve
F Reserves
For R

Reserves Target Res* Quantity of

Reserves
 Graph
G h 2:
2 When
Wh th the FFed
d sets
t a ttargett
Federal FF* for the fed funds rate, it must
Funds Rate supply Res* in reserves to support that
Target.
g

Supply Curve
for Reserves

Funds Rate
Target FF* Demand Curve
F Reserves
For R

Equilibrium Quantity Quantity of

of Reserves Res* Reserves
 Graph
G h 3:
3 When
Wh th the FFed
d sets
t a ttargett
Federal for reserves and the demand curve
Funds Rate for reserves shifts, the equilibrium
funds rate exhibits volatility.
y
Supply Curve
New Equilibrium
for Reserves
Funds Rate FF**

Old Equilibrium
Funds Rate FF*
Shifting
hf
Demand Curve
For Reserves

Reserves Target Res* Quantity of

Reserves
 Graph
p 4: When the Fed sets a target
g
Federal the fed funds rate, it can use open market
Funds Rate operations to defend that target even in
the face of a shifting demand curve
for reserves.
reserves

Funds Rate
Target F* Shifting
Demand Curve
Supply Curve For Reserves
for Reserves

Res* Res** Quantity of

Old and New Equilibrium Quantities of Reserves Reserves
 Graph
G h 5:
5 When
Wh th the FFed
d raises
i it
its
Federal Federal Funds Rate Target, it must
Funds Rate use open market operations to drain
reserves from the bankingg system.
y
Monetary policy becomes “tighter.”
New Funds Rate
Target FF**

Old Funds Rate

Target FF*

Shifting
Demand Curve
Supply Curve
For Reserves
for Reserves

Res** Res* Quantity of

Old and New Equilibrium Quantities of Reserves Reserves
 Graph
G h 6:
6 When
Wh th the FFed
d llowers it
its
Federal Federal Funds Rate Target, it must
Funds Rate use open market operations to add
reserves to the bankingg system.
y
Monetary policy becomes “looser.”

Old Funds Rate

Target FF*

New Funds Rate

Target FF**
Demand Curve
Shifting
For Reserves
Supply Curve
for Reserves

Res* Res** Quantity of

Old and New Equilibrium Quantities of Reserves Reserves
Liquidity and Solvency Problems in a
Fractional Reserve Banking System
A Simplified Bank Balance Sheet
Suppose that the First National Bank opens.

It owners buy $10 in newly‐issued stock/equity, and the bank uses these funds to buy bank buildings,
office equipment, and various “other assets.”

First National Bank

Assets Liabilities

Other assets $10 Shareholder’s equity $10

Suppose then the bank accepts $100 in deposits, holds $10 in reserves, and lends the remaining $90 out.

First National Bank

Assets Liabilities

Reserves $10 Deposits $100

Loans $90 Shareholder’s equity $10
Other assets $10

Example 1: A Liquidity Crisis

Now suppose that the First National Bank experiences an unexpected $50 deposit outflow.

It only has $10 in its vault to honor withdrawal requests, and it can’t reduce its loans on short notice.

This bank is “illiquid” but still “solvent.” It has assets that it could use to satisfy its depositors, but it can’t
convert those assets to currency quickly enough.

What can it do?

‐ Borrow reserves from another bank in the federal funds market.

‐ As a “last resort,” borrow money from the Fed.

If it still wants to hold $5 in reserves, it needs to borrow $45.

 2

First National Bank

Assets Liabilities

Reserves $5 Deposits $50

Loans $90 Borrowing $45
Other assets $10 Shareholder’s equity $10

Why might the First National Bank experience this deposit outflow?

Maybe there is a bank run: depositors, realizing that there is not enough cash in the bank’s vault, could
all rush to withdrawal their savings, since without the Fed’s discount window the bank might not be able
to honor more than $10 in withdrawal requests.

Today, the Federal Deposit Insurance Corporation (FDIC) insures most bank deposits.

So the Fed’s discount window and FDIC insurance work together to prevent banking panics.

The key features of the banking system that allow for this instability in the first place are:

‐ Fractional reserve banking.

‐ Deposits (liabilities) that are payable on demand, and are therefore like very short‐term debt.
‐ Assets that need to be held for the long term.

One element of the recent financial crisis is that many nonbank financial companies were funding
themselves with very short‐term debt but holding long‐term assets. They were behaving like banks but
did not have access to the Fed’s discount window or FDIC insurance.

As one reaction to the crisis, the Fed has extended credit to nonbank financial institutions, FDIC
insurance has been extended to money market mutual funds, and other federal government guarantees
have been made to make other short‐term debt more secure.

Example 2: A Solvency Crisis

Now let’s go back to the beginning:

First National Bank

Assets Liabilities

Reserves $10 Deposits $100

Loans $90 Shareholder’s equity $10
Other assets $10

Suppose now that $50 of the bank’s loans go bad: the borrowers go bankrupt and can’t repay.
 3

Now the bank must write off the value of those loans:

First National Bank

Assets Liabilities

Reserves $10 Deposits $100

Loans $40 Shareholder’s equity ‐$40
Other assets $10

Even if the bank sells off some of its other assets, it cannot repay what it, in turn, owns to its depositors.
Shareholder’s equity is wiped out and, technically, the bank is “insolvent” or bankrupt.

What can be done now?

The government can pay off the depositors from the FDIC insurance fund and recoup at least some of
the costs by selling the insolvent bank’s assets to another bank. Essentially, this is how the savings and
loan crisis of the early 1990s was resolved.

Or it could use taxpayer funds to “recapitalize” the bank, more like what is happening now.

For example: as part of this arrangement, the government might pay the bank $50 for the bad
(worthless) loans, and at the same time wipe out the original owner’s equity stake:

First National Bank

Assets Liabilities

Reserves $60 Deposits $100

Loans $40 Private shareholder’s equity $0
Other assets $10 Government’s equity $10

The bank could then go ahead and make $50 in new loans:

First National Bank

Assets Liabilities

Reserves $10 Deposits $100

Loans $90 Private shareholder’s equity $0
Other assets $10 Government’s equity $10
 4

The bank’s balance sheet now looks the same as it did before the crisis, but now it is owned by the
government.
Ch 30 Money Growth and Inflation
Introduction
Remember our previous example from Chapter 23, “Measuring the Cost of Living.” In 1931, the Yankees
paid Babe Ruth an annual salary of $80,000. But then again, in 1931, an ice cream cone cost a nickel and
a movie ticket cost a quarter.

The overall increase in the level of prices, as measured by the CPI or the GDP deflator, is called inflation.

Although at least some inflation seems inevitable today, in the 19th century many economies
experienced long periods of falling prices, or deflation.

And even in the more recent past, there have been wide variations in the inflation rate: from rates
exceeding 7 percent per year in the 1970s to the current rate of about 2 percent per year.

Also, in some countries during some periods, extremely high rates of inflation have been experienced. In
Germany after World War I, for instance, the price of a newspaper rose from 0.3 marks in January 1921
to 70,000,000 marks less than two years later. These episodes of extremely high inflation are called
hyperinflations.

But exactly what economic forces produce inflation, and lead to variations in the rate of inflation?

An economic theory called the quantity theory of money indicates that excess money creation is the
underlying cause of inflation. Interestingly, the 18th century Scottish philosopher David Hume was one of
the first to formulate a version of the quantity theory of money. A more recent proponent was Milton
Friedman.

After developing the quantity theory of money to explain inflation, this chapter goes on to identify the
costs that inflation, particularly very high rates of inflation, impose on the economy.

Outline
1. The Classical Theory of Inflation
A. The Level of Prices and the Value of Money
B. Money Supply, Money Demand, and Monetary Equilibrium
C. The Effects of a Monetary Injection
D. A Brief Look at the Adjustment Process
E. The Classical Dichotomy and Monetary Neutrality
F. Velocity and the Quantity Equation
G. The Inflation Tax
H. The Fisher Effect
2. The Costs of Inflation
 2

A. A Fall in Purchasing Power?

B. Shoeleather Costs
C. Menu Costs
D. Relative Price Variability
E. Inflation‐Induced Tax Distortions
F. Confusion and Inconvenience
G. Arbitrary Redistributions of Wealth

The Classical Theory of Inflation

The quantity theory is often called the classical theory of inflation, because it can be traced back to
Hume and other early writers on economics.

The Level of Prices and the Value of Money

We’ve already observed that, for example, an ice cream cone costs a lot more today than it did in the
1930s:

‐ Is this because ice cream cones are so much better today, that people are willing to pay more
for them? Probably not.
‐ More likely, the rise in the price of an ice cream cone indicates that dollars have become less
valuable, not that ice cream cones have become more valuable.
‐ In essence, that’s what the quantity theory is all about: the value of money as opposed to the
value of goods.

To make this idea concrete, let P denote the price level, as measured by the CPI or the GDP deflator:

P = number of dollars needed to purchase a basket of goods and services

Now flip the reasoning around:

1/P = number of baskets of goods required to “purchase” a dollar

This last equation highlights that inflation, an increase in P, represents a decline in the value of money.

Another way to think about this idea:

‐ P is the “dollar price of goods”

‐ 1/P is the “goods price of a dollar”
 3

Money Supply, Money Demand, and Monetary Equilibrium

Let’s build on this idea that 1/P measures the goods price of a dollar.

Figure 1 applies standard microeconomic supply‐and‐demand theory to money:

‐ The quantity of the good – in this case money – appears on the horizontal axis.
‐ The price of the good – in this case 1/P – appears on the vertical axis.
‐ The money demand curve slopes downward. There are two ways to think about this:
o When the price of money rises, the demand for money falls.
o When the goods price of money 1/P rises, the dollar price of goods P falls. Since fewer
dollars are needed to buy the same number of goods, the demand for money falls.
‐ The money supply curve is vertical, as the money stock is determined by Federal Reserve policy
(and by the response of banks to that policy).
‐ The goods price of money 1/P is determined by the intersection between demand and supply.
‐ When the goods price of money is below its equilibrium value, there is excess demand for
money, putting upward pressure on the goods price of money until equilibrium is restored.
‐ When the goods price of money is above its equilibrium value, there is excess supply of money,
putting downward pressure on the goods price of money until equilibrium is restored.
‐ Translate the goods price of money 1/P back into the money price of goods P, and the same
theory determines the price level.

The Effects of a Monetary Injection

Figure 2 illustrates what happens when the Fed acts to increase the money supply, either by

‐ Using open market operations to increase the supply of reserves to the banking system, which
then increases the money supply working through the money multiplier, or
‐ Lowering its target for the federal funds rate, which requires it to use open market operations to
increase the supply of reserves to the banking system.

When the supply curve shifts, a new equilibrium occurs at a lower goods price of money 1/P and hence a
higher price level P.

The upshot is that inflation, a rising price level, is associated with a policy of money creation.

This theory is called the quantity theory of money, as it asserts that the quantity of money available
determines the price level and the growth rate of money available determines the inflation rate.

A Brief Look at the Adjustment Process

Figure 2 can also be used to think about the process through which money creation leads to a higher
level of prices.

Suppose again that the money supply curve shifts, reflecting an increase in the money supply.

‐ If 1/P does not change, there is an excess supply of money. In other words, people find
themselves with more money than they need.
 4

‐ Some people will use the extra money to buy more goods and services. This causes the money
price of goods P to increase, and the goods price of money 1/P to fall.
‐ Other people will deposit the extra money in the bank. But then the bank will lend the money to
a borrower who wants to buy more goods and services. Again, P will rise and 1/P will fall.
‐ This process will continue until monetary equilibrium is restored at a higher price level.

The Classical Dichotomy and Monetary Neutrality

The quantity theory of money describes how changes in the money supply affect the price level. But
how do those changes affect other economic variables, like GDP, unemployment, and interest rates?

David Hume and his contemporaries suggested that economic variables be divided into two groups.

1. Nominal variables that are measured in units of money (monetary units).

2. Real variables that are measured in units of goods (physical units).

According to this classification, for example:

‐ Nominal GDP is a nominal variable because it measures the dollar value of an economy’s output
of goods and services.
‐ Real GDP is a real variable because it measures the value of an economy’s output of goods and
services correcting for inflation, that is, eliminating the effects of changes in the value of money.
‐ The CPI is a nominal variable because it measures the number of dollars that are required to
purchase a basket of goods and services.
‐ The unemployment rate is a real variable because it measures the percentage of the labor force
that is unemployed.

This theoretical separation of nominal and real variables is called the classical dichotomy.

The quantity theory of money implies that changes in the money supply affect nominal variables.

The theory of monetary neutrality goes a step further, and says that changes in the money supply do
not affect real variables.

Hume’s thought experiment:

‐ Suppose that the money supply doubles from $100 million to $200 million.
‐ Everybody has twice as much money, but the ability to produce goods and services has not
changed.
‐ Introspection suggests that the overall price level P should double, leaving output and all other
real variables unchanged.
‐ An analogy: suppose that the definition of a foot was changed from 12 inches to 6 inches. Would
this make everyone twice as tall? No! Everyone would physically be the same height as before,
but their height when measured in feet would be twice as big.
‐ Similarly, when the government doubles the money supply, the physical quantity of goods
produced would be the same as before, but prices measured in dollars would all be twice as big.
 5

Hume conceded that it might take time for the price level to fully adjust to a change in the money
supply. Today, most economists agree that the adjustment process takes time.

But Hume and most economists today also agree that in the long run, monetary neutrality holds true.

Velocity and the Quantity Equation

A complementary perspective on the quantity theory of money builds on the idea of the velocity of
money, defined as the rate at which money changes hands, as measured by the number of times each
dollar in the economy gets spent during a year.

Mathematically, the velocity of money V is defined as

Where Y is real GDP, P is the GDP deflator, P x Y is nominal GDP – recall that nominal GDP measures the
dollar value of expenditures in the economy as a whole, and M is the quantity of money.

Example:

‐ Suppose that an economy produces only a single good, pizza.

‐ The economy produces 100 pizzas per year, so that Y = 100.
‐ Each pizza costs $10, so that P = 10.
‐ The quantity of money is $50, so that M = 50.
‐ In math, V = (P x Y)/M = (10 x 100)/50 = 1000/50 = 20.
‐ In words, total spending is $10 x 100 = $1000. But the money is $50. So each dollar has to be
spent 1000/50 = 20 times.

Rearranging the equation defining the velocity of money leads to the so‐called quantity equation:

Figure 3 plots the money supply M, nominal GDP P x Y, and velocity V in the US since 1960:

‐ Velocity V has remained relatively stable.

‐ Hence, long‐run increase in M has been paralleled by a long‐run increase in nominal GDP.

In terms of the quantity equation, the quantity theory of money and the closely related idea of
monetary neutrality can be stated as:

1. The velocity of money V is relatively stable over time.

2. Because velocity is stable, an increase in the money supply M leads to an increase in nominal
GDP P x Y.
3. The increase in M does not affect real GDP Y in the long run, because the economy’s output of
goods and services Y is primarily determined by the availability of factors of production (labor,
physical capital, human capital, and natural resources) and by the stock of technological
knowledge (recall our analysis from Chapter 24).
 6

4. Hence, in the long run, the increase in nominal GDP brought about by an increase in the
quantity of money is reflected in the price level P rather than real output Y.
5. And so, when the central bank increases the money supply, the result is inflation.

Figure 4 shows the behavior of money supplies and inflation rates during four periods of hyperinflation.

‐ In all four cases, price levels rose dramatically in tandem with money supplies.
‐ And in all four cases, when the extreme growth in the money supply ended, so did the
hyperinflation.
‐ Analysis of these extreme historical cases bolstered economists’ confidence in the quantity
theory of money.

The Inflation Tax

Why do some economies experience hyperinflation?

Almost always, it is because the government needs to raise revenue to finance spending, but for political
reasons cannot obtain that revenue through standard income taxation. Hence, it must pay for the goods
and services it purchases not with existing money collected through taxes, but instead using newly‐
created money.

Since money creation leads to inflation, the inflation tax refers to the revenue that the government
raises through money creation.

Historically, many cases of hyperinflation occur during or after a war, when the government is in need of
large amounts of revenue to finance high levels of spending, and may not have the ability to raise this
revenue through standard income taxation. All of the hyperinflations shown in Figure 4, for example,
occurred in the aftermath of World War I.

The Fisher Effect

Another application of the classical dichotomy is to interest rates:

‐ The nominal interest rate is the interest rate measured without correcting for inflation.
‐ The real interest rate is the interest rate measured after correction for inflation.

Recall from Chapter 24 that mathematically,

Real Interest Rate = Nominal Interest rate – Inflation Rate

Example:

‐ A bank pays interest at the rate of 7 percent per year.

‐ You deposit $100 today, and have $107 at the end of one year.
‐ But the inflation rate is 3 percent, so your money next year buys 3 percent less.
‐ Your real, or inflation‐adjusted, return, is 7 percent – 3 percent = 4 percent.

We can rearrange this equation to read

 7

Nominal Interest Rate = Real Interest Rate + Inflation Rate

Under monetary neutrality, an increase in the rate of money growth will increase the rate of inflation,
but leave the real interest rate unchanged.

Hence, under monetary neutrality, an increase in the rate of money growth will lead to a higher nominal
interest rate as well as a higher rate of inflation.

This application of monetary neutrality to interest rates is associated with the economist Irving Fisher,
and the predicted association of the nominal interest rate and the inflation rate is called the Fisher
effect.

Figure 5 plots the inflation rate and the nominal interest rate in the US economy since 1960. Note that
these two variables move together, providing evidence for the Fisher effect.

The Costs of Inflation

Generally, economists and non‐economists alike believe that inflation is costly for the economy. But
why?

A Fall in Purchasing Power?

Many people dislike inflation because they believe it erodes the purchasing power of their income.

What this argument fails to recognize is that while inflation leads to an increase in the dollar prices of
goods and services, it also leads to an increase in nominal (dollar‐denominated) wages and incomes.

Real (inflation‐adjusted) wages and incomes should, according to the principle of monetary neutrality,
remain unaffected.

This argument would appear to be a fallacy, so long as monetary neutrality holds.

Shoeleather Costs
But inflation does erode the value of money that each person holds in his or her wallet.

Thus, when inflation rises, people make greater efforts to reduce the amounts of money that they hold,
for example, by going to the bank or the ATM more often, but withdrawing smaller amounts each time.

The costs that are associated with these efforts are called shoeleather costs, based on the imagery of
someone wearing out his or her shoes walking to the bank more often.

Generally, under moderate rates of inflation like those currently prevailing in the US, shoeleather costs
appear small – maybe even trivial.

But these costs can be substantial during episodes of hyperinflation.

‐ During the Bolivian hyperinflation of 1985, prices rose at an annual rate of 38,000 percent.
 8

‐ This translates into a daily rate of inflation of about 1.65 percent. Over the course of a week,
money loses 12 percent of its value.
‐ As soon as people received their paychecks, they rushed to either spend the money or convert
pesos into US dollars.

Menu Costs
Menu costs refer to the costs that firms incur when changing their prices, based on the imagery of a
restaurant having to print up new menus.

Again, these costs appear quite small under modest rates of inflation, but get much bigger as inflation
rises.

Relative Price Variability and the Misallocation of Resources

Building on the menu cost story, suppose that a restaurant prints new menus with new prices once per
year, while the economy experiences continual inflation throughout the year.

At the beginning of the year, just after the new menus have been printed, the restaurant’s prices are
high relative to the overall price level. But, as the price level rises because of inflation, the restaurant’s
relative prices decline.

But these changes in prices have nothing to do with changes in the costs of preparing and serving food.

In this example, inflation interferes with the market’s ability to use prices to efficiently allocate scarce
resources.

Inflation Induced Tax Distortions

While all of the costs mentioned so far appear to be minor in a low‐inflation economy like the US, costs
relating to the operation of the tax system may be more important.

Table 1 illustrates an example of how inflation interacts with the tax system.

‐ Consider two economies, one in which the inflation rate is zero and the other in which the
inflation rate is 8 percent.
‐ In both economies, the real interest rate is 4 percent.
‐ The differences in interest rates lead, through the Fisher effect, to differences in nominal
interest rates. With zero inflation, the nominal interest rate is 4 percent, but with 8 percent
inflation, the nominal interest rate is 12 percent.
‐ Suppose that interest income is taxed at the rate of 25 percent.
o This means that with a 4 percent before tax interest rate, the saver pays 1 percent in
taxes.
o But with a 12 percent before tax interest rate, the saver pays 3 percent in taxes.
‐ With zero inflation, the after tax real return to saving is 3 percent.
‐ But with 8 percent inflation, the after tax return is just 1 percent.

Hence, saving may be much lower in the economy with 8 percent inflation.
 9

Confusion and Inconvenience

Recall the analogy used earlier in our discussion of monetary neutrality: in a sense, a doubling of the
money supply and a corresponding doubling of the price level is like changing the definition of a foot
from 12 inches to 6 inches.

If the definition of a foot, or a pound, or a mile were continually changed, it would be confusing and
inconvenient to make comparisons over time.

Extending the analogy, the same might be said about the effects of inflation.

Arbitrary Redistributions of Wealth

Suppose that you take out a 30‐year mortgage at 7 percent interest, expecting the inflation rate to be 3
percent.

The real interest rate that you are paying is 4 percent.

But now suppose that unexpectedly, inflation turns out to be 1 percent.

Now the real interest rate that you are paying is 6 percent – considerably higher. The bank wins, but
you lose.

On the other hand, if inflation turns out to be 5 percent, the real interest rate you pay is only 2 percent.
You win, but the bank loses.

Unexpected changes in inflation lead to redistributions of wealth across borrowers and lenders. On net
the effects cancel out, but before knowing who wins and who loses, everyone might object to the
arbitrariness of these potential redistributions.

Conclusions
Both theory and evidence points to excessive money growth as the principal cause of inflation.

Many sources of the costs of inflation appear trivial when inflation is low, but become much more
significant when inflation is much higher.

However, even at modest rates of inflation, interactions between inflation and the tax code can have
negative effects of saving. And even small changes in inflation, if unexpected, can lead to large and
arbitrary redistributions of wealth across borrowers and lenders.
Ch 33 Aggregate Demand and Aggregate
Supply
Introduction
Typically, increases in the labor force, increases in the capital stock, and advances in technological
knowledge allow the economy to produce more and more over time.

But in some years, this normal growth does not occur. These periods of declining incomes and rising
unemployment are called recessions when they are relatively minor and depressions when they are
more severe. What causes these short‐run fluctuations in economic activity?

This chapter starts by presenting some facts about short‐run economic fluctuations and then develops
the model of aggregate demand and aggregate supply to help explain and understand those facts.

Outline
1. Three Key Facts About Economic Fluctuations
2. Explaining Short‐Run Fluctuations
3. The Aggregate Demand Curve
A. Why the Aggregate Demand Curve Slopes Downward
B. Why the Aggregate Demand Curve Might Shift
4. The Aggregate Supply Curve
A. Why the Aggregate Supply Curve is Vertical in the Long Run
B. Why the Long‐Run Aggregate Supply Curve Might Shift
C. Using Aggregate Demand and Long‐Run Aggregate Supply to Depict Long‐Run Growth and
Inflation
D. Why the Aggregate Supply Slopes Upward in the Short Run
E. Why the Short‐Run Aggregate Supply Curve Might Shift
5. Two Causes of Economic Fluctuations
A. The Effects of a Shift in Aggregate Demand
B. The Effects of a Shift in Aggregate Supply

Three Key Facts About Economic Fluctuations

Fact 1: Economic Fluctuations are Irregular and Unpredictable
Fluctuations in economic activity are often called the business cycle. But this term is somewhat
misleading, since these fluctuations do not follow a regular and predictable pattern.
 2

Panel (a) of Figure 1 shows that recessions are sometimes close together, as in 1980 and 1982, but
sometimes farther apart, as with 1991 and 2001.

Fact 2: Most Macroeconomic Quantities Fluctuate Together

Although real GDP is the variable that is most commonly used to monitor the economy, other variables
also fluctuate along with GDP: corporate profits, investment, consumption, retail sales, home sales, etc.

But some variables fluctuate more than others. Panel (b) of Figure 1 shows that investment spending, in
particular, tends to fluctuate widely. Even though investment averages only about one‐seventh of GDP,
its fluctuations account for about two‐thirds of the decline in GDP that takes place during recessions.

Fact 3: As Output Falls, Unemployment Rises

Panel (c) of Figure 1 shows that the unemployment rate rises considerably during recessions.

When the recession ends and real GDP begins to grow again, the unemployment declines.

But notice that the unemployment rate never falls to zero; instead, it fluctuates around its natural rate
of 5 or 6 percent.

Explaining Short­Run Economic Fluctuations

The Assumptions of Classical Economics

Recall that the classical dichotomy is the separation of economic variables into real variables, which are
measured in units of physical quantities, and nominal variables, which are measured in units of money.

According to classical macroeconomic theory, changes in the money supply affect nominal variables but
not real variables.

The classical idea of monetary neutrality allows us to study the determination of real variables, like
output and unemployment, separately from the determination of nominal variables, like inflation.

The Reality of Short­Run Fluctuations

Most economists believe that monetary neutrality holds in the long run but not in the short run, and
hence that changes in the money supply do have short‐run effects.

Even the classical economists, like David Hume, observed that changes in the money supply appear to
affect output and employment in the short run.

The Model of Aggregate Demand and Supply

The model of aggregate demand and aggregate supply is used by economists to explain short‐run
fluctuations in economic activity around its long‐run trend.

The model focuses on the behavior of two variables:

‐ The economy’s quantity of output, which can be measured by real GDP.

 3

‐ The economy’s price level, which can be measured by the CPI or the GDP deflator.

Since the first of these two variables is a real variable and the second a nominal variable, the model
departs from the classical assumptions that allow these variables to be considered separately.

Figure 2 illustrates the model.

‐ The downward‐sloping aggregate demand curve shows the quantity of goods and services that
households, firms, the government, and customers abroad want to buy at each price level.
‐ The upward‐sloping aggregate supply curve shows the quantity of goods and services that firms
choose to produce at each price level.

But where do these curves come from, and why do they have the slopes shown in Figure 2?

The Aggregate Demand Curve

In figure 2 and again in figure 3, the aggregate demand curve slopes down, indicating that as the price
level falls, the quantity of goods and services demand rises.

Why the Aggregate Demand Curve Slopes Downward

Recall that an economy’s GDP (Y) can be decomposed into four components: consumption (C),
investment (I), government purchases (G), and net exports (NX):

For now, let’s take G as being fixed by government policy, independent of the price level.

Why might the demand for consumption, investment, and net exports fall as the price level rises?

The Price Level and Consumption: The Wealth Effect

Some of the wealth that individuals possess is held in nominal form: as money in their wallets or in the
bank.

When the price level falls, the real value of this wealth – that is, its value in terms of the goods it can
purchase – rises. This increase in wealth increases consumer spending, and hence also increases the
quantity of goods and services demanded.

Conversely, when the price level rises, the real value of monetary wealth falls, leading to a decrease in
consumer spending and the quantity of goods and services demanded.

The Price Level and Investment: The Interest Rate Effect

When the price level falls, the real value of each consumer’s money holdings rises.

In response, some consumers will attempt to reduce their money holdings by purchasing more bonds.

As they do so, the interest rate on these bonds will fall.

 4

And when interest rates fall, firms will become more willing to borrow to finance new investment
projects.

Conversely, when the price level rises, the real value of each consumer’s money holdings falls. In
response, some households will try to acquire more money by selling bonds. As they do, the interest
rate of these bonds will rise. And, as the interest rate rises, firms will become less willing to borrow to
finance new investment projects.

Hence, as the price level falls, the demand for investment goods rises; and as the price level rises, the
demand for investment goods falls.

Note, too, that this interest effect can also impact on household’s purchases of consumer durables,
which may be bought on credit.

The Price Level and Net Exports: The Exchange Rate Effect
When the price level falls in the US, the US interest rate falls as well.

This makes US bonds less attractive to investors, both in the US and overseas. As these investors turn to
other countries’ bonds as alternative, higher‐yielding investments, they will sell dollars and buy foreign
currencies.

As a result, the US dollar depreciates, that is, its value in terms of foreign currencies falls. Since each
dollar buys fewer units of foreign currencies, foreign goods become more expensive than US goods.

This change in relative prices affects spending both in the US and abroad. US consumers buy fewer
goods from abroad, and foreign consumers buy more US goods.

Both of these changes cause net exports to rise.

Conversely, when the US price level rises, the US interest rate rises as well. Since US bonds become
more attractive to international investors, they buy dollars and sell foreign currencies. Hence, the US
dollar appreciates, that is, its value in terms of foreign currencies rises. Since each dollar buys more
units of foreign currencies, foreign goods become less expensive than US goods. This change in relative
prices makes US consumers buy more goods from abroad and foreign consumers buy fewer US goods.
Both of these changes cause net exports to fall.

Hence, as the price level falls, net exports rise; and as the price level rises, net exports fall.

Why the Aggregate Demand Curve Might Shift

Shifts Arising from Changes in Consumption
If consumers become more concerned about saving for retirement, they will reduce their demand for
goods and services at any given price level. The aggregate demand curve shifts left.

If consumers feel wealthier because the stock market rises, they will increase their demand for goods
and services at any given price level. The aggregate demand curve shifts right.
 5

When the government cuts taxes, consumers have more after‐tax income to spend. They will increase
their demand for goods and services at any given price level. The aggregate demand curve shifts right.

Shifts Arising from Changes in Investment

If firms become more optimistic about future business conditions, they will want to invest more at any
given price level. The aggregate demand curve shifts right.

An investment tax credit, that is a tax rebate that is tied to firms’ investment decisions, will also make
firms want to invest more at any given price level. Again, the aggregate demand curve will shift right.

As we will see in the next chapter, an increase in the money supply tends to lower the interest rate,
again making firms want to invest more at any given price level and shifting the aggregate demand curve
to the right.

Conversely, a decrease in the money supply raises the interest rate, making firms want to invest less at
any given price level and shifting the aggregate demand curve to the left.

Shifts Arising from Changes in Government Purchases

The most direct way for government policy to shift the aggregate demand curve is simply by changing
government purchases: an increase in government purchases shifts the aggregate demand curve to the
right, and a decrease in government purchases shifts the aggregate demand curve to the left.

Shifts Arising from Changes in Net Exports

When Europe experiences an economic boom, its demand for US exports rises at any given price level.
Net exports rise, shifting the aggregate demand curve to the right.

Conversely, when Europe (or any other foreign economy) experiences a recession, the demand for US
exports falls, shifting the aggregate demand curve left.

Net exports can also change because of exchange rate movements. Suppose, for instance, that
speculators lose confidence in foreign currencies, and purchase US dollars instead. This leads to an
appreciation of the dollar, which in turn makes US goods more expensive relative to foreign goods. This
depresses net exports and causes a leftward shift in the aggregate demand curve.

The Aggregate Supply Curve

Unlike the aggregate demand curve, which always slopes downward, the aggregate supply curve
describes a relationship between output and the price level that depends crucially on the time horizon
being considered.

In the long run, the aggregate supply curve is vertical, whereas in the short run, it slopes upward.

Why the Aggregate Supply Curve is Vertical in the Long Run

In the long run, an economy’s production of goods and services depends on its supplies of capital, labor,
and natural resources as well as its stock of technological knowledge. The long‐run neutrality of money
 6

implies that if two countries are identical except that one has a money supply that is twice as large, then
the price level in that economy will be twice as large too, but the output of goods and services will be
the same.

The way of depicting the classical dichotomy and the neutrality of money in the aggregate demand‐
aggregate supply model is to draw the aggregate supply curve as vertical in the long run, as shown in
figure 4.

Why the Long­Run Aggregate Supply Curve Might Shift

The position of the vertical long‐run aggregate supply curve is often called potential output, full
employment output, or the natural rate of output. The last term captures the idea that this is the level
of output that results when the unemployment rate is at its natural rate, or normal level.

And just as the unemployment rate tends to gravitate towards its natural rate over time, so too will the
level of output tend to gravitate towards its natural rate.

Then what causes the aggregate supply curve to shift? Anything that would cause the natural rate of
output to change, including:

1. Changes in the supply of labor, due to immigration.

2. Changes in natural rate of unemployment, due to changes in minimum wages, changes in
unionization, etc.
3. Changes in the stock of capital, physical or human.
4. Discoveries or depletion of stocks of natural resources.
5. Changes in technological knowledge.

Using Aggregate Demand and Aggregate Supply to Depict Long­Run Growth

and Inflation
Figure 5 uses the aggregate demand and aggregate supply model to describe the behavior of output and
prices over long periods of time.

The initial aggregate demand curve is downward sloping. The aggregate supply curve is vertical, as the
graph focuses on the long run.

In the long run, growth in the labor force and, more importantly, growth in the stocks of capital and
technological knowledge shift the aggregate supply curve to the right, as the natural rate of output rises.

If the Federal Reserve keeps the money supply constant, this long‐run economic growth will tend to
reduce the price level, that is, cause deflation.

But, historically, the Federal Reserve has acted to increase the money supply over long periods of time.
This increase in the money supply has shifted the aggregate demand curve to the right, too. Indeed, the
money supply has grown at a rate that has caused the aggregate demand curve to shift rightward at a
pace that is associated with inflation.
 7

Why the Aggregate Supply Curve Slopes Upward in the Short Run
Most economists believe in the long‐run neutrality of money, but also believe that changes in money or
other nominal variables are associated with changes in output, employment, and other real variables in
the short run.

That is, most economists believe that while the long‐run aggregate supply curve is vertical, the short‐run
aggregate supply curve is upward sloping, as shown in figure 6.

The upward‐sloping short‐run aggregate supply curve implies that the quantity of output supplied
deviates from its natural rate when the actual price level in the economy deviates from the price level
that most people expect to prevail:

‐ When prices rise above the level that people expect, output rises above its natural rate.
‐ When prices fall below the level that people expect, output falls below its natural rate.

Economists have devised several explanations for the upward‐sloping short‐run aggregate supply curve.

Sticky Wage Theory

As its name suggests, sticky wage theory posits that wages are slow to adjust to changing economic
conditions, either because workers and firms sign long‐term contracts or because wage‐setting
conventions make it difficult for firms to rapidly adjust the wages they pay.

An example best illustrates how the theory works:

‐ Suppose that one year ago, a firm expected the price level P to equal 100, and based on this
expectation, agreed to pay its workers $20 per hour.
‐ Now suppose that, instead, the price level turns out to be P = 105.
‐ In the long run, the firm will have to pay its workers higher wages to compensate them for the
higher cost of living, but in the short run the wages it pays are, in real terms (that is, in units of
output), “too low.”
‐ Since the firm can hire workers at relatively low wages, it hires more and produces more output.
‐ The unexpectedly high price level leads to an increase in output above its natural rate.
‐ And the same story works in reverse: if the price level turns out to be unexpectedly low, real
wages rise in the short run, leading firms to hire fewer workers and produce less.

Sticky Price Theory

Sticky price theory emphasizes, instead, that the prices of certain goods and services are slow to adjust
to changing economic conditions.

This theory uses the metaphor of menu costs: a restaurant may print up new menus, with new prices,
only once or twice per year. In the short run, its prices are fixed even if economic conditions change.

Menus and mail order catalogs provide literal examples of menu costs to changing prices. But other
prices may be slow to change because of managerial costs. For example, executives at Dunkin Donuts
 8

may decide at the beginning of the year that $1.49 is the “right price” to charge for a cup of coffee. They
may meet again later in the year to reconsider the pricing decision, but until then the price stays fixed.

So suppose that Dunkin Donuts sets its price at $1.49 but the price level, reflecting mainly the prices of
other goods and services, turns out to be unexpectedly high. A cup of coffee now looks “cheap” to
consumers. More will visit Dunkin Donuts and buy coffee. Dunkin Donuts will hire more workers and
produce more output. Hence, the unexpectedly high price level leads to an increase in output above its
natural rate.

And the same story works in reverse: if the price level turns out to be unexpectedly low, a cup of coffee
with a “sticky” price of $1.49 will look expensive. People will buy less; Dunkin Donuts will hire fewer
workers and produce less. The unexpectedly low price level leads to a decrease in output below its
natural rate.

But, like sticky wage theory, sticky price theory also suggests that in the long run, prices will adjust and
output will return to its natural rate.

Misperceptions Theory
A third story to explain the upward‐sloping short‐run aggregate supply curve is the misperceptions
theory.

Another example illustrates how this theory works:

‐ Suppose, at the beginning of the year, everyone expects the price level P to equal 100.
‐ But instead, the price level rises to P = 110.
‐ This means that, on average, the prices of all goods and services have risen by 10 percent.
‐ In the short‐run, however, individual firms may mistakenly believe that it is really just the price
of their particular good that is rising.
‐ Believing that it is an especially good time to produce, those firms will hire more workers.
‐ As a result, the unexpectedly high price level will lead to an increase in output above its natural
rate.
‐ Conversely, if the price level unexpected falls, each individual firm might mistakenly believe that
it is really just the price of its own output that is falling. The firm will hire fewer workers. The
unexpectedly low price will lead to a decrease in output below its natural rate.

Summary
Although some economists debate over which of these three theories – sticky wages, sticky prices, or
misperceptions – comes closest to describing actual economies, there is probably an element of truth in
each of them. And they are not mutually inconsistent, that is, they could all work together to describe
why the aggregate supply curve slopes upward.

And all three imply a short‐run relationship of the form:

 9

Where a is a number that governs the extent to which actual output responds to unexpected changes in
the price level.

Note that this same equation – and each of the three theories – also captures the idea that in the long
run, after expectations have shifted to recognize actual changes in the price level, the long‐run
aggregate supply curve is vertical.

Why the Short­Run Aggregate Supply Curve Might Shift

The equation from above also allows us to identify factors that will shift the short‐run aggregate supply
curve:

1. Anything that shifts the natural rate of output (and hence the long‐run aggregate supply curve).
2. Changes in the expected price level.

The equation indicates that an increase in the expected price level causes the quantity of output
supplied at any given actual price level to decrease. How?

Consider the answer given by sticky wage theory:

‐ If the expected price level increases, firms will set higher wages to compensate workers for the
higher cost of living.
‐ But, if the actual price level is held constant, this means higher real wages.
‐ Firms will hire fewer workers, and produce less output, at the given price level.
‐ The short‐run aggregate supply curve shifts to the left.
‐ Conversely, if the expected price level falls, firms will be able to set lower wages, hire more
workers, and produce more output, all at any given price level. The short‐run aggregate supply
curve shifts to the right.

Can you give the answers as they would be provided by the sticky price and misperceptions theories?

Two Causes of Economic Fluctuations

Figure 7 depicts in the economy in its long‐run equilibrium:

‐ Aggregate demand intersects with long‐run aggregate supply, determining output and the price
level.
‐ But here, the short‐run aggregate supply passes through the equilibrium point as well, indicating
that the expected price level has adjusted to this long‐run equilibrium as well.

From this starting point, we can consider the effects of forces that shift either aggregate demand or
aggregate supply, according to these four steps:

1. Decide whether the event shifts the aggregate demand curve, the aggregate supply curve, or
both.
2. Decide in which direction the curve shifts.
 10

3. Use the aggregate demand and aggregate supply diagram to see how output and the price level
change in the short run.
4. Use the same diagram to see how output and the price level change in the long run.

The Effects of a Shift in Aggregate Demand

Let’s consider a specific example: a wave of pessimism hits the economy, because of a political scandal
or a stock market crash. What happens to the economy as a result?

1. Since the wave of pessimism affects spending plans, it shifts the aggregate demand curve.
2. Because households and firms want to buy a smaller quantity of goods at a given price level, the
aggregate demand curve shifts left.
3. Figure 8 shows that in the short run this leftward shift of aggregate demand causes output to fall
below its natural rate. The price level falls as well. (Can you tell the specific stories implied by
sticky wage, sticky price, and misperceptions theories?) We have now moved from point A to
point B in figure 8.
4. As time passes, however, the expected price level will also fall. This shifts the aggregate supply
curve to the right (again, can you tell the specific stories implied by sticky wage, sticky price, and
misperceptions theories?). Now we move to point C in figure 8: the price level falls still further,
but output returns to its natural rate.

In this example, we implicitly assumed that the government does not respond to any of these events.
Another possibility is that the Federal Reserve could respond to the initial fall in aggregate demand by
increasing the money supply:

‐ As discussed earlier, and in more detail in the next chapter, an increase in the money supply will
shift the aggregate demand curve to the right, offsetting the initial leftward shift.
‐ In this case, the economy can move back to its initial long‐run equilibrium point A without a shift
in the expected price level and without a shift in aggregate supply.

Figure 9 shows changes in real GDP in the US since 1900. Two large swings stand out: the decline in GDP
during the Great Depression and the growth in GDP during World War II.

Most economists now blame the Great Depression on a large decline in the money supply.

‐ From 1929 to 1933, the money supply fell by 28 percent.

‐ To a large extent, this decline in the money supply was the result of bank failures, which lead to
a contraction of the money multiplier.
‐ A decline in the money supply causes the aggregate demand curve to shift to the left.
‐ In the short run, output falls as does the price level.
‐ Eventually, expectations adjust to the lower price level. The aggregate supply curve shifts to the
right. The price level falls further, but output returns to its natural rate.

During World War II, government (military) spending rose dramatically.

‐ An increase in government purchases causes the aggregate demand curve to shift to the right.
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‐ In the short run, output rises as does the price level.

‐ In the long run, the expected price level also rises. The aggregate supply curve shifts to the left.
The price level rises further, but output returns to its natural rate.

The US economy also experienced a recession during 2001, most likely due to shifts in aggregate
demand:

‐ Between August 2000 and August 2001, stock prices fell by about 25 percent.
‐ A fall in stock prices shifts aggregate demand to the left.
‐ Then in September 2001, terrorist attacks hit New York and Washington.
‐ Increased pessimism and uncertainty brought about by the attacks also shift the aggregate
demand curve to the left.
‐ But the Federal Reserve responded by cutting interest rates, which as we discussed previously
involves an increase in the money supply. Also, Congress responded by cutting taxes. All of these
policy decisions work to shift aggregate demand back to the right.

Let’s consider one final example. What happens when the Federal Reserve just decides to increase the
money supply?

‐ Again, an increase in the money supply will shift the aggregate demand curve to right.
‐ Output increases in the short run, as does the price level.
‐ But, in the long run, the expected price level will rise as well, shifting the aggregate supply curve
to the left. Output returns to its natural rate, but the price level is permanently higher.
‐ This example illustrates how the aggregate demand and aggregate supply model reconciles the
short and long‐run effects of monetary policy.

The Effects of a Shift in Aggregate Supply

Let’s suppose again that the economy starts out in its long run equilibrium, in which aggregate demand,
long‐run aggregate supply, and short‐run aggregate supply all intersect.

Now suppose that there is a disruption to worldwide oil supplies. What happens to the economy as a
result?

1. Because the availability of natural resources affects firms’ ability to produce goods, the
aggregate supply curve shifts.
2. Because the reduction in oil supplies makes it more difficult and costly for firms to produce
goods, the aggregate supply curve shifts to the left.
3. Figure 10 shows that in the short run, output falls and the price level rises. The economy
experiences stagflation: stagnation of economic growth and inflation.
4. Assuming that oil supplies are eventually restored in full, however, the long‐run aggregate
supply curve remains fixed. Instead, as oil supplies come back, the short‐run aggregate supply
curve will shift back to its original position.

This example assumes that government policymakers do not respond to the oil supply shock.
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‐ Figure 11 shows what happens when, instead, the Federal Reserve expands the money supply or
Congress increases government spending in an attempt to counteract the short‐run decline in
output.
‐ Now, in the short run, the aggregate demand curves to the right. If the monetary and/or fiscal
stimulus to demand is sufficiently strong, the government can bring output back to its natural
rate even in the short run.
‐ But, as the figure shows, this comes at the cost of making the inflation even worse.
‐ In cases like this one, the government is said to accommodate the shift in aggregate supply,
accepting a permanently higher price level in order to insulate output and employment from the
effects of the shift in aggregate supply.