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terms interchangeably. The vertical axis shows the aggregate price level, measured by the GDP deflator. With these variables on the axes, we can draw a curve, AD, showing how much aggregate output would have been demanded at any given aggregate price level. Since AD is meant to illustrate aggregate demand in 1933, one point on the curve corresponds to actual data for 1933, when the aggregate price level was 7.9 and the total quantity of domestic final goods and services purchased was $716 billion in 2005 dollars. As drawn in Figure 17.1, the aggregate demand curve is downward sloping, indicating a negative relationship between the aggregate price level and the quantity of aggregate output demanded. A higher aggregate price level, other things equal, reduces the quantity of aggregate output demanded; a lower aggregate price level, other things equal, increases the quantity of aggregate output demanded. According to Figure 17.1, if the price level in 1933 had been 5.0 instead of 7.9, the total quantity of domestic final 172 17.1 The Aggregate Demand Curve The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. The curve is downward sloping due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. Corresponding to the actual 1933 data, here the total quantity of goods and services demanded at an aggregate price level of 7.9 is $716 billion in 2005 dollars. According to our hypothetical curve, however, if the aggregate price level had been only 5.0, the quantity of aggregate output demanded would have risen to $950 billion. Aggregate price level (GDP deflator, 2005 = 100) 7.9 5.0 0 A movement down the AD curve leads to a lower aggregate price level and higher aggregate output. 1933 Aggregate demand curve, AD $716 950 Real GDP (billions of 2005 dollars) goods and services demanded would have been $950 billion in 2005 dollars instead of $716 billion. The first key question about the aggregate demand curve involves its negative slope. Why Is the Aggregate Demand Curve Downward Sloping? In Figure 17.1, the curve AD slopes downward. Why? Recall the basic equation of national income accounting: (17-1) GDP = C + I + G + X − IM where C is consumer spending, I is investment spending, G is government purchases of goods and services, X is exports to other countries, and IM is imports. If
we measure these variables in constant dollars—that is, in prices of a base year—then C + I + G + X − IM represents the quantity of domestically produced final goods and services demanded during a given period. G is decided by the government, but the other variables are private -sector decisions. To understand why the aggregate demand curve slopes downward, we need to understand why a rise in the aggregate price level reduces C, I, and X − IM. You might think that the downward slope of the aggregate demand curve is a natural consequence of the law of demand. That is, since the demand curve for any one good is downward sloping, isn’t it natural that the demand curve for aggregate output is also downward sloping? This turns out, however, to be a misleading parallel. The demand curve for any individual good shows how the quantity demanded depends on the price of that good, holding the prices of other goods and services constant. The main reason the quantity of a good demanded falls when the price of that good rises—that is, the quantity of a good demanded falls as we move up the demand curve—is that people switch their consumption to other goods and services that have become relatively less expensive. But when we consider movements up or down the aggregate demand curve, we’re considering a simultaneous change in the prices of all final goods and services. Furthermore, changes 173 in the composition of goods and services in consumer spending aren’t relevant to the aggregate demand curve: if consumers decide to buy fewer clothes but more cars, this doesn’t necessarily change the total quantity of final goods and services they demand. Why, then, does a rise in the aggregate price level lead to a fall in the quantity of all domestically produced final goods and services demanded? There are two main reasons: the wealth effect and the interest rate effect of a change in the aggregate price level. The Wealth Effect An increase in the aggregate price level, other things equal, reduces the purchasing power of many assets. Consider, for example, someone who has $5,000 in a bank account. If the aggregate price level were to rise by 25%, that $5,000 would buy only as much as $4,000 would have bought previously. With the loss in purchasing power, the owner of that bank account would probably scale back his or her consumption plans. Millions of other people would respond the same way, leading to a fall in spending on final goods and services, because a rise in the aggregate price level reduces the purchasing power
of everyone’s bank account. Correspondingly, a fall in the aggregate price level increases the purchasing power of consumers’ assets and leads to more consumer demand. The wealth effect of a change in the aggregate price level is the change in consumer spending caused by the altered purchasing power of consumers’ assets. Because of the wealth effect, consumer spending, C, falls when the aggregate price level rises, leading to a downward -sloping aggregate demand curve. The Interest Rate Effect Economists use the term money in its narrowest sense to refer to cash and bank deposits on which people can write checks. People and firms hold money because it reduces the cost and inconvenience of making transactions. An increase in the aggregate price level, other things equal, reduces the purchasing power of a given amount of money holdings. To purchase the same basket of goods and services as before, people and firms now need to hold more money. So, in response to an increase in the aggregate price level, the public tries to increase its money holdings, either by borrowing more or by selling assets such as bonds. This reduces the funds available for lending to other borrowers and drives interest rates up. A rise in the interest rate reduces investment spending because it makes the cost of borrowing higher. It also reduces consumer spending because households save more of their disposable income. So a rise in the aggregate price level depresses investment spending, I, and consumer spending, C, through its effect on the purchasing power of money holdings, an effect known as the interest rate effect of a change in the aggregate price level. This also leads to a downward -sloping aggregate demand curve. Shifts of the Aggregate Demand Curve When we introduced the analysis of supply and demand in the market for an individual good, we stressed the importance of the distinction between movements along the demand curve and shifts of the demand curve. The same distinction applies to the aggregate demand curve. Figure 17.1 shows a movement along the aggregate demand curve, a change in the aggregate quantity of goods and services demanded as the aggregate price level changes. But there can also be shifts of the aggregate demand curve, changes in the quantity of goods and services demanded at any given price level, as shown in Figure 17.2. When we talk about an increase in aggregate demand, we mean a shift of the aggregate demand curve to the right, as shown in panel (a) by the shift from AD1 to AD2. A rightward shift occurs when the quantity of aggregate output demanded increases at any given aggregate price level. A decrease
in aggregate demand means that the AD curve shifts to the left, as in panel (b). A leftward When the aggregate price level falls, the purchasing power of consumers’ assets rises, leading shoppers to place more items in their carts. The wealth effect of a change in the aggregate price level is the change in consumer spending caused by the altered purchasing power of consumers’ assets. The interest rate effect of a change in the aggregate price level is the change in investment and consumer spending caused by altered interest rates that result from changes in the demand for money. 174 17.2 Shifts of the Aggregate Demand Curve (a) Rightward Shift (b) Leftward Shift Aggregate price level Increase in Aggregate Demand Aggregate price level Decrease in Aggregate Demand AD1 AD2 Real GDP AD2 AD1 Real GDP Panel (a) shows the effect of events that increase the quantity of aggregate output demanded at any given aggregate price level, for example, improvements in business and consumer expectations or increased government spending. Such changes shift the aggregate demand curve to the right, from AD1 to AD2. Panel (b) shows the effect of events that decrease the quantity of aggregate output demanded at any given aggregate price level, such as a fall in wealth caused by a stock market decline. This shifts the aggregate demand curve leftward from AD1 to AD2 shift implies that the quantity of aggregate output demanded falls at any given aggregate price level. A number of factors can shift the aggregate demand curve. Among the most important factors are changes in expectations, changes in wealth, and the size of the existing stock of physical capital. In addition, both fiscal and monetary policy can shift the aggregate demand curve. All five factors set the multiplier process in motion. By causing an initial rise or fall in real GDP, they change disposable income, which leads to additional changes in aggregate spending, which lead to further changes in real GDP, and so on. For an overview of factors that shift the aggregate demand curve, see Table 17.1 on the next page. Changes in Expectations Both consumer spending and planned investment spending depend in part on people’s expectations about the future. Consumers base their spending not only on the income they have now but also on the income they expect to have in the future. Firms base their planned investment spending not only on current conditions but also on the sales they expect to make in the future. As a result, changes in expectations can push consumer spending and planned investment spending up or down. If consumers and firms become
more optimistic, aggregate spending rises; if they become more pessimistic, aggregate spending falls. In fact, short -run economic forecasters pay careful attention to surveys of consumer and business sentiment. In particular, forecasters watch the Consumer Confidence Index, a monthly measure calculated by the Conference Board, and the Michigan Consumer Sentiment Index, a similar measure calculated by the University of Michigan. Changes in Wealth Consumer spending depends in part on the value of household assets. When the real value of these assets rises, the purchasing power they embody also rises, leading to an increase in aggregate spending. For example, in the 1990s, there was a significant rise in the stock market that increased aggregate demand. And when the real value of household assets falls—for example, because of a stock market 175 t a b l e 17.1 Factors That Shift the Aggregate Demand Curve Changes in expectations Changes in wealth Size of the existing stock of physical capital Fiscal policy Monetary policy If consumers and firms become more optimistic,...... aggregate demand increases. If consumers and firms become more pessimistic,...... aggregate demand decreases. If the real value of household assets rises,...... aggregate demand increases. If the real value of household assets falls,...... aggregate demand decreases. If the existing stock of physical capital is relatively small,...... aggregate demand increases. If the existing stock of physical capital is relatively large,...... aggregate demand decreases. If the government increases spending or cuts taxes,...... aggregate demand increases. If the government reduces spending or raises taxes,...... aggregate demand decreases. If the central bank increases the quantity of money,...... aggregate demand increases. If the central bank reduces the quantity of money,...... aggregate demand decreases. crash—the purchasing power they embody is reduced and aggregate demand also falls. The stock market crash of 1929 was a significant factor leading to the Great Depression. Similarly, a sharp decline in real estate values was a major factor depressing consumer spending in 2008. Size of the Existing Stock of Physical Capital Firms engage in planned investment spending to add to their stock of physical capital. Their incentive to spend depends in part on how much physical capital they already have: the more they have, the less they will feel a need to add more, other things equal. The same applies to other types of investment spending—for example, if
a large number of houses have been built in recent years, this will depress the demand for new houses and as a result also tend to reduce residential investment spending. In fact, that’s part of the reason for the deep slump in residential investment spending that began in 2006. The housing boom of the previous few years had created an oversupply of houses: by spring 2008, the inventory of unsold houses on the market was equal to more than 11 months of sales, and prices had fallen more than 20% from their peak. This gave the construction industry little incentive to build even more homes. Government Policies and Aggregate Demand One of the key insights of macroeconomics is that the government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance. The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy. We’ll briefly discuss their influence on aggregate demand, leaving a full -length discussion for later. Fiscal Policy Fiscal policy is the use of either government spending—government purchases of final goods and services and government transfers—or tax policy to stabilize the economy. In practice, governments often respond to recessions by increasing The loss of wealth resulting from the stock market crash of 1929 was a significant factor leading to the Great Depression. Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to stabilize the economy. 176 spending, cutting taxes, or both. They often respond to inflation by reducing spending or increasing taxes. The effect of government purchases of final goods and services, G, on the aggregate demand curve is direct because government purchases are themselves a component of aggregate demand. So an increase in government purchases shifts the aggregate demand curve to the right and a decrease shifts it to the left. History’s most dramatic example of how increased government purchases affect aggregate demand was the effect of wartime government spending during World War II. Because of the war, U.S. federal purchases surged 400%. This increase in purchases is usually credited with ending the Great Depression. In the 1990s, Japan used large public works projects—such as government -financed construction of roads, bridges, and dams—in an effort to increase aggregate demand in the face of a slumping economy. In contrast, changes in either tax rates or government transfers influence the economy indirectly through their effect on disposable income. A lower tax rate means that consumers get to keep more of what they earn, increasing their disposable income. An increase in
government transfers also increases consumers’ disposable income. In either case, this increases consumer spending and shifts the aggregate demand curve to the right. A higher tax rate or a reduction in transfers reduces the amount of disposable income received by consumers. This reduces consumer spending and shifts the aggregate demand curve to the left. Monetary Policy In the next section, we will study the Federal Reserve System and monetary policy in detail. At this point, we just need to note that the Federal Reserve controls monetary policy—the use of changes in the quantity of money or the interest rate to stabilize the economy. We’ve just discussed how a rise in the aggregate price level, by reducing the purchasing power of money holdings, causes a rise in the interest rate. That, in turn, reduces both investment spending and consumer spending. But what happens if the quantity of money in the hands of households and firms changes? In modern economies, the quantity of money in circulation is largely determined by the decisions of a central bank created by the government. As we’ll learn in more detail later, the Federal Reserve, the U.S. central bank, is a special institution that is neither exactly part of the government nor exactly a private institution. When the central bank increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. The effect is to drive the interest rate down at any given aggregate price level, leading to higher investment spending and higher consumer spending. That is, increasing the quantity of money shifts the aggregate demand curve to the right. Reducing the quantity of money has the opposite effect: households and firms have less money holdings than before, leading them to borrow more and lend less. This raises the interest rate, reduces investment spending and consumer spending, and shifts the aggregate demand curve to the left. Monetary policy is the central bank’s use of changes in the quantity of money or the interest rate to stabilize the economy. M o d u l e 17 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Determine the effect on aggregate demand of each of the following events. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward). a. a rise in the interest rate caused by a change in monetary policy b. a fall in the real value of money in the economy due to a c. news of a worse-than-expected job market next year d
. a fall in tax rates e. a rise in the real value of assets in the economy due to a lower aggregate price level f. a rise in the real value of assets in the economy due to a surge in real estate values higher aggregate price level 177 Tackle the Test: Multiple-Choice Questions 1. Which of the following explains the slope of the aggregate 3. The Consumer Confidence Index is used to measure which of demand curve? I. the wealth effect of a change in the aggregate price level II. the interest rate effect of a change in the aggregate price level III. the product-substitution effect of a change in the aggregate price level the following? a. the level of consumer spending b. the rate of return on investments c. consumer expectations d. planned investment spending e. the level of current disposable income a. I only b. II only c. III only d. I and II only I, II, and III e. 2. Which of the following will shift the aggregate demand curve to the right? a. a decrease in wealth b. pessimistic consumer expectations c. a decrease in the existing stock of capital d. contractionary fiscal policy e. a decrease in the quantity of money 4. Decreases in the stock market decrease aggregate demand by decreasing which of the following? a. consumer wealth b. the price level c. the stock of existing physical capital d. interest rates e. tax revenues 5. Which of the following government policies will shift the aggregate demand curve to the left? a. a decrease in the quantity of money b. an increase in government purchases of goods and services c. a decrease in taxes d. a decrease in interest rates e. an increase in government transfers Tackle the Test: Free-Response Questions 1. a. Draw a correctly labeled graph showing aggregate demand. b. On your graph from part a, illustrate an increase in 1 point: Downward sloping curve labeled “AD” (or “AD1”) aggregate demand. 1 point: AD curve shifted to the right c. List the four factors that shift aggregate demand. d. Describe a change in each determinant of aggregate demand that would lead to the shift you illustrated in part b. Answer (12 points) Aggregate price level Increase in Aggregate Demand 1 point: Expectations 1 point: Wealth 1 point: Size of existing stock of physical capital 1 point: Government policies 1 point: Consumers/Producers more confident 1 point: Increase in wealth 1 point: Lower existing stock of
physical capital 1 point: An increase in government spending or in the money supply 2. Identify the two effects that cause the aggregate demand curve to have a downward slope. Explain each. AD1 AD2 Real GDP 1 point: Vertical axis labeled “Aggregate price level” (or “Price level”) 1 point: Horizontal axis labeled “Real GDP” 178 Module 18 Aggregate Supply: Introduction and Determinants Aggregate Supply Between 1929 and 1933, there was a sharp fall in aggregate demand—a reduction in the quantity of goods and services demanded at any given price level. One consequence of the economy -wide decline in demand was a fall in the prices of most goods and services. By 1933, the GDP deflator (one of the price indexes) was 26% below its 1929 level, and other indexes were down by similar amounts. A second consequence was a decline in the output of most goods and services: by 1933, real GDP was 27% below its 1929 level. A third consequence, closely tied to the fall in real GDP, was a surge in the unemployment rate from 3% to 25%. The association between the plunge in real GDP and the plunge in prices wasn’t an accident. Between 1929 and 1933, the U.S. economy was moving down its aggregate supply curve, which shows the relationship between the economy’s aggregate price level (the overall price level of final goods and services in the economy) and the total quantity of final goods and services, or aggregate output, producers are willing to supply. (As you will recall, we use real GDP to measure aggregate output, and we’ll often use the two terms interchangeably.) More specifically, between 1929 and 1933, the U.S. economy moved down its short -run aggregate supply curve. The Short-Run Aggregate Supply Curve The period from 1929 to 1933 demonstrated that there is a positive relationship in the short run between the aggregate price level and the quantity of aggregate output supplied. That is, a rise in the aggregate price level is associated with a rise in the quantity of aggregate output supplied, other things equal; a fall in the aggregate price level is associated with a fall in the quantity of aggregate output supplied, other things equal. To understand why this positive relationship exists, consider the most basic What you will learn in this Module: • How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy • What factors can shift the aggregate supply curve
• Why the aggregate supply curve is different in the short run from in the long run The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy 179 question facing a producer: is producing a unit of output profitable or not? Let’s define profit per unit: (18-1) Profit per unit of output = Price per unit of output − Production cost per unit of output Thus, the answer to the question depends on whether the price the producer receives for a unit of output is greater or less than the cost of producing that unit of output. At any given point in time, many of the costs producers face are fixed per unit of output and can’t be changed for an extended period of time. Typically, the largest source of inflexible production cost is the wages paid to workers. Wages here refers to all forms of worker compensation, including employer -paid health care and retirement benefits in addition to earnings. Wages are typically an inflexible production cost because the dollar amount of any given wage paid, called the nominal wage, is often determined by contracts that were signed some time ago. And even when there are no formal contracts, there are often informal agreements between management and workers, making companies reluctant to change wages in response to economic conditions. For example, companies usually will not reduce wages during poor economic times— unless the downturn has been particularly long and severe—for fear of generating worker resentment. Correspondingly, they typically won’t raise wages during better economic times—until they are at risk of losing workers to competitors—because they don’t want to encourage workers to routinely demand higher wages. As a result of both formal and informal agreements, then, the economy is characterized by sticky wages: nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. It’s important to note, however, that nominal wages cannot be sticky forever: ultimately, formal contracts and informal agreements will be renegotiated to take into account changed economic circumstances. How long it takes for nominal wages to become flexible is an integral component of what distinguishes the short run from the long run. To understand how the fact that many costs are fixed in nominal terms gives rise to an upward -sloping short -run aggregate supply curve, it’s helpful to know that prices are set somewhat differently in different kinds of markets. In perfectly competitive markets, producers take prices as given; in imperfectly competitive markets,
producers have some ability to choose the prices they charge. In both kinds of markets, there is a short run positive relationship between prices and output, but for slightly different reasons. Let’s start with the behavior of producers in perfectly competitive markets; remember, they take the price as given. Imagine that, for some reason, the aggregate price level falls, which means that the price received by the typical producer of a final good or service falls. Because many production costs are fixed in the short run, production cost per unit of output doesn’t fall by the same proportion as the fall in the price of output. So the profit per unit of output declines, leading perfectly competitive producers to reduce the quantity supplied in the short run. On the other hand, suppose that for some reason the aggregate price level rises. As a result, the typical producer receives a higher price for its final good or service. Again, many production costs are fixed in the short run, so production cost per unit of output doesn’t rise by the same proportion as the rise in the price of a unit. And since the typical perfectly competitive producer takes the price as given, profit per unit of output rises and output increases. Now consider an imperfectly competitive producer that is able to set its own price. If there is a rise in the demand for this producer’s product, it will be able to sell more at any given price. Given stronger demand for its products, it will probably choose to increase its prices as well as its output, as a way of increasing profit per unit of output. In The nominal wage is the dollar amount of the wage paid. Sticky wages are nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. 180 The short -run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed fact, industry analysts often talk about variations in an industry’s “pricing power”: when demand is strong, firms with pricing power are able to raise prices—and they do. Conversely, if there is a fall in demand, firms will normally try to limit the fall in their sales by cutting prices. Both the responses of firms in perfectly competitive industries and those of firms in imperfectly competitive industries lead to an upward -sloping relationship between aggregate output and the aggregate price level. The positive relationship between the aggregate
price level and the quantity of aggregate output producers are willing to supply during the time period when many production costs, particularly nominal wages, can be taken as fixed is illustrated by the short -run aggregate supply curve. The positive relationship between the aggregate price level and aggregate output in the short run gives the short -run aggregate supply curve its upward slope. Figure 18.1 shows a hypothetical short -run aggregate supply curve, SRAS, that matches actual U.S. data for 1929 and 1933. On the horizontal axis is aggregate output (or, equivalently, real GDP)—the total quantity of final goods and services supplied in the economy—measured in 2005 dollars. On the vertical axis is the aggregate price level as measured by the GDP deflator, with the value for the year 2005 equal to 100. In 1929, the aggregate price level was 10.6 and real GDP was $977 billion. In 1933, the aggregate price level was 7.9 and real GDP was only $716 billion. The movement down the SRAS curve corresponds to the deflation and fall in aggregate output experienced over those years. Shifts of the Short -Run Aggregate Supply Curve Figure 18.1 shows a movement along the short -run aggregate supply curve, as the aggregate price level and aggregate output fell from 1929 to 1933. But there can also be shifts of the short -run aggregate supply curve, as shown in Figure 18.2 on the next page. Panel (a) shows a decrease in short -run aggregate supply—a leftward shift of the short -run aggregate supply curve. Aggregate supply decreases when producers reduce the quantity of aggregate output they are willing to supply at any given aggregate price level. Panel (b) shows an increase in short -run aggregate supply—a rightward shift of the short -run aggregate supply f i g u r e 18.1 The Short -Run Aggregate Supply Curve The short -run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the short run, the period in which many production costs such as nominal wages are fixed. It is upward sloping because a higher aggregate price level leads to higher profit per unit of output and higher aggregate output given fixed nominal wages. Here we show numbers corresponding to the Great Depression, from 1929 to 1933: when deflation occurred and the aggregate price level fell from 10.6 (in 1929) to 7.9 (in 1933), firms responded by reducing the quantity of aggregate output supplied from $977 billion to $
716 billion measured in 2005 dollars. Aggregate price level (GDP deflator, 2005 = 100) 10.6 7.9 Short-run aggregate supply curve, SRAS 1933 1929 A movement down the SRAS curve leads to deflation and lower aggregate output. 0 $716 977 Real GDP (billions of 2005 dollars 181 f i g u r e 18. 2 Shifts of the Short -Run Aggregate Supply Curve (a) Leftward Shift (b) Rightward Shift Aggregate price level SRAS2 SRAS1 Aggregate price level SRAS1 SRAS2 Decrease in Short-Run Aggregate Supply Increase in Short-Run Aggregate Supply Real GDP Real GDP Panel (a) shows a decrease in short -run aggregate supply: the short run aggregate supply curve shifts leftward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level falls. Panel (b) shows an increase in short -run ag- gregate supply: the short -run aggregate supply curve shifts rightward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level rises. curve. Aggregate supply increases when producers increase the quantity of aggregate output they are willing to supply at any given aggregate price level. To understand why the short -run aggregate supply curve can shift, it’s important to recall that producers make output decisions based on their profit per unit of output. The short -run aggregate supply curve illustrates the relationship between the aggregate price level and aggregate output: because some production costs are fixed in the short run, a change in the aggregate price level leads to a change in producers’ profit per unit of output and, in turn, leads to a change in aggregate output. But other factors besides the aggregate price level can affect profit per unit and, in turn, aggregate output. It is changes in these other factors that will shift the short -run aggregate supply curve. To develop some intuition, suppose that something happens that raises production costs—say, an increase in the price of oil. At any given price of output, a producer now earns a smaller profit per unit of output. As a result, producers reduce the quantity supplied at any given aggregate price level, and the short -run aggregate supply curve shifts to the left. If, in contrast, something happens that lowers production costs—say, a fall in the nominal wage—a producer now earns a higher profit per unit of output at any given
price of output. This leads producers to increase the quantity of aggregate output supplied at any given aggregate price level, and the short -run aggregate supply curve shifts to the right. Now we’ll look more closely at the link between important factors that affect pro- ducers’ profit per unit and shifts in the short -run aggregate supply curve. Changes in Commodity Prices A surge in the price of oil caused problems for the U.S. economy in the 1970s and in early 2008. Oil is a commodity, a standardized input bought and sold in bulk quantities. An increase in the price of a commodity—oil— raised production costs across the economy and reduced the quantity of aggregate output supplied at any given aggregate price level, shifting the short -run aggregate supply curve to the left. Conversely, a decline in commodity prices reduces production costs, leading to an increase in the quantity supplied at any given aggregate price level and a rightward shift of the short -run aggregate supply curve. 182 Almost every good purchased today has a UPC barcode on it, which allows stores to scan and track merchandise with great speed. Why isn’t the influence of commodity prices already captured by the short -run aggregate supply curve? Because commodities—unlike, say, soft drinks—are not a final good, their prices are not included in the calculation of the aggregate price level. Furthermore, commodities represent a significant cost of production to most suppliers, just like nominal wages do. So changes in commodity prices have large impacts on production costs. And in contrast to noncommodities, the prices of commodities can sometimes change drastically due to industry -specific shocks to supply—such as wars in the Middle East or rising Chinese demand that leaves less oil for the United States. Changes in Nominal Wages At any given point in time, the dollar wages of many workers are fixed because they are set by contracts or informal agreements made in the past. Nominal wages can change, however, once enough time has passed for contracts and informal agreements to be renegotiated. Suppose, for example, that there is an economy -wide rise in the cost of health care insurance premiums paid by employers as part of employees’ wages. From the employers’ perspective, this is equivalent to a rise in nominal wages because it is an increase in employer -paid compensation. So this rise in nominal wages increases production costs and shifts the short -run aggregate supply curve to the left. Conversely, suppose there is an economy -wide fall in the cost of such
premiums. This is equivalent to a fall in nominal wages from the point of view of employers; it reduces production costs and shifts the short -run aggregate supply curve to the right. Signs of the times: high oil prices caused high gasoline prices in 2008 An important historical fact is that during the 1970s, the surge in the price of oil had the indirect effect of also raising nominal wages. This “knock -on” effect occurred because many wage contracts included cost -of -living allowances that automatically raised the nominal wage when consumer prices increased. Through this channel, the surge in the price of oil—which led to an increase in overall consumer prices—ultimately caused a rise in nominal wages. So the economy, in the end, experienced two leftward shifts of the aggregate supply curve: the first generated by the initial surge in the price of oil, the second generated by the induced increase in nominal wages. The negative effect on the economy of rising oil prices was greatly magnified through the cost -of -living allowances in wage contracts. Today, cost -of -living allowances in wage contracts are rare. Changes in Productivity An increase in productivity means that a worker can produce more units of output with the same quantity of inputs. For example, the introduction of bar -code scanners in retail stores greatly increased the ability of a single worker to stock, inventory, and resupply store shelves. As a result, the cost to a store of “producing” a dollar of sales fell and profit rose. And, correspondingly, the quantity supplied increased. (Think of Walmart and the increase in the number of its stores as an increase in aggregate supply.) So a rise in productivity, whatever the source, increases producers’ profits and shifts the short -run aggregate supply curve to the right. Conversely, a fall in productivity—say, due to new regulations that require workers to spend more time filling out forms—reduces the number of units of output a worker can produce with the same quantity of inputs 183 Consequently, the cost per unit of output rises, profit falls, and quantity supplied falls. This shifts the short -run aggregate supply curve to the left. For a summary of the factors that shift the short -run aggregate supply curve, see Table 18.1. t a b l e 18.1 Factors that Shift the Short -Run Aggregate Supply Curve Changes in commodity prices Changes in nominal wages Changes in productivity If commodity prices fall,...... short - run aggregate supply increases. If commodity
prices rise,...... short - run aggregate supply decreases. If nominal wages fall,...... short - run aggregate supply increases. If nominal wages rise,...... short - run aggregate supply decreases. If workers become more productive,...... short - run aggregate supply increases. If workers become less productive,...... short - run aggregate supply decreases. The Long-Run Aggregate Supply Curve We’ve just seen that in the short run, a fall in the aggregate price level leads to a decline in the quantity of aggregate output supplied. This is the result of nominal wages that are sticky in the short run. But as we mentioned earlier, contracts and informal agreements are renegotiated in the long run. So in the long run, nominal wages—like the aggregate price level—are flexible, not sticky. Wage flexibility greatly alters the long -run relationship between the aggregate price level and aggregate supply. In fact, in the long run the aggregate price level has no effect on the quantity of aggregate output supplied. To see why, let’s conduct a thought experiment. Imagine that you could wave a magic wand—or maybe a magic bar -code scanner—and cut all prices in the economy in half at the same time. By “all prices” we mean the prices of all inputs, including nominal wages, as well as the prices of final goods and services. What would happen to aggregate output, given that the aggregate price level has been halved and all input prices, including nominal wages, have been halved? The answer is: nothing. Consider Equation 18-1 again: each producer would receive a lower price for its product, but costs would fall by the same proportion. As a result, every unit of output profitable to produce before the change in prices would still be profitable to produce after the change in prices. So a halving of all prices in the economy has no effect on the economy’s aggregate output. In other words, changes in the aggregate price level now have no effect on the quantity of aggregate output supplied. In reality, of course, no one can change all prices by the same proportion at the same time. But now, we’ll consider the long run, the period of time over which all prices are fully flexible. In the long run, inflation or deflation has the same effect as someone changing all prices by the same proportion. As a result, changes in the aggregate price
level do not change the quantity of aggregate output supplied in the long run. That’s because changes in the aggregate price level will, in the long run, be accompanied by equal proportional changes in all input prices, including nominal wages. The long -run aggregate supply curve, illustrated in Figure 18.3 by the curve LRAS, shows the relationship between the aggregate price level and the quantity of aggregate The long -run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. 184 18.3 The Long -Run Aggregate Supply Curve The long -run aggregate supply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP, because in the long run a change in the aggregate price level has no effect on the quantity of aggregate output supplied. Aggregate price level (GDP deflator, 2005 = 100) 15.0 A fall in the aggregate price level… 7.5 0 Long-run aggregate supply curve, LRAS …leaves the quantity of aggregate output supplied unchanged in the long run. Potential output, YP $800 Real GDP (billions of 2005 dollars output supplied that would exist if all prices, including nominal wages, were fully flexible. The long -run aggregate supply curve is vertical because changes in the aggregate price level have no effect on aggregate output in the long run. At an aggregate price level of 15.0, the quantity of aggregate output supplied is $800 billion in 2005 dollars. If the aggregate price level falls by 50% to 7.5, the quantity of aggregate output supplied is unchanged in the long run at $800 billion in 2005 dollars. It’s important to understand not only that the LRAS curve is vertical but also that its position along the horizontal axis marks an important benchmark for output. The horizontal intercept in Figure 18.3, where LRAS touches the horizontal axis ($800 billion in 2005 dollars), is the economy’s potential output, YP: the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. In reality, the actual level of real GDP is almost always either above or below potential output. We’ll see why later, when we discuss the AD–AS model. Still, an economy’s potential output is an important number because it defines the trend around which actual aggregate output fluctuates from year to
year. In the United States, the Congressional Budget Office, or CBO, estimates annual potential output for the purpose of federal budget analysis. In Figure 18.4 on the next page, the CBO’s estimates of U.S. potential output from 1989 to 2009 are represented by the black line and the actual values of U.S. real GDP over the same period are represented by the blue line. Years shaded purple on the horizontal axis correspond to periods in which actual aggregate output fell short of potential output, years shaded green to periods in which actual aggregate output exceeded potential output. As you can see, U.S. potential output has risen steadily over time—implying a series of rightward shifts of the LRAS curve. What has caused these rightward shifts? The answer lies in the factors related to long -run growth: ■ increases in the quantity of resources, including land, labor, capital, and entrepreneurship ■ increases in the quality of resources, as with a better-educated workforce ■ technological progress Over the long run, as the size of the labor force and the productivity of labor both rise, for example, the level of real GDP that the economy is capable of producing also Potential output is the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible 185 f i g u r e 18.4 Actual and Potential Output from 1989 to 2009 Real GDP (billions of 2005 dollars) $14,000 13,000 12,000 11,000 10,000 9,000 8,000 7,000 6,000 Actual aggregate output exceeds potential output. Potential output exceeds actual aggregate output. Actual aggregate output roughly equals potential output. Potential output Actual aggregate output 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Year This figure shows the performance of actual and potential output in the United States from 1989 to 2009. The black line shows estimates, produced by the Congressional Budget Office, of U.S. potential output, and the blue line shows actual aggregate output. The purple -shaded years are periods in which actual aggregate output fell below potential output, and the green -shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after 2000—particularly during the recession that began in 2007. Actual aggregate output was significantly above potential output in the boom of the late 1990s. Source: Congressional Budget Office; Bureau of Economic
Analysis. rises. Indeed, one way to think about long -run economic growth is that it is the growth in the economy’s potential output. We generally think of the long -run aggregate supply curve as shifting to the right over time as an economy experiences long run growth. From the Short Run to the Long Run As you can see in Figure 18.4, the economy normally produces more or less than potential output: actual aggregate output was below potential output in the early 1990s, above potential output in the late 1990s, and below potential output for most of the 2000s. So the economy is normally on its short -run aggregate supply curve—but not on its long -run aggregate supply curve. Why, then, is the long -run curve relevant? Does the economy ever move from the short run to the long run? And if so, how? The first step to answering these questions is to understand that the economy is always in one of only two states with respect to the short -run and long -run aggregate supply curves. It can be on both curves simultaneously by being at a point where the curves cross (as in the few years in Figure 18.4 in which actual aggregate output and potential output roughly coincided). Or it can be on the short -run aggregate supply curve but not the long -run aggregate supply curve (as in the years in which actual aggregate output and potential output did not coincide). But that is not the end of the story. If the economy is on the short -run but not the long -run aggregate supply curve, the short -run aggregate supply curve will shift over time until the economy is at a 186 18.5 From the Short Run to the Long Run Aggregate price level P1 (a) Leftward Shift of the Short-Run Aggregate Supply Curve (b) Rightward Shift of the Short-Run Aggregate Supply Curve LRAS SRAS2 Aggregate price level LRAS SRAS1 A1 SRAS1 A rise in nominal wages shifts SRAS leftward. A1 P1 SRAS2 A fall in nominal wages shifts SRAS rightward YP Y1 Real GDP Y1 YP Real GDP In panel (a), the initial short -run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short -run aggregate supply curve from
SRAS1 to SRAS2. In panel (b), the reverse happens: at the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. High unemployment eventually leads to a fall in nominal wages over time and a rightward shift of the short -run aggregate supply curve. point where both curves cross—a point where actual aggregate output is equal to potential output. Figure 18.5 illustrates how this process works. In both panels LRAS is the long -run aggregate supply curve, SRAS1 is the initial short -run aggregate supply curve, and the aggregate price level is at P1. In panel (a) the economy starts at the initial production point, A1, which corresponds to a quantity of aggregate output supplied, Y1, that is higher than potential output, YP. Producing an aggregate output level (such as Y1) that is higher than potential output (YP) is possible only because nominal wages haven’t yet fully adjusted upward. Until this upward adjustment in nominal wages occurs, producers are earning high profits and producing a high level of output. But a level of aggregate output higher than potential output means a low level of unemployment. Because jobs are abundant and workers are scarce, nominal wages will rise over time, gradually shifting the short -run aggregate supply curve leftward. Eventually, it will be in a new position, such as SRAS2. (Later, we’ll show where the short -run aggregate supply curve ends up. As we’ll see, that depends on the aggregate demand curve as well.) In panel (b), the initial production point, A1, corresponds to an aggregate output level, Y1, that is lower than potential output, YP. Producing an aggregate output level (such as Y1) that is lower than potential output (YP) is possible only because nominal wages haven’t yet fully adjusted downward. Until this downward adjustment occurs, producers are earning low (or negative) profits and producing a low level of output. An aggregate output level lower than potential output means high unemployment. Because workers are abundant and jobs are scarce, nominal wages will fall over time, shifting the short -run aggregate supply curve gradually to the right. Eventually, it will be in a new position, such as SRAS2. We’ll see shortly that these shifts of the short -run aggregate supply curve will return the economy to potential output in the long run 187 fyi Prices and Output During the Great Depression
The figure shows the actual track of the aggregate price level, as measured by the GDP deflator, and real GDP, from 1929 to 1942. As you can see, aggregate output and the aggregate price level fell together from 1929 to 1933 and rose together from 1933 to 1937. Aggregate price level (GDP deflator, 2005 = 100) 11 10 9 8 0 1929 1930 1942 1931 1937 1939 1938 1941 1940 1932 1933 1936 1935 1934 800 1,000 1,200 1,400 1,600 Real GDP (billions of 2005 dollars) This is what we’d expect to see if the economy were moving down the short -run aggregate supply curve from 1929 to 1933 and moving up it (with a brief reversal in 1937–1938) thereafter. But even in 1942 the aggregate price level was still lower than it was in 1929; yet real GDP was much higher. What happened? The answer is that the short -run aggregate supply curve shifted to the right over time. This shift partly reflected rising productivity— a rightward shift of the underlying long -run aggregate supply curve. But since the U.S. economy was producing below potential output and had high unemployment during this period, the rightward shift of the short -run aggregate supply curve also reflected the adjustment process shown in panel (b) of Figure 18.5. So the movement of aggregate output from 1929 to 1942 reflected both movements along and shifts of the short -run aggregate supply curve. M o d u l e 18 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Determine the effect on short -run aggregate supply of each of 2. Suppose the economy is initially at potential output and the the following events. Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve. a. A rise in the consumer price index (CPI) leads producers to increase output. b. A fall in the price of oil leads producers to increase output. c. A rise in legally mandated retirement benefits paid to workers leads producers to reduce output. quantity of aggregate output supplied increases. What information would you need to determine whether this was due to a movement along the SRAS curve or a shift of the LRAS curve? Tackle the Test: Multiple-Choice Questions 1. Which of the following will shift the short-run aggregate supply curve? A change in a. profit per unit at any given price level. b. commodity prices. c. nominal wages. d. productivity
. e. all of the above 188. Because changes in the aggregate price level have no effect on 4. A decrease in which of the following will cause the short-run aggregate output in the long run, the long-run aggregate supply curve is a. vertical. b. horizontal. c. d. negatively sloped. e. positively sloped. fixed. aggregate supply curve to shift to the left? a. commodity prices b. the cost of health care insurance premiums paid by employers c. nominal wages d. productivity e. the use of cost-of-living allowances in labor contracts 3. The horizontal intercept of the long-run aggregate supply 5. That employers are reluctant to decrease nominal wages curve is a. at the origin. b. negative. c. at potential output. d. equal to the vertical intercept. e. always the same as the horizontal intercept of the short-run aggregate supply curve. during economic downturns and raise nominal wages during economic expansions leads nominal wages to be described as a. long-run. b. unyielding. flexible. c. d. real. e. sticky. Tackle the Test: Free-Response Questions 1. a. Draw a correctly labeled graph illustrating a long-run 2. a. Draw a correctly labeled short-run aggregate supply curve. aggregate supply curve. b. On your graph from part a, illustrate a decrease in short-run b On your graph from part a, label potential output. c. On your graph from part a, illustrate an increase in long-run aggregate supply. d. What could have caused the change you illustrated in part c? List three possible causes. aggregate supply. c. List three types of changes, including the factor that changes and the direction of the change, that could lead to a decrease in aggregate supply Answer (8 points) Aggregate price level LRAS1 LRAS2 YP1 YP2 Real GDP 1 point: Vertical axis labeled “Aggregate price level” (or “Price level”) 1 point: Horizontal axis labeled “Real GDP” 1 point: Vertical curve labeled “LRAS” (or “LRAS1”) 1 point: Potential output labeled YP (or YP 1) on horizontal axis at intercept of long-run aggregate supply curve 1 point: Long-run aggregate supply curve shifted to the right 1 point: An increase in the quantity of resources (land, labor, capital, or entrepreneurship) 1 point: An
increase in the quality of resources 1 point: Technological progress 189 What you will learn in this Module: • The difference between short-run and long-run macroeconomic equilibrium • The causes and effects of demand shocks and supply shocks • How to determine if an economy is experiencing a recessionary gap or an inflationary gap and how to calculate the size of output gaps In the AD–AS model, the aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations. The economy is in short -run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short -run equilibrium aggregate price level is the aggregate price level in the short -run macroeconomic equili brium. Short -run equilibrium aggregate output is the quantity of aggregate output produced in the short -run macroeconomic equilibrium. Module 19 Equilibrium in the Aggregate Demand–Aggregate Supply Model The AD–AS Model From 1929 to 1933, the U.S. economy moved down the short -run aggregate supply curve as the aggregate price level fell. In contrast, from 1979 to 1980, the U.S. economy moved up the aggregate demand curve as the aggregate price level rose. In each case, the cause of the movement along the curve was a shift of the other curve. In 1929–1933, it was a leftward shift of the aggregate demand curve—a major fall in consumer spending. In 1979–1980, it was a leftward shift of the short -run aggregate supply curve—a dramatic fall in short -run aggregate supply caused by the oil price shock. So to understand the behavior of the economy, we must put the aggregate supply curve and the aggregate demand curve together. The result is the AD–AS model, the basic model we use to understand economic fluctuations. Short-Run Macroeconomic Equilibrium We’ll begin our analysis by focusing on the short run. Figure 19.1 shows the aggregate demand curve and the short -run aggregate supply curve on the same diagram. The point at which the AD and SRAS curves intersect, ESR, is the short -run macroeconomic equilibrium: the point at which the quantity of aggregate output supplied is equal to the quantity demanded by domestic households, businesses, the government, and the rest of the world. The aggregate price level at ESR, PE, is the short -run equilibrium aggregate price level. The level of aggregate output at ESR, YE, is the short -run equilibrium aggregate output. 190 19.1 The AD–
AS Model The AD–AS model combines the aggregate demand curve and the short -run aggregate supply curve. Their point of intersection, ESR, is the point of short -run macroeconomic equilibrium where the quantity of aggregate output demanded is equal to the quantity of aggregate output supplied. PE is the short -run equilibrium aggregate price level, and YE is the short run equilibrium level of aggregate output. Aggregate price level PE SRAS ESR Short-run macroeconomic equilibrium AD YE Real GDP We have seen that a shortage of any individual good causes its market price to rise and a surplus of the good causes its market price to fall. These forces ensure that the market reaches equilibrium. The same logic applies to short -run macroeconomic equilibrium. If the aggregate price level is above its equilibrium level, the quantity of aggregate output supplied exceeds the quantity of aggregate output demanded. This leads to a fall in the aggregate price level and pushes it toward its equilibrium level. If the aggregate price level is below its equilibrium level, the quantity of aggregate output supplied is less than the quantity of aggregate output demanded. This leads to a rise in the aggregate price level, again pushing it toward its equilibrium level. In the discussion that follows, we’ll assume that the economy is always in short -run macroeconomic equilibrium. We’ll also make another important simplification based on the observation that in reality there is a long -term upward trend in both aggregate output and the aggregate price level. We’ll assume that a fall in either variable really means a fall compared to the long -run trend. For example, if the aggregate price level normally rises 4% per year, a year in which the aggregate price level rises only 3% would count, for our purposes, as a 1% decline. In fact, since the Great Depression there have been very few years in which the aggregate price level of any major nation actually declined—Japan’s period of deflation from 1995 to 2005 is one of the few exceptions (which we will explain later). There have, however, been many cases in which the aggregate price level fell relative to the long -run trend. The short -run equilibrium aggregate output and the short -run equilibrium aggregate price level can change because of shifts of either the AD curve or the SRAS curve. Let’s look at each case in turn. Shifts of Aggregate Demand: Short-Run Effects An event that shifts the aggregate demand curve, such as a change in expectations or wealth, the effect of the size
of the existing stock of physical capital, or the use of fiscal or monetary policy, is known as a demand shock. The Great Depression was caused by a negative demand shock, the collapse of wealth and of business and consumer confidence that followed the stock market crash of 1929 and the banking crises of 1930–1931. The Depression was ended by a positive demand shock—the huge increase An event that shifts the aggregate demand curve is a demand shock 191 © in government purchases during World War II. In 2008, the U.S. economy experienced another significant negative demand shock as the housing market turned from boom to bust, leading consumers and firms to scale back their spending. Figure 19.2 shows the short -run effects of negative and positive demand shocks. A negative demand shock shifts the aggregate demand curve, AD, to the left, from AD1 to AD2, as shown in panel (a). The economy moves down along the SRAS curve from E1 to E2, leading to lower short-run equilibrium aggregate output and a lower short-run equilibrium aggregate price level. A positive demand shock shifts the aggregate demand curve, AD, to the right, as shown in panel (b). Here, the economy moves up along the SRAS curve, from E1 to E2. This leads to higher short-run equilibrium aggregate output and a higher shortrun equilibrium aggregate price level. Demand shocks cause aggregate output and the aggregate price level to move in the same direction. f i g u r e 19.2 Demand Shocks (a) A Negative Demand Shock (b) A Positive Demand Shock Aggregate price level Aggregate price level A negative demand shock... SRAS A positive demand shock... SRAS P1 P2 E1...leads to a lower aggregate price level and lower aggregate output. E2 P2 P1 E2...leads to a higher aggregate price level and higher aggregate output. E1 AD1 AD2 Y2 Y1 Real GDP AD2 AD1 Y2 Y1 Real GDP A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (a), a negative demand shock shifts the aggregate demand curve leftward from AD1 to AD2, reducing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2. In panel (b), a positive demand shock shifts the aggregate demand curve rightward, increasing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2
. Shifts of the SRAS Curve An event that shifts the short -run aggregate supply curve, such as a change in commodity prices, nominal wages, or productivity, is known as a supply shock. A negative supply shock raises production costs and reduces the quantity producers are willing to supply at any given aggregate price level, leading to a leftward shift of the short -run aggregate supply curve. The U.S. economy experienced severe negative supply shocks following disruptions to world oil supplies in 1973 and 1979. In contrast, a positive supply shock reduces production costs and increases the quantity supplied at any given aggregate price level, leading to a rightward shift of the short -run aggregate supply curve. The United States experienced a positive supply shock between 1995 and 2000, when the increasing use of the Internet and other information technologies caused productivity growth to surge. An event that shifts the short -run aggregate supply curve is a supply shock. 192 The effects of a negative supply shock are shown in panel (a) of Figure 19.3. The initial equilibrium is at E1, with aggregate price level P1 and aggregate output Y1. The disruption in the oil supply causes the short -run aggregate supply curve to shift to the left, from SRAS1 to SRAS2. As a consequence, aggregate output falls and the aggregate price level rises, an upward movement along the AD curve. At the new equilibrium, E2, the short-run equilibrium aggregate price level, P2, is higher, and the short-run equilibrium aggregate output level, Y2, is lower than before The combination of inflation and falling aggregate output shown in panel (a) has a special name: stagflation, for “stagnation plus inflation.” When an economy experiences stagflation, it’s very unpleasant: falling aggregate output leads to rising unemployment, and people feel that their purchasing power is squeezed by rising prices. Stagflation in the 1970s led to a mood of national pessimism. It also, as we’ll see shortly, poses a dilemma for policy makers. A positive supply shock, shown in panel (b), has exactly the opposite effects. A rightward shift of the SRAS curve, from SRAS1 to SRAS2 results in a rise in aggregate output and a fall in the aggregate price level, a downward movement along the AD curve. The favorable supply shocks of the late 1990s led to a combination of full employment and declining inflation. That is, the aggregate price level fell compared with the long -run
trend. This combination produced, for a time, a great wave of national optimism. The distinctive feature of supply shocks, both negative and positive, is that, unlike demand shocks, they cause the aggregate price level and aggregate output to move in opposite directions. f i g u r e 19.3 Supply Shocks Producers are vulnerable to dramatic changes in the price of oil, a cause of supply shocks. Stagflation is the combination of inflation and stagnating (or falling) aggregate output. Aggregate price level P2 P1 (a) A Negative Supply Shock (b) A Positive Supply Shock Aggregate price level P1 P2 A negative supply shock... SRAS2 SRAS1 E2 E1...leads to lower aggregate output and a higher aggregate price level. AD A positive supply shock... E1 E2 SRAS1 SRAS2...leads to higher aggregate output and a lower aggregate price level. AD Y2 Y1 Real GDP Y1 Y2 Real GDP A supply shock shifts the short -run aggregate supply curve, moving the aggregate price level and aggregate output in opposite directions. Panel (a) shows a negative supply shock, which shifts the short -run aggregate supply curve leftward and causes stagflation— lower aggregate output and a higher aggregate price level. Here the short -run aggregate supply curve shifts from SRAS1 to SRAS2, and the economy moves from E1 to E2. The aggregate price level rises from P1 to P2, and aggregate output falls from Y1 to Y2. Panel (b) shows a positive supply shock, which shifts the short -run aggregate supply curve rightward, generating higher aggregate output and a lower aggregate price level. The short -run aggregate supply curve shifts from SRAS1 to SRAS2, and the economy moves from E1 to E2. The aggregate price level falls from P1 to P2, and aggregate output rises from Y1 to Y2 193 The economy is in long -run macroeconomic equilibrium when the point of short -run macroeconomic equilibrium is on the long -run aggregate supply curve. There’s another important contrast between supply shocks and demand shocks. As we’ve seen, monetary policy and fiscal policy enable the government to shift the AD curve, meaning that governments are in a position to create the kinds of shocks shown in Figure 19.2. It’s much harder for governments to shift the AS curve. Are there good policy reasons to shift the AD curve? We’
ll turn to that question soon. First, however, let’s look at the difference between short -run macroeconomic equilibrium and long run macroeconomic equilibrium. Long-Run Macroeconomic Equilibrium Figure 19.4 combines the aggregate demand curve with both the short -run and long run aggregate supply curves. The aggregate demand curve, AD, crosses the short -run aggregate supply curve, SRAS, at ELR. Here we assume that enough time has elapsed that the economy is also on the long -run aggregate supply curve, LRAS. As a result, ELR is at the intersection of all three curves—SRAS, LRAS, and AD. So short -run equilibrium aggregate output is equal to potential output, YP. Such a situation, in which the point of short -run macroeconomic equilibrium is on the long -run aggregate supply curve, is known as long -run macroeconomic equilibrium. To see the significance of long -run macroeconomic equilibrium, let’s consider what happens if a demand shock moves the economy away from long -run macroeconomic equilibrium. In Figure 19.5, we assume that the initial aggregate demand curve is AD1 and the initial short -run aggregate supply curve is SRAS1. So the initial macroeconomic equilibrium is at E1, which lies on the long -run aggregate supply curve, LRAS. The economy, then, starts from a point of short -run and long -run macroeconomic equilibrium, and short -run equilibrium aggregate output equals potential output at Y1. Now suppose that for some reason—such as a sudden worsening of business and consumer expectations—aggregate demand falls and the aggregate demand curve shifts leftward to AD2. This results in a lower equilibrium aggregate price level at P2 and a lower equilibrium aggregate output level at Y2 as the economy settles in the short run at E2. The short -run effect of such a fall in aggregate demand is what the f i g u r e 19.4 Long -Run Macroeconomic Equilibrium Here the point of short -run macroeconomic equilibrium also lies on the long run aggregate supply curve, LRAS. As a result, short -run equilibrium aggregate output is equal to potential output, YP. The economy is in long -run macroeconomic equilibrium at ELR. Aggregate price level PE LRAS SRAS ELR Long-run macroeconomic equilibrium AD Real GDP YP Potential output 194 Aggregate price level 2. …reduces the aggregate price level and aggregate output and leads to higher
unemployment in the short run… LRAS SRAS1 SRAS2 1. An initial negative demand shock… E2 P1 P2 P3 E1 E3 AD2 3. …until an eventual fall in nominal wages in the long run increases short-run aggregate supply and moves the economy back to potential output. AD1 Y2 Y1 Potential output Recessionary gap Real GDP 19.5 Short -Run Versus Long -Run Effects of a Negative Demand Shock In the long run the economy is self -correcting: demand shocks have only a short -run effect on aggregate output. Starting at E1, a negative demand shock shifts AD1 leftward to AD2. In the short run the economy moves to E2 and a recessionary gap arises: the aggregate price level declines from P1 to P2, aggregate output declines from Y1 to Y2, and unemployment rises. But in the long run nominal wages fall in response to high unemployment at Y2, and SRAS1 shifts rightward to SRAS2. Aggregate output rises from Y2 to Y1, and the aggregate price level declines again, from P2 to P3. Long -run macroeconomic equilibrium is eventually restored at E3. There is a recessionary gap when aggregate output is below potential output. U.S. economy experienced in 1929–1933: a falling aggregate price level and falling aggregate output. Aggregate output in this new short -run equilibrium, E2, is below potential output. When this happens, the economy faces a recessionary gap. A recessionary gap inflicts a great deal of pain because it corresponds to high unemployment. The large recessionary gap that had opened up in the United States by 1933 caused intense social and political turmoil. And the devastating recessionary gap that opened up in Germany at the same time played an important role in Hitler’s rise to power. But this isn’t the end of the story. In the face of high unemployment, nominal wages eventually fall, as do any other sticky prices, ultimately leading producers to increase output. As a result, a recessionary gap causes the short -run aggregate supply curve to gradually shift to the right. This process continues until SRAS1 reaches its new position at SRAS2, bringing the economy to equilibrium at E3, where AD2, SRAS2, and LRAS all intersect. At E3, the economy is back in long -run macroeconomic equilibrium; it is back at potential output Y1 but at a lower
aggregate price level, P3, reflecting a long -run fall in the aggregate price level. The economy is self -correcting in the long run. What if, instead, there was an increase in aggregate demand? The results are shown in Figure 19.6 on the next page, where we again assume that the initial aggregate demand curve is AD1 and the initial short -run aggregate supply curve is SRAS1, so that the initial macroeconomic equilibrium, at E1, lies on the long -run aggregate supply curve, LRAS. Initially, then, the economy is in long -run macroeconomic equilibrium. Now suppose that aggregate demand rises, and the AD curve shifts rightward to AD2. This results in a higher aggregate price level, at P2, and a higher aggregate output level, at Y2, as the economy settles in the short run at E2. Aggregate output in this new short -run equilibrium is above potential output, and unemployment is low in order to 195 Aggregate price level P3 P2 P1 f i g u r e 19.6 Short -Run Versus Long -Run Effects of a Positive Demand Shock Starting at E1, a positive demand shock shifts AD1 rightward to AD2, and the economy moves to E2 in the short run. This results in an inflationary gap as aggregate output rises from Y1 to Y2, the aggregate price level rises from P1 to P2, and unemployment falls to a low level. In the long run, SRAS1 shifts leftward to SRAS2 as nominal wages rise in response to low unemployment at Y2. Aggregate output falls back to Y1, the aggregate price level rises again to P3, and the economy self -corrects as it returns to long -run macro economic equilibrium at E3. 1. An initial positive demand shock… LRAS 3. …until an eventual rise in nominal wages in the long run reduces short-run aggregate supply and moves the economy back to potential output. SRAS2 SRAS1 E3 E1 E2 AD1 AD2 2. …increases the aggregate price level and aggregate output and reduces unemployment in the short run… Potential output Y1 Y2 Inflationary gap Real GDP There is an inflationary gap when aggregate output is above potential output. The output gap is the percentage difference between actual aggregate output and potential output. The economy is self -correcting when shocks to aggregate demand affect aggregate output in the short run, but not the
long run. produce this higher level of aggregate output. When this happens, the economy experiences an inflationary gap. As in the case of a recessionary gap, this isn’t the end of the story. In the face of low unemployment, nominal wages will rise, as will other sticky prices. An inflationary gap causes the short -run aggregate supply curve to shift gradually to the left as producers reduce output in the face of rising nominal wages. This process continues until SRAS1 reaches its new position at SRAS2, bringing the economy into equilibrium at E3, where AD2, SRAS2, and LRAS all intersect. At E3, the economy is back in long -run macroeconomic equilibrium. It is back at potential output, but at a higher price level, P3, reflecting a long -run rise in the aggregate price level. Again, the economy is self -correcting in the long run. To summarize the analysis of how the economy responds to recessionary and inflationary gaps, we can focus on the output gap, the percentage difference between actual aggregate output and potential output. The output gap is calculated as follows: (19-1) Output gap = Actual aggregate output − Potential output Potential output × 100 Our analysis says that the output gap always tends toward zero. If there is a recessionary gap, so that the output gap is negative, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero. If there is an inflationary gap, so that the output gap is positive, nominal wages eventually rise, also moving the economy back to potential output and again bringing the output gap back to zero. So in the long run the economy is self -correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run. 196 fyi Let’s get specific. Officially there have been twelve recessions in the United States since World War II. However, two of these, in 1979– 1980 and 1981–1982, are often treated as a single “double -dip” recession, bringing the total number down to 11. Of these 11 recessions, only two—the recession of 1973–1975 and the double -dip recession of 1979–1982—showed the distinctive combination of falling aggregate output and a surge in the price level that we call stagflation. In each case, the cause of the supply shock was political turmoil in the Middle East—the Arab–Israeli war of 1973
and the Iranian revolution of 1979—that disrupted world oil supplies and sent oil prices skyrocketing. In fact, economists sometimes refer to the two slumps as “OPEC I” and “OPEC II,” after the Organization of Petroleum Exporting Countries, the world oil cartel. A third recession that began Supply Shocks Versus Demand Shocks in Practice How often do supply shocks and demand shocks, respectively, cause recessions? The verdict of most, though not all, macroeconomists is that recessions are mainly caused by demand shocks. But when a negative supply shock does happen, the resulting recession tends to be particularly severe. in December 2007, and that had lasted for almost two years by the time this book went to press, was at least partially caused by a spike in oil prices. So 8 of 11 postwar recessions were purely the result of demand shocks, not supply shocks. The few supply -shock recessions, however, were the worst as measured by the unemployment rate. The figure shows the U.S. unemployment rate since 1948, with the dates of the 1973 Arab–Israeli war, the 1979 Iranian revolution, and the 2007 oil price shock marked on the graph. The three highest unemployment rates since World War II came after these big negative supply shocks. There’s a reason the aftermath of a supply shock tends to be particularly severe for the economy: macroeconomic policy has a much harder time dealing with supply shocks than with demand shocks. 1979 Iranian revolution 1973 Arab–Israeli war 2007 Oil price shock Unemployment rate 12% 10 8 6 4 1948 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 (Bureau of Labor Statistics) Year M o d u l e 19 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Describe the short -run effects of each of the following shocks 2. A rise in productivity increases potential output, but some on the aggregate price level and on aggregate output. a. The government sharply increases the minimum wage, worry that demand for the additional output will be insufficient even in the long run. How would you respond? raising the wages of many workers. b. Solar energy firms launch a major program of investment spending. c. Congress raises taxes and cuts spending. d. Severe weather destroys crops around the world 197 Tackle the Test: Multiple-Choice Questions 1. Which of the following causes a negative supply shock? Refer to the graph for questions 4 and 5. I. a technological advance II
. increasing productivity III. an increase in oil prices a. I only b. II only c. III only d. I and III only I, II, and III e. 2. Which of the following causes a positive demand shock? a. an increase in wealth b. pessimistic consumer expectations c. a decrease in government spending d. an increase in taxes e. an increase in the existing stock of capital 3. During stagflation, what happens to the aggregate price level and real GDP? Aggregate price level a. decreases b. decreases c. increases d. increases e. stays the same Real GDP increases decreases increases decreases stays the same Aggregate price level P1 LRAS SRAS E AD Y1 Real GDP 4. Which of the following statements is true if this economy is operating at P1 and Y1? I. The level of aggregate output equals potential output. II. It is in short-run macroeconomic equilibrium. III. It is in long-run macroeconomic equilibrium. a. I only b. II only c. III only d. II and III I and III e. 5. The economy depicted in the graph is experiencing a(n) Tackle the Test: Free-Response Questions Aggregate price level SRAS LRAS a. contractionary gap. b. recessionary gap. c. inflationary gap. d. demand gap. e. supply gap. Answer (7 points) 1 point: Yes P1 E 1 point: The economy is in short-run equilibrium because it operates at the point where short-run aggregate supply and aggregate demand intersect. $1,000 1,200 Real GDP AD 1 point: No 1 point: Short-run equilibrium occurs at a level of aggregate output that is not equal to potential output 1 point: Inflationary gap Y1 1 point: [($1,200 − $1,000)/$1,000] × 100 = 20% 1. Refer to the graph above. a. Is the economy in short-run macroeconomic equilibrium? Explain. b. Is the economy in long-run macroeconomic equilibrium? Explain. c. What type of gap exists in this economy? d. Calculate the size of the output gap. e. What will happen to the size of the output gap in the long run? 1 point: It will approach zero 2. Draw a correctly labeled aggregate demand and aggregate supply graph illustrating an economy in long-run macroeconomic equilibrium. 198 What you will learn in this Module: • How the AD–AS
model is used to formulate macroeconomic policy • The rationale for stabilization policy • Why fiscal policy is an important tool for managing economic fluctuations • Which policies constitute expansionary fiscal policy and which constitute contractionary fiscal policy Stabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions. Module 20 Economic Policy and the Aggregate Demand–Aggregate Supply Model Macroeconomic Policy We’ve just seen that the economy is self correcting in the long run: it will eventually trend back to potential output. Most macroeconomists believe, however, that the process of self -correction typically takes a decade or more. In particular, if aggregate output is below potential output, the economy can suffer an extended period of depressed aggregate output and high unemployment before it returns to normal. This belief is the background to one of the most famous quotations in economics: John Maynard Keynes’s declaration, “In the long run we are all dead.” Economists usually interpret Keynes as having recommended that governments not wait for the economy to correct itself. Instead, it is argued by many economists, but not all, that the government should use fiscal policy to get the economy back to potential output in the aftermath of a shift of the aggregate demand curve. This is the rationale for active stabilization policy, which is the Some people use Keynesian economics as a synonym for left-wing economics—but the truth is that the ideas of John Maynard Keynes have been accepted across a broad range of the political spectrum 199 use of government policy to reduce the severity of recessions and rein in excessively strong expansions. Can stabilization policy improve the economy’s performance? As we saw in Figure 18.4, the answer certainly appears to be yes. Under active stabilization policy, the U.S. economy returned to potential output in 1996 after an approximately five year recessionary gap. Likewise, in 2001, it also returned to potential output after an approximately four -year inflationary gap. These periods are much shorter than the decade or more that economists believe it would take for the economy to self correct in the absence of active stabilization policy. However, as we’ll see shortly, the ability to improve the economy’s performance is not always guaranteed. It depends on the kinds of shocks the economy faces. Policy in the Face of Demand Shocks Imagine that the economy experiences a negative demand shock, like the one shown by the shift from AD1 to AD2 in Figure 19.5. Monetary and
fiscal policy shift the aggregate demand curve. If policy makers react quickly to the fall in aggregate demand, they can use monetary or fiscal policy to shift the aggregate demand curve back to the right. And if policy were able to perfectly anticipate shifts of the aggregate demand curve and counteract them, it could short -circuit the whole process shown in Figure 19.5. Instead of going through a period of low aggregate output and falling prices, the government could manage the economy so that it would stay at E1. Why might a policy that short -circuits the adjustment shown in Figure 19.5 and maintains the economy at its original equilibrium be desirable? For two reasons: First, the temporary fall in aggregate output that would happen without policy intervention is a bad thing, particularly because such a decline is associated with high unemployment. Second, price stability is generally regarded as a desirable goal. So preventing deflation—a fall in the aggregate price level—is a good thing. Does this mean that policy makers should always act to offset declines in aggregate demand? Not necessarily. As we’ll see, some policy measures to increase aggregate demand, especially those that increase budget deficits, may have long - term costs in terms of lower long -run growth. Furthermore, in the real world policy makers aren’t perfectly informed, and the effects of their policies aren’t perfectly predictable. This creates the danger that stabilization policy will do more harm than good; that is, attempts to stabilize the economy may end up creating more instability. We’ll describe the long running debate over macroeconomic policy in later modules. Despite these qualifications, most economists believe that a good case can be made for using macroeconomic policy to offset major negative shocks to the AD curve. Should policy makers also try to offset positive shocks to aggregate demand? It may not seem obvious that they should. After all, even though inflation may be a bad thing, isn’t more output and lower unemployment a good thing? Again, not necessarily. Most economists now believe that any short -run gains from an inflationary gap must be paid back later. So policy makers today usually try to offset positive as well as negative demand shocks. For reasons we’ll explain later, attempts to eliminate recessionary gaps and inflationary gaps usually rely on monetary rather than fiscal policy. For now, let’s explore how macroeconomic policy can respond to supply shocks. Responding to Supply Shocks In panel (a) of Figure 19.3 we showed the effects of a negative supply shock
: in the short run such a shock leads to lower aggregate output but a higher aggregate price level. As we’ve noted, policy makers can respond to a negative demand shock by using monetary and fiscal policy to return aggregate demand to its original level. But what can or should they do about a negative supply shock? In contrast to the case of a demand shock, there are no easy remedies for a supply shock. That is, there are no government policies that can easily counteract the 200 changes in production costs that shift the short-run aggregate supply curve. So the policy response to a negative supply shock cannot aim to simply push the curve that shifted back to its original position. And if you consider using monetary or fiscal policy to shift the aggregate demand curve in response to a supply shock, the right response isn’t obvious. Two bad things are happening simultaneously: a fall in aggregate output, leading to a rise in unemployment, and a rise in the aggregate price level. Any policy that shifts the aggregate demand curve helps one problem only by making the other worse. If the government acts to increase aggregate demand and limit the rise in unemployment, it reduces the decline in output but causes even more inflation. If it acts to reduce aggregate demand, it curbs inflation but causes a further rise in unemployment. It’s a trade -off with no good answer. In the end, the United States and other economically advanced nations suffering from the supply shocks of the 1970s eventually chose to stabilize prices even at the cost of higher unemployment. But being an economic policy maker in the 1970s, or in early 2008, meant facing even harder choices than usual In 2008, stagflation made for difficult policy choices for Federal Reserve Chairman Ben Bernanke fyi Is Stabilization Policy Stabilizing? We’ve described the theoretical rationale for stabilization policy as a way of responding to demand shocks. But does stabilization policy actually stabilize the economy? One way we might try to answer this question is to look at the long - term historical record. Before World War II, the U.S. government didn’t really have a stabilization policy, largely because macroeconomics as we know it didn’t exist, and there was no consensus about what to do. Since World War II, and especially since 1960, active stabilization policy has become standard practice. So here’s the question: has the economy actually become more stable since the government began trying to stabilize it? The answer is a qualified yes. It’s qualified because data from
the pre – World War II era are less reliable than more modern data. But there still seems to be a clear reduction in the size of economic fluctuations. The figure shows the number of unemployed as a percentage of the nonfarm labor force since 1890. (We focus on nonfarm workers because farmers, though they often suffer economic hardship, are rarely reported as un- employed.) Even ignoring the huge spike in unemployment during the Great Depression, unemployment seems to have varied a lot more before World War II than after. It’s also worth noticing that the peaks in postwar unemployment in 1975 and 1982 corresponded to major supply shocks—the kind of shock for which stabilization policy has no good answer. It’s possible that the greater stability of the economy reflects good luck rather than policy. But on the face of it, the evidence suggests that stabilization policy is indeed stabilizing. Source: C. Romer, “Spurious Volititility in Historical Unemployment Data,” Journal of Political Economy 94, no. 1 (1986): 1–37 (years 1890–1930); Bureau of Labor statistics (years 1931–2009). Great Depression (1929–1941) Unemployment rate 30% 25 20 15 10 5 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2009 Year 201 Fiscal Policy: The Basics Let’s begin with the obvious: modern governments spend a great deal of money and collect a lot in taxes. Figure 20.1 shows government spending and tax revenue as percentages of GDP for a selection of high -income countries in 2008. As you can see, the Swedish government sector is relatively large, accounting for more than half of the Swedish economy. The government of the United States plays a smaller role in the economy than those of Canada or most European countries. But that role is still sizable. As a result, changes in the federal budget—changes in government spending or in taxation—can have large effects on the American economy. f i g u r e 20.1 Government Spending and Tax Revenue for Some High -Income Countries in 2008 Government spending and tax revenue are represented as a percentage of GDP. Sweden has a particularly large government sector, representing nearly 60% of its GDP. The U.S. government sector, although sizable, is smaller than those of Canada and most European countries. Source: OECD (data for Japan is for year 2007). United States Japan Canada France Sweden 0 39% 32% 36% 33% 40% 40% Government spending Government tax revenue 53% 49% 53
% 56% 20 40 Government spending, tax revenue (percent of GDP) 60% To analyze these effects, we begin by showing how taxes and government spending affect the economy’s flow of income. Then we can see how changes in spending and tax policy affect aggregate demand. Taxes, Government Purchases of Goods and Services, Transfers, and Borrowing In the circular flow diagram discussed in Module 10, we showed the circular flow of income and spending in the economy as a whole. One of the sectors represented in that figure was the government. Funds flow into the government in the form of taxes and government borrowing; funds flow out in the form of government purchases of goods and services and government transfers to households. What kinds of taxes do Americans pay, and where does the money go? Figure 20.2 shows the composition of U.S. tax revenue in 2008. Taxes, of course, are required payments to the government. In the United States, taxes are collected at the national level by the federal government; at the state level by each state government; and at local levels by counties, cities, and towns. At the federal level, the main taxes are income taxes on both personal income and corporate profits as well as social insurance taxes, which we’ll explain shortly. At the state and local levels, the picture is more complex: these governments rely on a mix of sales taxes, property taxes, income taxes, and fees of various kinds. Overall, taxes on personal income and corporate profits accounted for 44% of total government revenue in 2008; social insurance taxes accounted for 27%; and a variety of other taxes, collected mainly at the state and local levels, accounted for the rest. 202 20.2 Sources of Tax Revenue in the United States, 2008 Personal income taxes, taxes on corporate profits, and social insurance taxes account for most government tax revenue. The rest is a mix of property taxes, sales taxes, and other sources of revenue. Source: Bureau of Economic Analysis. Personal income taxes, 37% Other taxes, 29% Social insurance taxes, 27% Corporate profit taxes, 7% Figure 20.3 shows the composition of 2008 total U.S. government spending, which takes two forms. One form is purchases of goods and services. This includes everything from ammunition for the military to the salaries of public schoolteachers (who are treated in the national accounts as providers of a service—education). The big items here are national defense and education. The large category labeled “Other goods and services�
� consists mainly of state and local spending on a variety of services, from police and firefighters to highway construction and maintenance. f i g u r e 20.3 Government Spending in the United States, 2008 The two types of government spending are purchases of goods and services and government transfers. The big items in government purchases are national defense and education. The big items in government transfers are Social Security and the Medicare and Medicaid health care programs. Source: Bureau of Economic Analysis. Other government transfers, 9% National defense, 13% Education, 16% Medicare and Medicaid, 20% Social Security, 15% Other goods and services, 27% The other form of government spending is government transfers, which are payments by the government to households for which no good or service is provided in return. In the modern United States, as well as in Canada and Europe, government transfers represent a very large proportion of the budget. Most U.S. government spending on transfer payments is accounted for by three big programs: ■ Social Security, which provides guaranteed income to older Americans, disabled Americans, and the surviving spouses and dependent children of deceased beneficiaries ■ Medicare, which covers much of the cost of health care for Americans over age 65 ■ Medicaid, which covers much of the cost of health care for Americans with low incomes 203 Government transfers on their way: Social Security checks are run through a printer at the U.S. Treasury printing facility in Philadelphia, Pennsylvania. The term social insurance is used to describe government programs that are intended to protect families against economic hardship. These include Social Security, Medicare, and Medicaid, as well as smaller programs such as unemployment insurance and food stamps. In the United States, social insurance programs are largely paid for with special, dedicated taxes on wages—the social insurance taxes we mentioned earlier. But how do tax policy and government spending affect the economy? The answer is that taxation and government spending have a strong effect on total aggregate spending in the economy. The Government Budget and Total Spending Let’s recall the basic equation of national income accounting: (20-1) GDP = C + I + G + X − IM The left -hand side of this equation is GDP, the value of all final goods and services produced in the economy. The right -hand side is aggregate spending, the total spending on final goods and services produced in the economy. It is the sum of consumer spending (C), investment spending (I), government purchases of goods and services (G), and the value of exports (X) minus the value of imports (IM).
It includes all the sources of aggregate demand. The government directly controls one of the variables on the right -hand side of Equation 20-1: government purchases of goods and services (G). But that’s not the only effect fiscal policy has on aggregate spending in the economy. Through changes in taxes and transfers, it also influences consumer spending (C) and, in some cases, investment spending (I). To see why the budget affects consumer spending, recall that disposable income, the total income households have available to spend, is equal to the total income they receive from wages, dividends, interest, and rent, minus taxes, plus government transfers. So either an increase in taxes or a decrease in government transfers reduces disposable income. And a fall in disposable income, other things equal, leads to a fall in consumer spending. Conversely, either a decrease in taxes or an increase in government transfers increases disposable income. And a rise in disposable income, other things equal, leads to a rise in consumer spending. The government’s ability to affect investment spending is a more complex story, which we won’t discuss in detail. The important point is that the government taxes profits, and changes in the rules that determine how much a business owes can increase or reduce the incentive to spend on investment goods. Because the government itself is one source of spending in the economy, and because taxes and transfers can affect spending by consumers and firms, the government can use changes in taxes or government spending to shift the aggregate demand curve. There are sometimes good reasons to shift the aggregate demand curve. In early 2008, there was bipartisan agreement that the U.S. government should act to prevent a fall in aggregate demand—that is, to move the aggregate demand curve to the right of where it would otherwise be. The 2008 stimulus package was a classic example of fiscal policy: the use of taxes, government transfers, or government purchases of goods and services to stabilize the economy by shifting the aggregate demand curve. Social insurance programs are government programs intended to protect families against economic hardship. Expansionary and Contractionary Fiscal Policy Why would the government want to shift the aggregate demand curve? Because it wants to close either a recessionary gap, created when aggregate output falls below potential output, or an inflationary gap, created when aggregate output exceeds potential output. 204 20.4 Expansionary Fiscal Policy Can Close a Recessionary Gap At E1 the economy is in short -run macroeconomic equilibrium where the aggregate demand curve, AD1, intersects the SRAS curve.
At E1, there is a recessionary gap of YP − Y1. An expansionary fiscal policy—an increase in government purchases of goods and services, a reduction in taxes, or an increase in government transfers— shifts the aggregate demand curve rightward. It can close the recessionary gap by shifting AD1 to AD2, moving the economy to a new short -run macroeconomic equilibrium, E2, which is also a long -run macroeconomic equilibrium. Aggregate price level LRAS SRAS P2 P1 E2 E1 AD2 AD1 Y1 YP Recessionary gap Potential output Real GDP Expansionary fiscal policy increases aggregate demand. Contractionary fiscal policy reduces aggregate demand. Figure 20.4 shows the case of an economy facing a recessionary gap. SRAS is the short -run aggregate supply curve, LRAS is the long -run aggregate supply curve, and AD1 is the initial aggregate demand curve. At the initial short -run macroeconomic equilibrium, E1, aggregate output is Y1, below potential output, YP. What the government would like to do is increase aggregate demand, shifting the aggregate demand curve rightward to AD2. This would increase aggregate output, making it equal to potential output. Fiscal policy that increases aggregate demand, called expansionary fiscal policy, normally takes one of three forms: ■ an increase in government purchases of goods and services ■ a cut in taxes ■ an increase in government transfers Figure 20.5 on the next page shows the opposite case—an economy facing an inflationary gap. At the initial equilibrium, E1, aggregate output is Y1, above potential output, YP. As we’ll explain later, policy makers often try to head off inflation by eliminating inflationary gaps. To eliminate the inflationary gap shown in Figure 20.5, fiscal policy must reduce aggregate demand and shift the aggregate demand curve leftward to AD2. This reduces aggregate output and makes it equal to potential output. Fiscal policy that reduces aggregate demand, called contractionary fiscal policy, is the opposite of expansionary fiscal policy. It is implemented by: ■ a reduction in government purchases of goods and services ■ an increase in taxes ■ a reduction in government transfers A classic example of contractionary fiscal policy occurred in 1968, when U.S. policy makers grew worried about rising inflation. President Lyndon Johnson imposed a temporary 10% surcharge on income taxes—everyone’s income taxes were increased by 10%. He also tried to scale back government purchases of goods and services
, which had risen dramatically because of the cost of the Vietnam War 205 f i g u r e 20.5 Contractionary Fiscal Policy Can Close an Inflationary Gap At E1 the economy is in short -run macroeconomic equilibrium where the aggregate demand curve, AD1, intersects the SRAS curve. At E1, there is an inflationary gap of Y1 − YP. A contractionary fiscal policy—such as reduced government purchases of goods and services, an increase in taxes, or a reduction in government transfers—shifts the aggregate demand curve leftward. It closes the inflationary gap by shifting AD1 to AD2, moving the economy to a new short run macroeconomic equilibrium, E2, which is also a long -run macroeconomic equilibrium. Aggregate price level P1 P2 LRAS SRAS E1 E2 AD1 AD2 Potential output YP Y1 Real GDP Inflationary gap A Cautionary Note: Lags in Fiscal Policy Looking at Figures 20.4 and 20.5, it may seem obvious that the government should actively use fiscal policy—always adopting an expansionary fiscal policy when the economy faces a recessionary gap and always adopting a contractionary fiscal policy when the economy faces an inflationary gap. But many economists caution against an extremely active stabilization policy, arguing that a government that tries too hard to stabilize the economy—through either fiscal policy or monetary policy—can end up making the economy less stable. We’ll leave discussion of the warnings associated with monetary policy to later modules. In the case of fiscal policy, one key reason for caution is that there are important time lags in its use. To understand the nature of these lags, think about what has to happen before the government increases spending to fight a recessionary gap. First, the government has to realize that the recessionary gap exists: economic data take time to collect and analyze, and recessions are often recognized only months after they have begun. Second, the government has to develop a spending plan, which can itself take months, particularly if politicians take time debating how the money should be spent and passing legislation. Finally, it takes time to spend money. For example, a road construction project begins with activities such as surveying that don’t involve spending large sums. It may be quite some time before the big spending begins. Because of these lags, an attempt to increase spending to fight a recessionary gap may take so long to get going that the economy has already
recovered on its own. In fact, the recessionary gap may have turned into an inflationary gap by the time the fiscal policy takes effect. In that case, the fiscal policy will make things worse instead of better Will the stimulus come in time to be worthwhile? President Barack Obama listens to a question during a news conference in the East Room of the White House in Washington D.C. 206 This doesn’t mean that fiscal policy should never be actively used. In early 2008, there was good reason to believe that the U.S. economy had begun a lengthy slowdown caused by turmoil in the financial markets, so that a fiscal stimulus designed to arrive within a few months would almost surely push aggregate demand in the right direction. But the problem of lags makes the actual use of both fiscal and monetary policy harder than you might think from a simple analysis like the one we have just given. M o d u l e 20 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. In each of the following cases, determine whether the policy is 3. Suppose someone says, “Using monetary or fiscal policy to an expansionary or contractionary fiscal policy. a. Several military bases around the country, which together employ tens of thousands of people, are closed. b. The number of weeks an unemployed person is eligible for pump up the economy is counterproductive—you get a brief high, but then you have the pain of inflation.” a. Explain what this means in terms of the AD–AS model. b. Is this a valid argument against stabilization policy? Why unemployment benefits is increased. c. The federal tax on gasoline is increased. or why not? 2. Explain why federal disaster relief, which quickly disburses funds to victims of natural disasters such as hurricanes, floods, and large -scale crop failures, will stabilize the economy more effectively after a disaster than relief that must be legislated. Tackle the Test: Multiple-Choice Questions 1. Which of the following contributes to the lag in implementing 3. Which of the following is an example of expansionary fiscal policy? fiscal policy? I. It takes time for Congress and the President to pass spending and tax changes. II. Current economic data take time to collect and analyze. III. It takes time to realize an output gap exists. increasing taxes a. b. increasing government spending c. decreasing government transfers d. decreasing interest rates e. increasing the money supply a. I only b. II only c. III only
d. I and III only I, II, and III e. 2. Which of the following is a government transfer program? a. Social Security b. Medicare/Medicaid c. unemployment insurance d. food stamps e. all of the above 4. Which of the following is a fiscal policy that is appropriate to combat inflation? a. decreasing taxes b. decreasing government spending c. increasing government transfers d. increasing interest rates e. expansionary fiscal policy 5. An income tax rebate is an example of a. an expansionary fiscal policy. b. a contractionary fiscal policy. c. an expansionary monetary policy. d. a contractionary monetary policy. e. none of the above 207 Tackle the Test: Free-Response Questions Aggregate price level SRAS LRAS PE E AD YP YE Real GDP 1. Refer to the graph above. a. What type of gap exists in this economy? b. What type of fiscal policy is appropriate in this situation? c. List the three variables the government can change to implement fiscal policy. d. How would the government change each of the three variables to implement the policy you listed in part b. Answer (8 points) 1 point: Inflationary 1 point: Contractionary 1 point: Taxes 1 point: Government transfers 1 point: Government purchases of goods and services 1 point: Increase taxes 1 point: Decrease Government transfers 1 point: Decrease government purchases of goods and services 2. a. Draw a correctly labeled graph showing an economy experiencing a recessionary gap. b. What type of fiscal policy is appropriate in this situation? c. Give an example of what the government could do to implement the type of policy you listed in part b. 208 What you will learn in this Module: • Why fiscal policy has a multiplier effect • How the multiplier effect is influenced by automatic stabilizers Module 21 Fiscal Policy and the Multiplier Using the Multiplier to Estimate the Influence of Government Policy An expansionary fiscal policy, like the American Recovery and Reinvestment Act, pushes the aggregate demand curve to the right. A contractionary fiscal policy, like Lyndon Johnson’s tax surcharge, pushes the aggregate demand curve to the left. For policy makers, however, knowing the direction of the shift isn’t enough: they need estimates of how much the aggregate demand curve is shifted by a given policy. To get these estimates, they use the concept of the multiplier. Multiplier Effects of an Increase in Government Purchases of Goods and Services Suppose
that a government decides to spend $50 billion building bridges and roads. The government’s purchases of goods and services will directly increase total spending on final goods and services by $50 billion. But there will also be an indirect effect because the government’s purchases will start a chain reaction throughout the economy. The firms producing the goods and services purchased by the government will earn revenues that flow to households in the form of wages, profit, interest, and rent. This increase in disposable income will lead to a rise in consumer spending. The rise in consumer spending, in turn, will induce firms to increase output, leading to a further rise in disposable income, which will lead to another round of consumer spending increases, and so on. In Module 16 we learned about the concept of the multiplier: the ratio of the change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. An increase in government purchases of goods and services is an example of an autonomous increase in aggregate spending. Any change in government purchases of goods and services will lead to an even greater change in real GDP. This chain reaction will cause the initial change in government purchases to multiply through the economy, resulting in an even larger final change in real GDP. The initial 209 When the government hires Boeing to build a space shuttle, Boeing employees spend their earnings on things like cars and the automakers spend their earnings on things like education, and so on, creating a multiplier effect. change in spending, multiplied by the multiplier gives us the final change in real GDP. Let’s consider a simple case in which there are no taxes or international trade. In this case, any change in GDP accrues entirely to households. Assume that the aggregate price level is fixed, so that any increase in nominal GDP is also a rise in real GDP, and that the interest rate is fixed. In that case, the multiplier is 1/(1 − MPC). Recall that MPC is the marginal propensity to consume, the fraction of an additional dollar in disposable income that is spent. For example, if the marginal propensity to consume is 0.5, the multiplier is 1/(1 − 0.5) = 1/0.5 = 2. Given a multiplier of 2, a $50 billion increase in government purchases of goods and services would increase real GDP by $100 billion. Of that $100 billion, $50 billion is the initial effect from the increase in G, and the remaining $50 billion is the subsequent effect of more production leading to
more income which leads to more consumer spending, which leads to more production, and so on. What happens if government purchases of goods and services are instead reduced? The math is exactly the same, except that there’s a minus sign in front: if government purchases of goods and services fall by $50 billion and the marginal propensity to consume is 0.5, real GDP falls by $100 billion. This is the result of less production leading to less income, which leads to less consumption, which leads to less production, and so on. Multiplier Effects of Changes in Government Transfers and Taxes Expansionary or contractionary fiscal policy need not take the form of changes in government purchases of goods and services. Governments can also change transfer payments or taxes. In general, however, a change in government transfers or taxes shifts the aggregate demand curve by less than an equal -sized change in government purchases, resulting in a smaller effect on real GDP. To see why, imagine that instead of spending $50 billion on building bridges, the government simply hands out $50 billion in the form of government transfers. In this case, there is no direct effect on aggregate demand as there was with government purchases of goods and services. Real GDP and income grow only because households spend some of that $50 billion—and they probably won’t spend it all. In fact, they will spend additional income according to the MPC. If the MPC is 0.5, households will spend only 50 cents of every additional dollar they receive in transfers. Table 21.1 shows a hypothetical comparison of two expansionary fiscal policies assuming an MPC equal to 0.5 and a multiplier equal to 2: one in which the government t a b l e 21.1 Hypothetical Effects of a Fiscal Policy with a Multiplier of 2 Effect on real GDP First round Second round Third round • • • $50 billion rise in government purchases of goods and services $50 billion rise in government transfer payments $50 billion $25 billion $12.5 billion • • • $25 billion $12.5 billion $6.25 billion • • • Eventual effect $100 billion $50 billion 210 directly purchases $50 billion in goods and services and one in which the government makes transfer payments instead, sending out $50 billion in checks to consumers. In each case, there is a first -round effect on real GDP, either from purchases by the government or from purchases by the consumers who received the checks, followed by a series of additional
rounds as rising real GDP raises income (all of which is disposable under our assumption of no taxes), which raises consumption. However, the first -round effect of the transfer program is smaller; because we have assumed that the MPC is 0.5, only $25 billion of the $50 billion is spent, with the other $25 billion saved. And as a result, all the further rounds are smaller, too. In the end, the transfer payment increases real GDP by only $50 billion. In comparison, a $50 billion increase in government purchases produces a $100 billion increase in real GDP. Overall, when expansionary fiscal policy takes the form of a rise in transfer payments, real GDP may rise by either more or less than the initial government outlay— that is, the multiplier may be either more or less than 1. In Table 21.1, a $50 billion rise in transfer payments increases real GDP by $50 billion, so that the multiplier is exactly 1. If a smaller share of the initial transfer had been spent, the multiplier on that transfer would have been less than 1. If a larger share of the initial transfer had been spent, the multiplier would have been more than 1. A tax cut has an effect similar to the effect of a transfer. It increases disposable income, leading to a series of increases in consumer spending. But the overall effect is smaller than that of an equal -sized increase in government purchases of goods and services: the autonomous increase in aggregate spending is smaller because households save part of the amount of the tax cut. They save a fraction of the tax cut equal to their MPS (or 1 − MPC). We should also note that taxes introduce a further complication: they typically change the size of the multiplier. That’s because in the real world governments rarely impose lump -sum taxes, in which the amount of tax a household owes is independent of its income. Instead, the great majority of tax revenue is raised via taxes that depend positively on the level of real GDP. As we’ll discuss shortly, taxes that depend positively on real GDP reduce the size of the multiplier. In practice, economists often argue that it also matters who among the population gets tax cuts or increases in government transfers. For example, compare the effects of an increase in unemployment benefits with a cut in taxes on profits distributed to shareholders as dividends. Consumer surveys suggest that the average unemployed worker will spend a higher share of any increase in his or her disposable income than would the average recipient of dividend income. That
is, people who are unemployed tend to have a higher MPC than people who own a lot of stocks because the latter tend to be wealthier and tend to save more of any increase in disposable income. If that’s true, a dollar spent on unemployment benefits increases aggregate demand more than a dollar’s worth of dividend tax cuts. Such arguments played an important role in the final provisions of the 2008 stimulus package. How Taxes Affect the Multiplier Government taxes capture some part of the increase in real GDP that occurs in each round of the multiplier process, since most government taxes depend positively on real GDP. As a result, disposable income increases by considerably less than $1 once we include taxes in the model. The increase in government tax revenue when real GDP rises isn’t the result of a deliberate decision or action by the government. It’s a consequence of the way the tax laws are written, which causes most sources of government revenue to increase automatically when real GDP goes up. For example, income tax receipts increase when real GDP rises because the amount each individual owes in taxes depends positively on his Lump -sum taxes are taxes that don’t depend on the taxpayer’s income 211 Automatic stabilizers are government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands. Discretionary fiscal policy is fiscal policy that is the result of deliberate actions by policy makers rather than rules. o t o h P P A A historical example of discretionary fiscal policy was the Works Progress Administration (WPA), a relief measure established during the Great Depression that put the unemployed to work building bridges, roads, buildings, and parks. or her income, and households’ taxable income rises when real GDP rises. Sales tax receipts increase when real GDP rises because people with more income spend more on goods and services. And corporate profit tax receipts increase when real GDP rises because profits increase when the economy expands. The effect of these automatic increases in tax revenue is to reduce the size of the multiplier. Remember, the multiplier is the result of a chain reaction in which higher real GDP leads to higher disposable income, which leads to higher consumer spending, which leads to further increases in real GDP. The fact that the government siphons off some of any increase in real GDP means that at each stage of this process, the increase in consumer spending is smaller than it would be if taxes weren’t part of the picture. The result is to reduce the multiplier. Many macroeconom
ists believe it’s a good thing that in real life taxes reduce the multiplier. Most, though not all, recessions are the result of negative demand shocks. The same mechanism that causes tax revenue to increase when the economy expands causes it to decrease when the economy contracts. Since tax receipts decrease when real GDP falls, the effects of these negative demand shocks are smaller than they would be if there were no taxes. The decrease in tax revenue reduces the adverse effect of the initial fall in aggregate demand. The automatic decrease in government tax revenue generated by a fall in real GDP—caused by a decrease in the amount of taxes households pay—acts like an automatic expansionary fiscal policy implemented in the face of a recession. Similarly, when the economy expands, the government finds itself automatically pursuing a contractionary fiscal policy—a tax increase. Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands, without requiring any deliberate action by policy makers, are called automatic stabilizers. The rules that govern tax collection aren’t the only automatic stabilizers, although they are the most important ones. Some types of government transfers also play a stabilizing role. For example, more people receive unemployment insurance when the economy is depressed than when it is booming. The same is true of Medicaid and food stamps. So transfer payments tend to rise when the economy is contracting and fall when the economy is expanding. Like changes in tax revenue, these automatic changes in transfers tend to reduce the size of the multiplier because the total change in disposable income that results from a given rise or fall in real GDP is smaller. As in the case of government tax revenue, many macroeconomists believe that it’s a good thing that government transfers reduce the multiplier. Expansionary and contractionary fiscal policies that are the result of automatic stabilizers are widely considered helpful to macroeconomic stabilization, because they blunt the extremes of the business cycle. But what about fiscal policy that isn’t the result of automatic stabilizers? Discretionary fiscal policy is fiscal policy that is the direct result of deliberate actions by policy makers rather than automatic adjustment. For example, during a recession, the government may pass legislation that cuts taxes and increases government spending in order to stimulate the economy. In general, mainly due to problems with time lags as discussed in Module 10, economists tend to support the use of discretionary fiscal policy only in special circumstances, such as an especially severe recession. 212 fyi About That Stimulus Package
... In early 2008, there was broad bipartisan agreement that the U.S. economy needed a fiscal stimulus. There was, however, sharp partisan disagreement about what form that stimulus should take. The eventual bill was a compromise that left both sides unhappy and arguably made the stimulus less effective than it could have been. Initially, there was little support for an increase in government purchases of goods and services—that is, neither party wanted to build bridges and roads to stimulate the economy. Both parties believed that the economy needed a quick boost, and ramping up spending would take too long. But there was a fierce debate over whether the stimulus should take the form of a tax cut, which would deliver its biggest benefits to those who paid the most taxes, or an increase in transfer payments targeted at Americans most in economic distress. The eventual compromise gave most taxpayers a flat $600 rebate, $1,200 for married couples. Very high -income taxpayers were not entitled to a rebate; low earners who didn’t make enough to pay income taxes, but did pay other taxes, re- ceived $300. In effect, the plan was a combination of tax cuts for most Americans and transfer payments to Americans with low incomes. How well designed was the stimulus plan? Many economists believed that only a fraction of the rebate checks would actually be spent, so that the eventual multiplier would be fairly low. White House economists appeared to agree: they estimated that the stimulus would raise employment by half a million jobs above what it would have been otherwise, the same number offered by independent economists who believed that the multiplier on the plan would be around 0.75. (Remember, the multiplier on changes in taxes or transfers can be less than 1.) Some economists were critical, arguing that Congress should have insisted on a plan that yielded more “bang for the buck.” Both Democratic and Republican economists working for Congress defended the plan, arguing that the perfect is the enemy of the good— that it was the best that could be negotiated on short notice and was likely to be of real help in fighting the economy’s weakness. But by late summer 2008, with the U.S. economy still in the doldrums, there was widespread agreement that the plan’s results had been disappointing. And by late 2008, with the economy shrinking further, policy makers were working on a new, much larger stimulus plan that relied more heavily on government purchases. The American Recovery and Reinvestment Act was passed in February 2009. The bill called for $
787 billion in expenditures on stimulus in three areas: help for the unemployed and those receiving Medicaid and food stamps; investments in infrastructure, energy, and health care; and tax cuts for families and small businesses. Despite controversies over specifics, the gen- eral consensus about active stabilization policy is apparent: when at first you don’t succeed, try, try again. M o d u l e 21 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Explain why a $500 million increase in government purchases of goods and services will generate a larger rise in real GDP than a $500 million increase in government transfers. 2. Explain why a $500 million reduction in government purchases of goods and services will generate a larger fall in real GDP than a $500 million tax increase. 3. The country of Boldovia has no unemployment insurance benefits and a tax system using only lump-sum taxes. The neighboring country of Moldovia has generous unemployment benefits and a tax system in which residents must pay a percentage of their income. Which country will experience greater variation in real GDP in response to demand shocks, positive and negative? Explain 213 Tackle the Test: Multiple-Choice Questions 1. The marginal propensity to consume 3. The presence of taxes has what effect on the multiplier? They a. increase it. b. decrease it. c. destabilize it. d. negate it. e. have no effect on it. 4. A lump-sum tax is a. higher as income increases. lower as income increases. b. c. independent of income. d. the most common form of tax. e. a type of business tax. 5. Which of the following is NOT an automatic stabilizer? income taxes a. b. unemployment insurance c. Medicaid d. food stamps e. monetary policy 2. A change in government purchases of goods and services results in a change in real GDP equal to $200 million. Assume the absence of taxes, international trade, and changes in the aggregate price level. a. Suppose that the MPC is equal to 0.75. What was the size of the change in government purchases of goods and services that resulted in the increase in real GDP of $200 million? b. Now suppose that the change in government purchases of goods and services was $20 million. What value of the multiplier would result in an increase in real GDP of $200 million? c. Given the value of the multiplier you calculated in part b, what marginal propensity to save
would have led to that value of the multiplier? I. has a negative relationship to the multiplier. II. is equal to 1. III. represents the proportion of consumers’ disposable income that is spent. a. I only b. II only c. III only d. I and III only I, II, and III e. 2. Assume that taxes and interest rates remain unchanged when government spending increases, and that both savings and consumer spending increase when income increases. The ultimate effect on real GDP of a $100 million increase in government purchases of goods and services will be a. an increase of $100 million. b. an increase of more than $100 million. c. an increase of less than $100 million. d. an increase of either more than or less than $100 million, depending on the MPC. e. a decrease of $100 million. Tackle the Test: Free-Response Questions 1. Assume the MPC in an economy is 0.8 and the government increases government purchases of goods and services by $50 million. Also assume the absence of taxes, international trade, and changes in the aggregate price level. a. What is the value of the multiplier? b. By how much will real GDP change as a result of the increase in government purchases? c. What would happen to the size of the effect on real GDP if the MPC fell? Explain. d. If we relax the assumption of no taxes, automatic changes in tax revenue as income changes will have what effect on the size of the multiplier? Answer (5 points) 1 point: Multiplier = 1/(1 − MPC ) = 1/(1 − 0.8) = 1/0.2 = 5 1 point: $50 million × 5 = $250 million 1 point: It would decrease. 1 point: The multiplier is 1/(1 − MPC ). A fall in MPC increases the denominator, (1 − MPC ), and therefore decreases the multiplier. 1 point: Decrease it 214 Review Summary 1. The consumption function shows how an individual household’s consumer spending is determined by its current disposable income. The aggregate consumption function shows the relationship for the entire economy. According to the life-cycle hypothesis, households try to smooth their consumption over their lifetimes. As a result, the aggregate consumption function shifts in response to changes in expected future disposable income and changes in aggregate wealth. 2. Planned investment spending depends negatively on the interest rate and on existing production capacity; it depends positively
on expected future real GDP. 3. Firms hold inventories of goods so that they can satisfy consumer demand quickly. Inventory investment is positive when firms add to their inventories, negative when they reduce them. Often, however, changes in inventories are not a deliberate decision but the result of mistakes in forecasts about sales. The result is unplanned inventory investment, which can be either positive or negative. Actual investment spending is the sum of planned investment spending and unplanned inventory investment. 4. The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. 5. The aggregate demand curve is downward sloping for two reasons. The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the interest rate effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ and firms’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending. 6. The aggregate demand curve shifts because of changes in expectations, changes in wealth not due to changes in the aggregate price level, and the effect of the size of the existing stock of physical capital. Policy makers can use fiscal policy and monetary policy to shift the aggregate demand curve. 7. The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied. 8. The short -run aggregate supply curve is upward sloping because nominal wages are sticky in the short run: a higher aggregate price level leads to higher profit per unit of output and increased aggregate output in the short run. Section 4 Summary 9. Changes in commodity prices, nominal wages, and productivity lead to changes in producers’ profits and shift the short -run aggregate supply curve. 10. In the long run, all prices, including nominal wages, are flexible and the economy produces at its potential output. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise. So the long -run aggregate supply curve is vertical at potential output. 11. In the AD–AS model, the intersection of the short -run aggregate supply curve and the aggregate demand curve is the point of short -run macroeconomic equilibrium. It determines the short -run equilibrium aggregate price level and the level
of short -run equilibrium aggregate output. 12. Economic fluctuations occur because of a shift of the aggregate demand curve (a demand shock) or the short run aggregate supply curve (a supply shock). A demand shock causes the aggregate price level and aggregate output to move in the same direction as the economy moves along the short -run aggregate supply curve. A supply shock causes them to move in opposite directions as the economy moves along the aggregate demand curve. A particularly nasty occurrence is stagflation—inflation and falling aggregate output— which is caused by a negative supply shock. 13. Demand shocks have only short -run effects on aggregate output because the economy is self -correcting in the long run. In a recessionary gap, an eventual fall in nominal wages moves the economy to long -run macroeconomic equilibrium, in which aggregate output is equal to potential output. In an inflationary gap, an eventual rise in nominal wages moves the economy to long -run macroeconomic equilibrium. We can use the output gap, the percentage difference between actual aggregate output and potential output, to summarize how the economy responds to recessionary and inflationary gaps. Because the economy tends to be self -correcting in the long run, the output gap always tends toward zero. 14. The high cost—in terms of unemployment—of a recessionary gap and the future adverse consequences of an inflationary gap lead many economists to advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. There can be drawbacks, however, because such policies may contribute to a long -term rise in the budget deficit, leading to lower S u m m a r y 215 long -run growth. Also, poorly timed policies can increase economic instability. 15. Negative supply shocks pose a policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump. 16. The government plays a large role in the economy, collecting a large share of GDP in taxes and spending a large share both to purchase goods and services and to make transfer payments, largely for social insurance. Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. But many economists caution that a very active fiscal policy may in fact make the economy less stable due to time lags in policy formulation and implementation. 17. Government purchases of goods and services directly affect aggregate demand, and changes in taxes and government transfers affect aggregate demand indirectly
by changing households’ disposable income. Expansionary fiscal policy shifts the aggregate demand curve rightward; contractionary fiscal policy shifts the aggregate demand curve leftward. 18. Fiscal policy has a multiplier effect on the economy, the size of which depends upon the fiscal policy. Except in the case of lump-sum taxes, taxes reduce the size of the multiplier. Expansionary fiscal policy leads to an increase in real GDP, while contractionary fiscal policy leads to a reduction in real GDP. Because part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a more powerful effect on the economy than equal-size changes in taxes or transfers. 19. An autonomous change in aggregate spending leads to a chain reaction in which the total change in real GDP is equal to the multiplier times the initial change in aggregate spending. The size of the multiplier, 1/(1 − MPC), depends on the marginal propensity to consume, MPC, the fraction of an additional dollar of disposable income spent on consumption. The larger the MPC, the larger the multiplier and the larger the change in real GDP for any given autonomous change in aggregate spending. The fraction of an additional dollar of disposable income that is saved is called the marginal propensity to save, MPS. 20. Rules governing taxes—with the exception of lump-sum taxes—and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle. In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle. Interest rate effect of a change in the aggregate Demand shock, p. 191 Key Terms Marginal propensity to consume (MPC), p. 159 Marginal propensity to save (MPS), p. 159 Autonomous change in aggregate spending, p. 160 Multiplier, p. 160 price level, p. 174 Fiscal policy, p. 176 Monetary policy, p. 177 Aggregate supply curve, p. 179 Consumption function, p. 162 Nominal wage, p. 180 Autonomous consumer spending, p. 162 Sticky wages, p. 180 Aggregate consumption function, p. 164 Short -run aggregate supply curve, p. 181 Planned investment spending, p. 166 Long -run aggregate supply curve, p. 184 Inventories, p. 168 Inventory investment, p. 168 Unplanned inventory investment, p. 169 Potential output, p. 185 AD–AS model, p. 190 Short-run
macroeconomic equilibrium, p. 190 Actual investment spending, p. 169 Short -run equilibrium aggregate price level, Aggregate demand curve, p. 172 p. 190 Wealth effect of a change in the aggregate price Short -run equilibrium aggregate output, p. 190 level, p. 174 Problems Supply shock, p. 192 Stagflation, p. 193 Long -run macroeconomic equilibrium, p. 194 Recessionary gap, p. 195 Inflationary gap, p. 196 Output gap, p. 196 Self -correcting, p. 196 Stabilization policy, p. 199 Social insurance, p. 204 Expansionary fiscal policy, p. 205 Contractionary fiscal policy, p. 205 Lump -sum taxes, p. 211 Automatic stabilizers, p. 212 Discretionary fiscal policy, p. 212 1. A fall in the value of the dollar against other currencies makes U.S. final goods and services cheaper to foreigners even though the U.S. aggregate price level stays the same. As a result, foreigners demand more American aggregate output. Your study part- ner says that this represents a movement down the aggregate demand curve because foreigners are demanding more in response to a lower price. You, however, insist that this represents a rightward shift of the aggregate demand curve. Who is right? Explain. 216 Section 4 Summary 2. Your study partner is confused by the upward -sloping short-run aggregate supply curve and the vertical long -run aggregate supply curve. How would you explain the shapes of these two curves? 3. Suppose that in Wageland all workers sign annual wage contracts each year on January 1. No matter what happens to prices of final goods and services during the year, all workers earn the wage specified in their annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are signed. Answer the following questions using a diagram and assume that the economy starts at potential output. short -run macroeconomic equilibrium to another. Illustrate with a diagram. 9. The Conference Board publishes the Consumer Confidence Index (CCI) every month based on a survey of 5,000 representative U.S. households. It is used by many economists to track the state of the economy. A press release by the Board on April 29, 2008 stated: “The Conference Board Consumer Confidence Index, which had declined sharply in March, fell further in April. The Index now stands at 62.3 (1985 = 100), down from 65.9 in March.” a.
In the short run, how will the quantity of aggregate output a. As an economist, is this news encouraging for economic supplied respond to the fall in prices? growth? b. What will happen when firms and workers renegotiate their wages? 4. Determine whether, in the short run, each of the following events causes a shift of a curve or a movement along a curve. Also determine which curve is involved and the direction of the change. a. As a result of new discoveries of iron ore used to make steel, producers now pay less for steel, a major commodity used in production. b. An increase in the money supply by the Federal Reserve in- creases the quantity of money that people wish to lend, lowering interest rates. c. Greater union activity leads to higher nominal wages. d. A fall in the aggregate price level increases the purchasing power of households’ and firms’ money holdings. As a result, they borrow less and lend more. 5. Suppose that all households hold all their wealth in assets that automatically rise in value when the aggregate price level rises (an example of this is what is called an “inflation -indexed bond”—a bond for which the interest rate, among other things, changes one -for- one with the inflation rate). What happens to the wealth effect of a change in the aggregate price level as a result of this allocation of assets? What happens to the slope of the aggregate demand curve? Will it still slope downward? Explain. 6. Suppose that the economy is currently at potential output. Also suppose that you are an economic policy maker and that a college economics student asks you to rank, if possible, your most preferred to least preferred type of shock: positive demand shock, negative demand shock, positive supply shock, negative supply shock. For those shocks that can be ranked, how would you rank them and why? 7. Explain whether the following government policies affect the aggregate demand curve or the short -run aggregate supply curve and how. a. The government reduces the minimum nominal wage. b. The government increases Temporary Assistance to Needy Families (TANF) payments, government transfers to families with dependent children. c. To reduce the budget deficit, the government announces that households will pay much higher taxes beginning next year. d. The government reduces military spending. 8. In Wageland, all workers sign an annual wage contract each year on January 1. In late January, a new computer operating system is introduced that increases labor productivity dramatically. Explain how
Wageland will move from one b. Explain your answer to part a with the help of the AD–AS model. Draw a typical diagram showing two equilibrium points (E1) and (E2). Label the vertical axis “Aggregate price level” and the horizontal axis “Real GDP.” Assume that all other major macroeconomic factors remain unchanged. c. How should the government respond to this news? What are some policy measures that could be used to help neutralize the effect of falling consumer confidence? 10. There were two major shocks to the U.S. economy in 2007, leading to a severe economic slowdown. One shock was related to oil prices; the other was the slump in the housing market. This question analyzes the effect of these two shocks on GDP using the AD–AS framework. a. Draw typical aggregate demand and short-run aggregate supply curves. Label the horizontal axis “Real GDP” and the vertical axis “Aggregate price level.” Label the equilibrium point E1, the equilibrium quantity Y1, and equilibrium price P1. b. Data taken from the Department of Energy indicate that the average price of crude oil in the world increased from $54.63 per barrel on January 5, 2007, to $92.93 on December 28, 2007. Would an increase in oil prices cause a demand shock or a supply shock? Redraw the diagram from part a to illustrate the effect of this shock by shifting the appropriate curve. c. The Housing Price Index, published by the Office of Federal Housing Enterprise Oversight, calculates that U.S. home prices fell by an average of 3.0% in the 12 months between January 2007 and January 2008. Would the fall in home prices cause a supply shock or demand shock? Redraw the diagram from part b to illustrate the effect of this shock by shifting the appropriate curve. Label the new equilibrium point E2, the equilibrium quantity Y2, and equilibrium price P2. d. Compare the equilibrium points E1 and E2 in your diagram for part c. What was the effect of the two shocks on real GDP and the aggregate price level (increase, decrease, or indeterminate)? 11. Using aggregate demand, short -run aggregate supply, and long run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long -run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short -run and long run
effects on the aggregate price level and aggregate output? a. There is a decrease in households’ wealth due to a decline in the stock market. b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases. S u m m a r y 217 12. Using aggregate demand, short -run aggregate supply, and long -run aggregate supply curves, explain the process by which each of the following government policies will move the economy from one long -run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short -run and long -run effects on the aggregate price level and aggregate output? a. There is an increase in taxes on households. b. There is an increase in the quantity of money. c. There is an increase in government spending. 13. The economy is in short -run macroeconomic equilibrium at point E1 in the accompanying diagram. Based on the diagram, answer the following questions. Aggregate price level LRAS SRAS1 P1 E1 AD1 Y1 YP Real GDP a. Is the economy facing an inflationary or a recessionary gap? b. What policies can the government implement that might bring the economy back to long -run macroeconomic equilibrium? Illustrate with a diagram. Use another diagram to show the effect of policies chosen to address the change in the aggregate price level. c. Why do supply shocks present a dilemma for government policy makers? 15. The late 1990s in the United States were characterized by substantial economic growth with low inflation; that is, real GDP increased with little, if any, increase in the aggregate price level. Explain this experience using aggregate demand and aggregate supply curves. Illustrate with a diagram. 16. In each of the following cases, either a recessionary or inflationary gap exists. Assume that the aggregate supply curve is horizontal, so that the change in real GDP arising from a shift of the aggregate demand curve equals the size of the shift of the curve. Calculate both the change in government purchases of goods and services, and, alternatively, the change in government transfers necessary to close the gap. a. Real GDP equals $100 billion, potential output equals $160 billion, and the marginal propensity to consume is 0.75. b. Real GDP equals $250 billion, potential output equals $200 billion, and the marginal propensity to consume is 0.5. c. Real GDP equals $180 billion, potential output equals $100 billion, and the marginal propensity to
consume is 0.8. 17. Most macroeconomists believe it is a good thing that taxes act as automatic stabilizers and lower the size of the multiplier. However, a smaller multiplier means that the change in government purchases of goods and services, government transfers, or taxes necessary to close an inflationary or recessionary gap is larger. How can you explain this apparent inconsistency? c. If the government did not intervene to close this gap, would the economy return to long -run macroeconomic equilibrium? Explain and illustrate with a diagram. 18. The accompanying table shows how consumers’ marginal propensities to consume in a particular economy are related to their level of income. d. What are the advantages and disadvantages of the govern- ment implementing policies to close the gap? 14. In the accompanying diagram, the economy is in long -run macroeconomic equilibrium at point E1 when an oil shock shifts the short -run aggregate supply curve to SRAS2. Based on the diagram, answer the following questions. Aggregate price level LRAS SRAS2 SRAS1 P1 E1 Y1 AD1 Real GDP a. How do the aggregate price level and aggregate output change in the short run as a result of the oil shock? What is this phenomenon known as? b. What fiscal policies can the government use to address the effects of the supply shock? Use a diagram that shows the effect of policies chosen to address the change in real GDP. Income range $0 − $20,000 $20,001 − $40,000 $40,001 − $60,000 $60,001 − $80,000 Above $80,000 Marginal propensity to consume 0.9 0.8 0.7 0.6 0.5 a. Suppose the government engages in increased purchases of goods and services. For each of the income groups in the accompanying table, what is the value of the multiplier—that is, what is the “bang for the buck” from each dollar the government spends on government purchases of goods and services in each income group? b. If the government needed to close a recessionary or infla- tionary gap, at which group should it primarily aim its fiscal policy of changes in government purchases of goods and services? 19. From 2003 to 2008, Eastlandia experienced large fluctuations in both aggregate consumer spending and disposable income, but wealth, the interest rate, and expected future disposable income did not change. The accompanying table shows the level of aggregate consumer spending and disposable income in 218
Section 4 Summary millions of dollars for each of these years. Use this information to answer the following questions. Year 2003 2004 2005 2006 2007 2008 Disposable income (millions of dollars) Consumer spending (millions of dollars) $100 350 300 400 375 500 $180 380 340 420 400 500 a. Is Albernia facing a recessionary or inflationary gap? b. Which type of fiscal policy—expansionary or contrac- tionary—would move the economy of Albernia to potential output, YP? What are some examples of such policies? c. Use a diagram to illustrate the macroeconomic situation in Albernia after the successful fiscal policy has been implemented. 24. The accompanying diagram shows the current macroeconomic situation for the economy of Brittania; real GDP is Y1, and the aggregate price level is P1. You have been hired as an economic consultant to help the economy move to potential output, YP. a. Plot the aggregate consumption function for Eastlandia. b. What is the marginal propensity to consume? What is the marginal propensity to save? c. What is the aggregate consumption function? 20. From the end of 1995 to March 2000, the Standard and Poor’s 500 (S&P 500) stock index, a broad measure of stock market prices, rose almost 150%, from 615.93 to a high of 1,527.46. From that time to September 10, 2001, the index fell 28.5% to 1,092.54. How do you think the movements in the stock index influenced both the growth in real GDP in the late 1990s and the concern about maintaining consumer spending after the terrorist attacks on September 11, 2001? 21. How will investment spending change as the following events occur? a. The interest rate falls as a result of Federal Reserve policy. b. The U.S. Environmental Protection Agency decrees that corporations must upgrade or replace their machinery in order to reduce their emissions of sulfur dioxide. c. Baby boomers begin to retire in large numbers and reduce their savings, resulting in higher interest rates 22. Explain how each of the following actions will affect the level of investment spending and unplanned inventory investment. a. The Federal Reserve raises the interest rate. b. There is a rise in the expected growth rate of real GDP. Aggregate price level P1 LRAS SRAS E1 AD1 Potential output YP Y1 Real GDP a. Is Brittania facing a recessionary or inflationary gap
? b. Which type of fiscal policy—expansionary or contrac- tionary—would move the economy of Brittania to potential output, YP? What are some examples of such policies? c. Illustrate the macroeconomic situation in Brittania with a diagram after the successful fiscal policy has been implemented. 25. An economy is in long -run macroeconomic equilibrium when each of the following aggregate demand shocks occurs. What kind of gap—inflationary or recessionary—will the economy face after the shock, and what type of fiscal policies would help move the economy back to potential output? How would your recommended fiscal policy shift the aggregate demand curve? a. A stock market boom increases the value of stocks held c. A sizable inflow of foreign funds into the country lowers by households. the interest rate. 23. The accompanying diagram shows the current macroeconomic situation for the economy of Albernia. You have been hired as an economic consultant to help the economy move to potential output, YP. Aggregate price level LRAS SRAS b. Firms come to believe that a recession in the near future is likely. c. Anticipating the possibility of war, the government in- creases its purchases of military equipment. d. The quantity of money in the economy declines and interest rates increase. P1 E1 AD1 Y1 YP Potential output Real GDP S u m m a r y 219 This page intentionally left blank 5 The Financial Sector s e c t i o n Module 22: Saving, Investment, and the Financial System Module 23: The Definition and Measurement of Money Module 24: The Time Value of Money Module 25: Banking and Money Creation Module 26: The Federal Reserve System: History and Structure Module 27: The Federal Reserve System: Monetary Policy Module 28: The Money Market Module 29: The Market for Loanable Funds Economics by Example: “Does the Money Supply Matter?” On October 2, 2004, FBI and Secret Service agents seized a shipping container that had just arrived in Newark, New Jersey, on a ship from China. Inside the container, under cardboard boxes containing plastic toys, they found what they were looking for: more than $300,000 in counterfeit $100 bills. Two months later, another shipment with $3 million in counterfeit bills was intercepted. Government and law enforcement officials began alleging publicly that these bills—which were high quality fakes, very hard to tell from the real thing—were being produced by the government of North Korea In fact, here�
�s a riddle: If a fake $100 bill from North Korea enters the United States, and nobody ever realizes it’s fake, who gets hurt? Accepting a fake $100 bill isn’t like buying a car that turns out to be a lemon or a meal that turns out to be inedible; as long as the bill’s counterfeit nature remains undiscovered, it will pass from hand to hand just like a real $100 bill. The answer to the riddle is that the real victims of North Korean counterfeiting are U.S. taxpayers because counterfeit dollars reduce the revenues available to pay for the operations of the U.S. government. Accordingly, the Secret Service diligently monitors the integrity of U.S. currency, promptly investigating any reports of counterfeit dollars The funny thing is that elaborately decorated pieces of paper have little or no intrinsic value. Indeed, a $100 bill printed with blue or orange ink literally wouldn’t be worth the paper it was printed on. But if the ink on that decorated piece of paper is just the right shade of green, people will think that it’s money and will accept it as payment for very real goods and services. Why? Because they believe, correctly, that they can do the same thing: exchange that piece of green paper for real goods and services “ Money is the essential channel that links the various parts of the modern economy. The efforts of the Secret Service attest to the fact that money isn’t like ordinary goods and services. In this section we’ll look at the role money plays, the workings of a modern monetary system, and the institutions that sustain and regulate it. We’ll then see how models of the money and loanable funds markets help us understand monetary policy as carried out by our central bank—the Federal Reserve. 221 What you will learn in this Module: • The relationship between savings and investment spending • The purpose of the four principal types of financial assets: stocks, bonds, loans, and bank deposits • How financial intermediaries help investors achieve diversification The interest rate is the price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year. According to the savings–investment spending identity, savings and investment spending are always equal for the economy as a whole. Module 22 Saving, Investment, and the Financial System Matching Up Savings and Investment Spending Two instrumental sources of economic growth are increases in the skills and knowledge
of the workforce, known as human capital, and increases in capital—goods used to make other goods—which can also be called physical capital to distinguish it from human capital. Human capital is largely provided by the government through public education. (In countries with a large private education sector, like the United States, private post-secondary education is also an important source of human capital.) But physical capital, with the exception of infrastructure such as roads and bridges, is mainly created through private investment spending—that is, spending by firms rather than by the government. Who pays for private investment spending? In some cases it’s the people or corporations who actually do the spending—for example, a family that owns a business might use its own savings to buy new equipment or a new building, or a corporation might reinvest some of its own profits to build a new factory. In the modern economy, however, individuals and firms who create physical capital often do it with other people’s money—money that they borrow or raise by selling stock. If they borrow money to create physical capital, they are charged an interest rate. The interest rate is the price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year. To understand how investment spending is financed, we need to look first at how savings and investment spending are related for the economy as a whole. The Savings– Investment Spending Identity The most basic point to understand about savings and investment spending is that they are always equal. This is not a theory; it’s a fact of accounting called the savings– investment spending identity. To see why the savings– investment spending identity must be true, first imagine a highly simplified economy in which there is no government and no interaction with 222 other countries. The overall income of this simplified economy would, by definition, be equal to total spending in the economy. Why? Because the only way people could earn income would be by selling something to someone else, and every dollar spent in the economy would create income for somebody. So in this simplified economy, (22-1) Total income = Total spending Now, what can people do with income? They can either spend it on consumption or save it. So it must be true that (22-2) Total income = Consumer spending + Savings Meanwhile, spending consists of either consumer spending or investment spending: (22-3) Total spending = Consumer spending + Investment spending Putting these together, we get: (22-4) Consumer spending +
Savings = Consumer spending + Investment spending Subtract consumer spending from both sides, and we get: (22-5) Savings = Investment spending As we said, then, it’s a basic accounting fact that savings equals investment spending for the economy as a whole. So far, however, we’ve looked only at a simplified economy in which there is no government and no economic interaction with the rest of the world. Bringing these realistic complications back into the story changes things in two ways. First, households are not the only parties that can save in an economy. In any given year the government can save, too, if it collects more tax revenue than it spends. When this occurs, the difference is called a budget surplus and is equivalent to savings by government. If, alternatively, government spending exceeds tax revenue, there is a budget deficit—a negative budget surplus. In this case we often say that the government is “dissaving”: by spending more than its tax revenues, the government is engaged in the opposite of saving. We’ll define the term budget balance to refer to both cases, with the understanding that the budget balance can be positive (a budget surplus) or negative (a budget deficit). National savings is equal to the sum of private savings and the budget balance, whereas private savings is disposable income (income after taxes) minus consumption. Second, the fact that any one country is part of a wider world economy means that savings need not be spent on physical capital located in the same country in which the savings are generated. That’s because the savings of people who live in any one country can be used to finance investment spending that takes place in other countries. So any given country can receive inflows of funds—foreign savings that finance investment spending in the country. Any given country can also generate outflows of funds— domestic savings that finance investment spending in another country. The net effect of international inflows and outflows of funds on the total savings available for investment spending in any given country is known as the capital inflow into that country, equal to the total inflow of foreign funds minus the total outflow of domestic funds to other countries. Like the budget balance, a capital inflow can be negative—that is, more capital can flow out of a country than flows into it. In recent years the United States has experienced a consistent net inflow of capital from foreigners, who view our economy as an attractive place to put their savings. In 2008, for example, capital inf
lows into the United States were $707 billion. The budget surplus is the difference between tax revenue and government spending when tax revenue exceeds government spending. The budget deficit is the difference between tax revenue and government spending when government spending exceeds tax revenue. The budget balance is the difference between tax revenue and government spending. National savings, the sum of private savings and the budget balance, is the total amount of savings generated within the economy. Capital inflow is the net inflow of funds into a country 223 It’s important to note that, from a national perspective, a dollar generated by national savings and a dollar generated by capital inflow are not equivalent. Yes, they can both finance the same dollar’s worth of investment spending, but any dollar borrowed from a saver must eventually be repaid with interest. A dollar that comes from national savings is repaid with interest to someone domestically—either a private party or the government. But a dollar that comes as capital inflow must be repaid with interest to a foreigner. So a dollar of investment spending financed by a capital inflow comes at a higher national cost—the interest that must eventually be paid to a foreigner—than a dollar of investment spending financed by national savings. So the application of the savings–investment spending identity to an economy that is open to inflows or outflows of capital means that investment spending is equal to savings, where savings is equal to national savings plus capital inflow. That is, in an economy with a positive capital inflow, some investment spending is funded by the savings of foreigners. And in an economy with a negative capital inflow (a net outflow), some portion of national savings is funding investment spending in other countries. In the United States in 2008, investment spending totaled $2,632 billion. Private savings were $2,506.9 billion, offset by a budget deficit of $683 billion and supplemented by capital inflows of $707 billion. Notice that these numbers don’t quite add up; because data collection isn’t perfect, there is a “statistical discrepancy” of $101 billion. But we know that this is an error in the data, not in the theory, because the savings–investment spending identity must hold in reality. The Financial System Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets. A financial asset is a paper claim that entitles the buyer to future income from the seller. For example, when a saver lends
funds to a company, the loan is a financial asset sold by the company that entitles the lender (the buyer) to future income from the company. A household can also invest its current savings or wealth by purchasing a physical asset, a claim on a tangible object, such as a preexisting house or preexisting piece of equipment. It gives the owner the right to dispose of the object as he or she wishes (for example, rent it or sell it). If you were to go to your local bank and get a loan—say, to buy a new car—you and the bank would be creating a financial asset: your loan. A loan is one important kind of financial asset in the real world, one that is owned by the lender—in this case, your local bank. In creating that loan, you and the bank would also be creating a liability, a requirement to pay money in the future. So although your loan is a financial asset from the bank’s point of view, it is a liability from your point of view: a requirement that you repay the loan, including any interest. In addition to loans, there are three other important kinds of financial assets: stocks, bonds, and bank deposits. Because a financial asset is a claim to future income that someone has to pay, it is also someone else’s liability. We’ll explain in detail shortly who bears the liability for each type of financial asset. These four types of financial assets exist because the economy has developed a set of specialized markets, like the stock market and the bond market, and specialized institutions, like banks, that facilitate the flow of funds from lenders to borrowers. A well functioning financial system is a critical ingredient in achieving long -run growth because it encourages greater savings and investment spending. It also ensures that savings and investment spending are undertaken efficiently. To understand how this occurs, we first need to know what tasks the financial system needs to accomplish. Then we can see how the job gets done The corner of Wall and Broad Streets is at the center of New York City’s financial district. A household’s wealth is the value of its accumulated savings. A financial asset is a paper claim that entitles the buyer to future income from the seller. A physical asset is a claim on a tangible object that gives the owner the right to dispose of the object as he or she wishes. A liability is a requirement to pay money in the future. 224 Three Tasks of a Financial System There are three important problems facing
borrowers and lenders: transaction costs, risk, and the desire for liquidity. The three tasks of a financial system are to reduce these problems in a cost -effective way. Doing so enhances the efficiency of financial markets: it makes it more likely that lenders and borrowers will make mutually beneficial trades—trades that make society as a whole richer. Reducing Transaction Costs Transaction costs are the expenses of actually putting together and executing a deal. For example, arranging a loan requires spending time and money negotiating the terms of the deal, verifying the borrower’s ability to pay, drawing up and executing legal documents, and so on. Suppose a large business decided that it wanted to raise $1 billion for investment spending. No individual would be willing to lend that much. And negotiating individual loans from thousands of different people, each willing to lend a modest amount, would impose very large total costs because each individual transaction would incur a cost. Total costs would be so large that the entire deal would probably be unprofitable for the business. Fortunately, that’s not necessary: when large businesses want to borrow money, they either get a loan from a bank or sell bonds in the bond market. Obtaining a loan from a bank avoids large transaction costs because it involves only a single borrower and a single lender. We’ll explain more about how bonds work in the next section. For now, it is enough to know that the principal reason there is a bond market is that it allows companies to borrow large sums of money without incurring large transaction costs. Reducing Risk A second problem that real -world borrowers and lenders face is financial risk, uncertainty about future outcomes that involve financial losses or gains. Financial risk (which from now on we’ll simply call “risk”) is a problem because the future is uncertain; it holds the potential for losses as well as gains. Most people are risk -averse, although to differing degrees. A well -functioning financial system helps people reduce their exposure to risk. Suppose the owner of a business expects to make a greater profit if she buys additional capital equipment but isn’t completely sure of this result. She could pay for the equipment by using her savings or selling her house. But if the profit is significantly less than expected, she will have lost her savings, or her house, or both. That is, she would be exposing herself to a lot of risk due to uncertainty about how well or poorly the business performs. So, being risk -averse, this business owner
wants to share the risk of purchasing new capital equipment with someone, even if that requires sharing some of the profit if all goes well. How can she do this? By selling shares of her company to other people and using the money she receives from selling shares, rather than money from the sale of her other assets, to finance the equipment purchase. By selling shares in her company, she reduces her personal losses if the profit is less than expected: she won’t have lost her other assets. But if things go well, the shareholders earn a share of the profit as a return on their investment. By selling a share of her business, the owner has achieved diversification: she has been able to invest in several things in a way that lowers her total risk. She has maintained her investment in her bank account, a financial asset; in ownership of her house, a physical asset; and in ownership of the unsold portion of her business, also a physical asset. By engaging in diversification—investing in several assets with unrelated, or independent, risks—our business owner has lowered her total risk of loss. The desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and a stock market. Providing Liquidity The third and final task of the financial system is to provide investors with liquidity, which—like risk—becomes relevant because the future is uncertain. Suppose that, having made a loan, a lender suddenly finds himself in need of cash—say, to pay for a medical emergency. Unfortunately, if that loan was made to a business that used it to buy new equipment, the business cannot repay the loan on Transaction costs are the expenses of negotiating and executing a deal. Financial risk is uncertainty about future outcomes that involve financial losses and gains. An individual can engage in diversification by investing in several different assets so that the possible losses are independent events 225 short notice to satisfy the lender’s need to recover his money. Knowing this in advance—that there is a danger of needing to get his money back before the term of the loan is up—our lender might be reluctant to lock up his money by lending it to a business. An asset is liquid if it can be quickly converted into cash without much loss of value, illiquid if it cannot. As we’ll see, stocks and bonds are a partial answer to the problem of liquidity. Banks provide a further way for individuals to hold liquid assets and still finance illiquid investments. To help lenders and borrowers make mutually
beneficial deals, then, the economy needs ways to reduce transaction costs, to reduce and manage risk through diversification, and to provide liquidity. How does it achieve these tasks? With a variety of financial assets. Types of Financial Assets In the modern economy there are four main types of financial assets: loans, bonds, stocks, and bank deposits. In addition, financial innovation has allowed the creation of a wide range of loan-backed securities. Each serves a somewhat different purpose. We’ll explain loans, bonds, stocks, and loan-backed securities first. Then we’ll turn to bank deposits when we explain the role banks play as financial intermediaries. Loans A loan is a lending agreement between an individual lender and an individual borrower. Most people encounter loans in the form of bank loans to finance the purchase of a car or a house. And small businesses usually use bank loans to buy new equipment. The good aspect of loans is that a given loan is usually tailored to the needs of the borrower. Before a small business can get a loan, it usually has to discuss its business plans, its profits, and so on with the lender. This results in a loan that meets the borrower’s needs and ability to repay. The bad aspect of loans is that making a loan to an individual person or a business typically involves a lot of transaction costs, such as the cost of negotiating the terms of the loan, investigating the borrower’s credit history and ability to repay, and so on. To minimize these costs, large borrowers such as major corporations and governments often take a more streamlined approach: they sell (or issue) bonds. Bonds A bond is an IOU issued by the borrower. Normally, the seller of the bond promises to pay a fixed sum of interest each year and to repay the principal—the value stated on the face of the bond—to the owner of the bond on a particular date. So a bond is a financial asset from its owner’s point of view and a liability from its issuer’s point of view. A bond issuer sells a number of bonds with a given interest rate and maturity date to whoever is willing to buy them, a process that avoids costly negotiation of the terms of a loan with many individual lenders. Bond purchasers can acquire information free of charge on the quality of the bond issuer, such as the bond issuer’s credit history, from bond rating agencies rather than having to incur the expense of investigating it themselves. A particular concern for investors is the possibility of default
, the risk that the bond issuer might fail to make payments as specified by the bond contract. Once a bond’s risk of default has been rated, it can be sold on the bond market as a more or less standardized product—a product with clearly defined terms and quality. In general, bonds with a higher default risk must pay a higher interest rate to attract investors. Another important advantage of bonds is that they are easy to resell. This provides liquidity to bond purchasers. Indeed, a bond will often pass through many hands before it finally comes due. Loans, in contrast, are much more difficult to resell because, unlike bonds, they are not standardized: they differ in size, quality, terms, and so on. This makes them a lot less liquid than bonds An asset is liquid if it can be quickly converted into cash without much loss of value. An asset is illiquid if it cannot be quickly converted into cash without much loss of value. A loan is a lending agreement between an individual lender and an individual borrower. A default occurs when a borrower fails to make payments as specified by the loan or bond contract © 226 © Loan-backed Securities Loan-backed securities, assets created by pooling individual loans and selling shares in that pool (a process called securitization), have become extremely popular over the past two decades. While mortgage-backed securities, in which thousands of individual home mortgages are pooled and shares sold to investors, are the best-known example, securitization has also been widely applied to student loans, credit card loans, and auto loans. These loan-backed securities trade on financial markets like bonds and are preferred by investors because they provide more diversification and liquidity than individual loans. However, with so many loans packaged together, it can be difficult to assess the true quality of the asset. That difficulty came to haunt investors during the financial crisis of 2007–2008, when the bursting of the housing bubble led to widespread defaults on mortgages and large losses for holders of “supposedly safe” mortgage-backed securities, causing pain that spread throughout the entire financial system. Stocks A stock is a share in the ownership of a company. A share of stock is a financial asset from its owner’s point of view and a liability from the company’s point of view. Not all companies sell shares of their stock; “privately held” companies are owned by an individual or a few partners, who get to keep all of the company’s profit
. Most large companies, however, do sell stock. For example, as this book goes to press, Microsoft has nearly 9 billion shares outstanding; if you buy one of those shares, you are entitled to one-nine billionth of the company’s profit, as well as 1 of 9 billion votes on company decisions. Why does Microsoft, historically a very profitable company, allow you to buy a share in its ownership? Why don’t Bill Gates and Paul Allen, the two founders of Microsoft, keep complete ownership for themselves and just sell bonds for their investment spending needs? The reason, as we have just learned, is risk: few individuals are risk -tolerant enough to face the risk involved in being the sole owner of a large company. Reducing the risk that business owners face, however, is not the only way in which the existence of stocks improves society’s welfare: it also improves the welfare of investors who buy stocks (that is, shareowners, or shareholders). Shareowners are able to enjoy the higher returns over time that stocks generally offer in comparison to bonds. Over the past century, stocks have typically yielded about 7% after adjusting for inflation; bonds have yielded only about 2%. But as investment companies warn you, “Past performance is no guarantee of future performance.” And there is a downside: owning the stock of a given company is riskier than owning a bond issued by the same company. Why? Loosely speaking, a bond is a promise while a stock is a hope: by law, a company must pay what it owes its lenders (bondholders) before it distributes any profit to its shareholders. And if the company should fail (that is, be unable to pay its interest obligations and declare bankruptcy), its physical and financial assets go to its bondholders—its lenders—while its shareholders typically receive nothing. So, although a stock generally provides a higher return to an investor than a bond, it also carries higher risk. The financial system has devised ways to help investors as well as business owners simultaneously manage risk and enjoy somewhat higher returns. It does that through the services of institutions known as financial intermediaries. Financial Intermediaries A financial intermediary is an institution that transforms funds gathered from many individuals into financial assets. The most important types of financial intermediaries are mutual funds, pension funds, life insurance companies, and banks. About three quarters of the financial assets Americans own are held through these intermediaries rather than directly. A loan-backed security is an asset
created by pooling individual loans and selling shares in that pool. A financial intermediary is an institution that transforms the funds it gathers from many individuals into financial assets 227 Mutual Funds As we’ve explained, owning shares of a company entails risk in return for a higher potential reward. But it should come as no surprise that stock investors can lower their total risk by engaging in diversification. By owning a diversified portfolio of stocks—a group of stocks in which risks are unrelated to, or offset, one another— rather than concentrating investment in the shares of a single company or a group of related companies, investors can reduce their risk. In addition, financial advisers, aware that most people are risk -averse, almost always advise their clients to diversify not only their stock portfolio but also their entire wealth by holding other assets in addition to stock—assets such as bonds, real estate, and cash. (And, for good measure, to have plenty of insurance in case of accidental losses!) However, for individuals who don’t have a large amount of money to invest—say $1 million or more—building a diversified stock portfolio can incur high transaction costs (particularly fees paid to stockbrokers) because they are buying a few shares of a lot of companies. Fortunately for such investors, mutual funds help solve the problem of achieving diversification without high transaction costs. A mutual fund is a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors. By buying these shares, investors with a relatively small amount of money to invest can indirectly hold a diversified portfolio, achieving a better return for any given level of risk than they could otherwise achieve. The mutual fund industry represents a huge portion of the modern U.S. economy, not just of the U.S. financial system. In total, U.S. mutual funds had assets of $10 trillion in late 2009. The largest mutual fund company at the end of 2009 was Fidelity Investments, which managed $1.5 trillion in funds. We should mention, by the way, that mutual funds do charge fees for their services. These fees are quite small for mutual funds that simply hold a diversified portfolio of stocks, without trying to pick winners. But the fees charged by mutual funds that claim to have special expertise in investing your money can be quite high. Pension Funds and Life Insurance Companies In addition to mutual funds, many Americans have holdings in pension funds, nonprofit institutions that collect the savings of their
members and invest those funds in a wide variety of assets, providing their members with income when they retire. Although pension funds are subject to some special rules and receive special treatment for tax purposes, they function much like mutual funds. They invest in a diverse array of financial assets, allowing their members to achieve more cost -effective diversification and conduct more market research than they would be able to individually. At the end of 2009, pension funds in the United States held more than $9 trillion in assets. Americans also have substantial holdings in the policies of life insurance companies, which guarantee a payment to the policyholder’s beneficiaries (typically, the family) when the policyholder dies. By enabling policyholders to cushion their beneficiaries from financial hardship arising from their death, life insurance companies also improve welfare by reducing risk. Banks Recall the problem of liquidity: other things equal, people want assets that can be readily converted into cash. Bonds and stocks are much more liquid than physical assets or loans, yet the transaction cost of selling bonds or stocks to meet a sudden expense can be large. Furthermore, for many small and moderate -size companies, the cost of issuing bonds and stocks is too large, given the modest amount of money they seek to raise. A bank is an institution that helps resolve the conflict between lenders’ needs for liquidity and the financing needs of borrowers who don’t want to use the stock or bond markets. A bank works by first accepting funds from depositors: when you put your money in a bank, you are essentially becoming a lender by lending the bank your money. In return The daily performance of hundreds of different mutual funds is listed in the business section of most large city newspapers. A mutual fund is a financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors. A pension fund is a type of mutual fund that holds assets in order to provide retirement income to its members. A life insurance company sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies. 228 bank deposit is a claim on a bank that obliges the bank to give the depositor his or her cash when demanded. A bank is a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers you receive credit for a bank deposit—a claim on the bank, which is obliged to give you your cash if and when you demand it. So a bank deposit is a financial asset owned by the
depositor and a liability of the bank that holds it. A bank, however, keeps only a fraction of its customers’ deposits in the form of ready cash. Most of its deposits are lent out to businesses, buyers of new homes, and other borrowers. These loans come with a long -term commitment by the bank to the borrower: as long as the borrower makes his or her payments on time, the loan cannot be recalled by the bank and converted into cash. So a bank enables those who wish to borrow for long lengths of time to use the funds of those who wish to lend but simultaneously want to maintain the ability to get their cash back on demand. More formally, a bank is a financial intermediary that provides liquid financial assets in the form of deposits to lenders and uses their funds to finance the illiquid investment spending needs of borrowers. In essence, a bank is engaging in a kind of mismatch: lending for long periods of time but also subject to the condition that its depositors could demand their funds back at any time. How can it manage that? The bank counts on the fact that, on average, only a small fraction of its depositors will want their cash at the same time. On any given day, some people will make withdrawals and others will make new deposits; these will roughly cancel each other out. So the bank needs to keep only a limited amount of cash on hand to satisfy its depositors. In addition, if a bank becomes financially incapable of paying its depositors, individual bank deposits are currently guaranteed to depositors up to $250,000 by the Federal Deposit Insurance Corporation, or FDIC, a federal agency. This reduces the risk to a depositor of holding a bank deposit, in turn reducing the incentive to withdraw funds if concerns about the financial state of the bank should arise. So, under normal conditions, banks need hold only a fraction of their depositors’ cash. By reconciling the needs of savers for liquid assets with the needs of borrowers for long -term financing, banks play a key economic role. M o d u l e 2 2 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Rank the following assets from the lowest level to the highest level of (i) transaction costs, (ii) risk, (iii) liquidity. Ties are acceptable for items that have indistinguishable rankings. a. a bank deposit with a guaranteed interest rate b. a share of a highly diversified mutual fund, which can be quickly sold
c. a share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale 2. What relationship would you expect to find between the level of development of a country’s financial system and its level of economic development? Explain in terms of the country’s levels of savings and investment spending. Tackle the Test: Multiple-Choice Questions 1. Decreasing which of the following is a task of the financial system? 2. Which of the following is NOT a type of financial asset? I. transaction costs II. risk III. liquidity a. I only b. II only c. III only d. I and II only I, II, and III e. a. bonds b. stocks c. bank deposits d. loans e. houses 229 3. The federal government is said to be “dissaving” when a. there is a budget deficit. b. there is a budget surplus. c. there is no budget surplus or deficit. d. savings does not equal investment spending. e. national savings equals private savings. 4. A nonprofit institution collects the savings of its members and invests those funds in a wide variety of assets in order to provide its members with income after retirement. This describes a a. mutual fund. b. bank. Tackle the Test: Free-Response Questions c. savings and loan. d. pension fund. e. life insurance company. 5. A financial intermediary that provides liquid financial assets in the form of deposits to lenders and uses their funds to finance the illiquid investment spending needs of borrowers is called a a. mutual fund. b. bank. c. corporation. d. pension fund. e. life insurance company. 1. Identify and describe the three tasks of a well-functioning 2. List and describe the four most important types of financial financial system. intermediaries. Answer (6 points) 1 point: Decrease transaction costs 1 point: A well -functioning financial system facilitates investment spending by allowing companies to borrow large sums of money without incurring large transaction costs. 1 point: Decrease risk 1 point: A well -functioning financial system helps people reduce their exposure to risk, so that they are more willing to engage in investment spending in the face of uncertainty in the economy. 1 point: Provide liquidity 1 point: A well-functioning financial system allows the fast, low-cost conversion of assets into cash. 230 Module 23 The Definition and Measurement of Money The Meaning of Money
In everyday conversation, people often use the word money to mean “wealth.” If you ask, “How much money does Bill Gates have?” the answer will be something like, “Oh, $50 billion or so, but who’s counting?” That is, the number will include the value of the stocks, bonds, real estate, and other assets he owns. But the economist’s definition of money doesn’t include all forms of wealth. The dollar bills in your wallet are money; other forms of wealth—such as cars, houses, and stock certificates—aren’t money. What, according to economists, distinguishes money from other forms of wealth? What Is Money? Money is defined in terms of what it does: money is any asset that can easily be used to purchase goods and services. In Module 22 we defined an asset as liquid if it can easily be converted into cash. Money consists of cash itself, which is liquid by definition, as well as other assets that are highly liquid. You can see the distinction between money and other assets by asking yourself how you pay for groceries. The person at the cash register will accept dollar bills in return for milk and frozen pizza—but he or she won’t accept stock certificates or a collection of vintage baseball cards. If you want to convert stock certificates or vintage baseball cards into groceries, you have to sell them—trade them for money—and then use the money to buy groceries. Of course, many stores allow you to write a check on your bank account in payment for goods (or to pay with a debit card that is linked to your bank account). Does that make your bank account money, even if you haven’t converted it into cash? Yes. Currency in circulation—actual cash in the hands of the public—is considered money. So are checkable bank deposits—bank accounts on which people can write checks. Are currency and checkable bank deposits the only assets that are considered money? It depends. As we’ll see later, there are two widely used definitions of the money supply, What you will learn in this Module: • The definition and functions of money • The various roles money plays and the many forms it takes in the economy • How the amount of money in the economy is measured Money is any asset that can easily be used to purchase goods and services. Currency in circulation is cash held by the public. Checkable bank deposits are bank accounts on which people can
write checks. The money supply is the total value of financial assets in the economy that are considered money 231 A medium of exchange is an asset that individuals acquire for the purpose of trading goods and services rather than for their own consumption. A store of value is a means of holding purchasing power over time Gambling at the Stalag 383 prisoner of war camp during World War II was carried out using cigarettes as currency. the total value of financial assets in the economy that are considered money. The narrower definition considers only the most liquid assets to be money: currency in circulation, traveler’s checks, and checkable bank deposits. The broader definition includes these three categories plus other assets that are “almost” checkable, such as savings account deposits that can be transferred into a checking account online with a few mouse clicks. Both definitions of the money supply, however, make a distinction between those assets that can easily be used to purchase goods and services, and those that can’t. Money plays a crucial role in generating gains from trade because it makes indirect exchange possible. Think of what happens when a cardiac surgeon buys a new refrigerator. The surgeon has valuable services to offer—namely, performing heart operations. The owner of the store has valuable goods to offer: refrigerators and other appliances. It would be extremely difficult for both parties if, instead of using money, they had to directly barter the goods and services they sell. In a barter system, a cardiac surgeon and an appliance store owner could trade only if the store owner happened to want a heart operation and the surgeon happened to want a new refrigerator. This is known as the problem of finding a “double coincidence of wants”: in a barter system, two parties can trade only when each wants what the other has to offer. Money solves this problem: individuals can trade what they have to offer for money and trade money for what they want. Because the ability to make transactions with money rather than relying on bartering makes it easier to achieve gains from trade, the existence of money increases welfare, even though money does not directly produce anything. As Adam Smith put it, money “may very properly be compared to a highway, which, while it circulates and carries to market all the grass and corn of the country, produces itself not a single pile of either.” Let’s take a closer look at the roles money plays in the economy. Roles of Money Money plays three main roles in any modern economy: it is a medium
of exchange, a store of value, and a unit of account. Medium of Exchange Our cardiac surgeon/appliance store owner example illustrates the role of money as a medium of exchange—an asset that individuals use to trade for goods and services rather than for consumption. People can’t eat dollar bills; rather, they use dollar bills to trade for edible goods and their accompanying services. In normal times, the official money of a given country—the dollar in the United States, the peso in Mexico, and so on—is also the medium of exchange in virtually all transactions in that country. During troubled economic times, however, other goods or assets often play that role instead. For example, during economic turmoil people often turn to other countries’ moneys as the medium of exchange: U.S. dollars have played this role in troubled Latin American countries, as have euros in troubled Eastern European countries. In a famous example, cigarettes functioned as the medium of exchange in World War II prisoner -of -war camps. Even nonsmokers traded goods and services for cigarettes because the cigarettes could in turn be easily traded for other items. During the extreme German inflation of 1923, goods such as eggs and lumps of coal became, briefly, mediums of exchange. Store of Value In order to act as a medium of exchange, money must also be a store of value—a means of holding purchasing power over time. To see why this is necessary, imagine trying to operate an economy in which ice -cream cones were the medium of exchange. Such an economy would quickly suffer from, well, monetary meltdown: your medium of exchange would often turn into a sticky puddle before you could use it to buy something else. Of course, money is by no means the only store of value. Any asset that holds its purchasing power over time is a store of value. So the store -of -value role is a necessary but not distinctive feature of money. 232 unit of account is a measure used to set prices and make economic calculations. Commodity money is a good used as a medium of exchange that has intrinsic value in other uses. Commodity -backed money is a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods. Unit of Account Finally, money normally serves as the unit of account—the commonly accepted measure individuals use to set prices and make economic calculations. To understand the importance of this role, consider a historical fact: during the Middle Ages
, peasants typically were required to provide landowners with goods and labor rather than money. A peasant might, for example, be required to work on the landowner’s land one day a week and also hand over one -fifth of his harvest. Today, rents, like other prices, are almost always specified in money terms. That makes things much clearer: imagine how hard it would be to decide which apartment to rent if modern landowners followed med ieval practice. Suppose, for example, that Mr. Smith says he’ll let you have a place if you clean his house twice a week and bring him a pound of steak every day, whereas Ms. Jones wants you to clean her house just once a week but wants four pounds of chicken every day. Who’s offering the better deal? It’s hard to say. If, on the other hand, Smith wants $600 a month and Jones wants $700, the comparison is easy. In other words, without a commonly accepted measure, the terms of a transaction are harder to determine, making it more difficult to make transactions and achieve gains from trade. Types of Money In some form or another, money has been in use for thousands of years. For most of that period, people used commodity money: the medium of exchange was a good, normally gold or silver, that had intrinsic value in other uses. These alternative uses gave commodity money value independent of its role as a medium of exchange. For example, the cigarettes that served as money in World War II POW camps were valuable because many prisoners smoked. Gold was valuable because it was used for jewelry and ornamentation, aside from the fact that it was minted into coins. By 1776, the year in which the United States declared its independence and Adam Smith published The Wealth of Nations, there was widespread use of paper money in addition to gold or silver coins. Unlike modern dollar bills, however, this paper money consisted of notes issued by private banks, which promised to exchange their notes for gold or silver coins on demand. So the paper currency that initially replaced commodity money was commodity -backed money, a medium of exchange with no intrinsic value whose ultimate value was guaranteed by a promise that it could always be converted into valuable goods on demand. The big advantage of commodity -backed money over simple commodity money, like gold and silver coins, was that it tied up fewer valuable resources. Although a noteissuing bank still had to keep some gold and silver on hand, it had to keep only enough to satisfy demands for redemption
of its notes. And it could rely on the fact that on a normal day only a fraction of its paper notes would be redeemed. So the bank needed to keep only a portion of the total value of its notes in circulation in the form of gold and silver in its vaults. It could lend out the remaining gold and silver to those who wished to use it. This allowed society to use the remaining gold and silver for other purposes, all with no loss in the ability to achieve gains from trade. In a famous passage in The Wealth of Nations, Adam Smith described paper money as a “waggon -way through the air.” Smith was making an analogy between money and an imaginary highway that did not absorb valuable land beneath it. An actual highway provides a useful service but at a cost: land that could be used to grow crops is instead paved over. If the highway could be built through the air, it wouldn’t destroy useful land. As Smith understood, when banks replaced gold and silver money with paper notes, they accomplished a similar feat: they reduced the amount of real resources used by society to provide the functions of money. At this point you may ask, why make any use at all of gold and silver in the monetary system, even to back paper money? In fact, today’s monetary system goes even further than the system Smith admired, having eliminated any role for gold and silver. A U.S. dollar bill isn’t commodity money, and it isn’t even commodity -backed. Rather, its value arises entirely from the fact that it is generally accepted as a means of payment 233 fyi The History of the Dollar U.S. dollar bills are pure fiat money: they have no intrinsic value, and they are not backed by anything that does. But American money wasn’t always like that. In the early days of European settlement, the colonies that would become the United States used commodity money, partly consisting of gold and silver coins minted in Europe. But such coins were scarce on this side of the Atlantic, so the colonists relied on a variety of other forms of commodity money. For example, settlers in Virginia used tobacco as money and settlers in the Northeast used “wampum,” a type of clamshell. Later in American history, commodity -backed paper money came into widespread use. But this wasn’t paper money as we now know it, issued by the U.S. government and bearing the signature of
the Secretary of the Treasury. Before the Civil War, the U.S. government didn’t issue any paper money. Instead, dollar bills were issued by private banks, which promised that their bills could be redeemed for silver coins on demand. These promises weren’t always credible because banks sometimes failed, leaving holders of their bills with worthless pieces of paper. Understandably, people were reluctant to accept currency from any bank rumored to be in financial trouble. In other words, in this private money system, some dollars were less valuable than others. A curious legacy of that time was notes issued by the Citizens’ Bank of Louisiana, based in New Orleans. They became among the most widely used bank notes in the southern states. These notes were printed in English on one side and French on the other. (At the time, many people in New Orleans, originally a colony of France, spoke French.) Thus, the $10 bill read Ten on one side and Dix, the French word for “ten,” on the other. These $10 bills became known as “dixies,” probably the source of the nickname of the U.S. South. The U.S. government began issuing official paper money, called “greenbacks,” during the Civil War, as a way to help pay for the war. At first greenbacks had no fixed value in terms of commodities. After 1873, the U.S. government guaranteed the value of a dollar in terms of gold, effectively turning dollars into commodity backed money. In 1933, when President Franklin D. Roosevelt broke the link between dollars and gold, his own federal budget director— who feared that the public would lose confidence in the dollar if it wasn’t ultimately backed by gold—declared ominously, “This will be the end of Western civilization.” It wasn’t. The link between the dollar and gold was restored a few years later, and then dropped again—seemingly for good—in August 1971. Despite the warnings of doom, the U.S. dollar is still the world’s most widely used currency. role that is ultimately decreed by the U.S. government. Money whose value derives entirely from its official status as a means of exchange is known as fiat money because it exists by government fiat, a historical term for a policy declared by a ruler. Fiat money has two major advantages over commodity -backed money. First, it is even more of a
“waggon -way through the air”—it doesn’t tie up any real resources, except for the paper it’s printed on. Second, the money supply can be managed based on the needs of the economy, instead of being determined by the amount of gold and silver prospectors happen to discover. On the other hand, fiat money poses some risks. One such risk is counterfeiting. Counterfeiters usurp a privilege of the U.S. government, which has the sole legal right to print dollar bills. And the benefit that counterfeiters get by exchanging fake bills for real goods and services comes at the expense of the U.S. federal government, which covers a small but nontrivial part of its own expenses by issuing new currency to meet growing demand for money. The larger risk is that government officials who have the authority to print money will be tempted to abuse the privilege by printing so much money that they create inflation. Measuring the Money Supply The Federal Reserve (an institution we’ll talk about shortly) calculates the size of two monetary aggregates, overall measures of the money supply, which differ in how strictly money is defined. The two aggregates are known, rather cryptically, as M1 and M2. (There used to be a third aggregate named—you guessed it—M3, but in 2006 the Federal Reserve concluded that measuring it was no longer useful.) M1, the narrowest definition, contains only currency in circulation (also known as cash), The image of a valid U.S. five-dollar bill shows a pattern in the background of the Lincoln Memorial image as seen through a Document Security Systems, Inc. document verifier. Fiat money is a medium of exchange whose value derives entirely from its official status as a means of payment. A monetary aggregate is an overall measure of the money supply. 234 fyi What’s with All the Currency? Alert readers may be a bit startled at one of the numbers in the money supply: $861.1 billion of currency in circulation in January 2010. That’s $2,789 in cash for every man, woman, and child in the United States. How many people do you know who carry $2,789 in their wallets? Not many. So where is all that cash? Part of the answer is that it isn’t in individuals’ wallets: it’s in cash registers. Businesses as well as individuals need to hold cash. Economists
also believe that cash plays an important role in transactions that people want to keep hidden. Small businesses and the self -employed sometimes prefer to be paid in cash so they can avoid paying taxes by hiding income from the Internal Revenue Service. Also, drug dealers and other criminals obviously don’t want bank records of their dealings. In fact, some analysts have tried to infer the amount of illegal activity in the economy from the total amount of cash holdings held by the public.The most important reason for those huge currency holdings, however, is foreign use of dollars. The Federal Reserve estimates that 60% of U.S. currency is actually held outside the United States— largely in countries in which residents are so distrustful of their national currencies that the U.S. dollar has become a widely accepted medium of exchange. traveler’s checks, and checkable bank deposits. M2 starts with M1 and adds several other kinds of assets, often referred to as near -moneys—financial assets that aren’t directly usable as a medium of exchange but can be readily converted into cash or checkable bank deposits, such as savings accounts. Examples are time deposits such as small denomination CDs, which aren’t checkable but can be withdrawn at any time before their maturity date by paying a penalty. Because currency and checkable deposits are directly usable as a medium of exchange, M1 is the most liquid measure of money. In January 2010, M1 was valued at $1,676.4 billion, with approximately 51% accounted for by currency in circulation, approximately 48% accounted for by checkable bank deposits, and a tiny slice accounted for by traveler’s checks. In turn, M1 made up 20% of M2, valued at $8,462.9 billion. M2 consists of M1 plus other types of assets: two types of bank deposits, known as savings deposits and time deposits, both of which are considered non checkable, plus money market funds, which are mutual funds that invest only in liquid assets and bear a close resemblance to bank deposits. These nearmoneys pay interest while cash (currency in circulation) does not, and they typically pay higher interest rates than any offered on checkable bank deposits © Near -moneys are financial assets that can’t be directly used as a medium of exchange but can be readily converted into cash or checkable bank deposits. M o d u l e 23 AP R e v i e w Solutions appear at the back of the book. Check
Your Understanding 1. Suppose you hold a gift certificate, good for certain products at participating stores. Is this gift certificate money? Why or why not? 2. Although most bank accounts pay some interest, depositors can get a higher interest rate by buying a certificate of deposit, or CD. The difference between a CD and a checking account is that the depositor pays a penalty for withdrawing the money before the CD comes due—a period of months or even years. Small CDs are counted in M2, but not in M1. Explain why they are not part of M1. 3. Explain why a system of commodity -backed money uses resources more efficiently than a system of commodity money 235 Tackle the Test: Multiple-Choice Questions 1. When you use money to purchase your lunch, money is serving which role(s)? I. medium of exchange II. store of value III. unit of account a. I only b. II only c. III only d. I and III only I, II, and III e. 2. When you decide you want “$10 worth” of a product, money is serving which role(s)? I. medium of exchange II. store of value III. unit of account a. I only b. II only c. III only d. I and II only I, II, and III e. 3. In the United States, the dollar is a. backed by silver. b. backed by gold and silver. c. commodity-backed money. d. commodity money. e. fiat money. 4. Which of the following is the most liquid monetary aggregate? a. M1 b. M2 c. M3 d. near-moneys e. dollar bills 5. Which of the following is the best example of using money as a store of value? a. A customer pays in advance for $10 worth of gasoline at a gas station. b. A babysitter puts her earnings in a dresser drawer while she saves to buy a bicycle. c. Travelers buy meals on board an airline flight. d. Foreign visitors to the United States convert their currency to dollars at the airport. e. You use $1 bills to purchase soda from a vending machine. Tackle the Test: Free-Response Questions 1. a. What does it mean for an asset to be “liquid”? 2. a. The U.S. dollar derives its value from what? That is, what b. Which of the assets listed below is the most liquid
? Explain. “backs” U.S. currency? A Federal Reserve note (dollar bill) A savings account deposit A house c. Which of the assets listed above is the least liquid? Explain. d. In which monetary aggregate(s) calculated by the Federal Reserve are checkable deposits included? b. What is the term used to describe the type of money used in the United States today? c. What other two types of money have been used throughout history? Define each. Answer (6 points) 1 point: It can be easily converted into cash. 1 point: A Federal Reserve note 1 point: It is already cash. 1 point: A house 1 point: It takes time and resources to sell a house. 1 point: M1 and M2 236 What you will learn in this Module: • Why a dollar today is worth more than a dollar a year from now • How the concept of present value can help you make decisions when costs or benefits come in the future Module 24 The Time Value of Money The Concept of Present Value Individuals are often faced with financial decisions that will have consequences long into the future. For example, when you decide to attend college, you are committing yourself to years of study, which you expect will pay off for the rest of your life. So the decision to attend college is a decision to embark on a long-term project. The basic rule in deciding whether or not to undertake a project is that you should compare the benefits of that project with its costs, implicit as well as explicit. But making these comparisons can sometimes be difficult because the benefits and costs of a project may not arrive at the same time. Sometimes the costs of a project come at an earlier date than the benefits. For example, going to college involves large immediate costs: tuition, income forgone because you are in school, and so on. The benefits, such as a higher salary in your future career, come later, often much later. In other cases, the benefits of a project come at an earlier date than the costs. If you take out a loan to pay for a vacation cruise, the satisfaction of the vacation will come immediately, but the burden of making payments will come later. How, specifically is time an issue in economic decision-making? Borrowing, Lending, and Interest In general, having a dollar today is worth more than having a dollar a year from now. To see why, let’s consider two examples. First, suppose that you get a new job that comes
with a $1,000 bonus, which will be paid at the end of the first year. But you would like to spend the extra money now—say, on new clothes for work. Can you do that? The answer is yes—you can borrow money today and use the bonus to repay the debt a year from now. But if that is your plan, you cannot borrow the full $1,000 today. You must borrow less than that because a year from now you will have to repay the amount borrowed plus interest. Now consider a different scenario. Suppose that you are paid a bonus of $1,000 today, and you decide that you don’t want to spend the money until a year from now. What do Va 237 you do with it? You put it in the bank; in effect, you are lending the $1,000 to the bank, which in turn lends it out to its customers who wish to borrow. At the end of a year, you will get more than $1,000 back—you will receive the $1,000 plus the interest earned. All of this means that having $1,000 today is worth more than having $1,000 a year from now. As any borrower and lender know, this is what allows a lender to charge a borrower interest on a loan: borrowers are willing to pay interest in order to have money today rather than waiting until they acquire that money later on. Most interest rates are stated as the percentage of the borrowed amount that must be paid to the lender for each year of the loan. Whether money is actually borrowed for 1 month or 10 years, and regardless of the amount, the same principle applies: money in your pocket today is worth more than money in your pocket tomorrow. To keep things simple in the discussions that follow, we’ll restrict ourselves to examples of 1-year loans of $1. Because the value of money depends on when it is paid or received, you can’t evaluate a project by simply adding up the costs and benefits when those costs and benefits arrive at different times. You must take time into account when evaluating the project because $1 that is paid to you today is worth more than $1 that is paid to you a year from now. Similarly, $1 that you must pay today is more burdensome than $1 that you must pay next year. Fortunately, there is a simple way to adjust for these complications so that we can correctly compare the value of dollars received and paid out at different times
. Next we’ll see how the interest rate can be used to convert future benefits and costs into what economists call present values. By using present values when evaluating a project, you can evaluate a project as if all relevant costs and benefits were occurring today rather than at different times. This allows people to “factor out” the complications created by time. We’ll start by defining the concept of present value. Defining Present Value The key to the concept of present value is to understand that you can use the interest rate to compare the value of a dollar realized today with the value of a dollar realized later. Why the interest rate? Because the interest rate correctly measures the cost to you of delaying the receipt of a dollar of benefit and, correspondingly, the benefit to you of delaying the payment of a dollar of cost. Let’s illustrate this with some examples. Suppose that you are evaluating whether or not to take a job in which your employer promises to pay you a bonus at the end of the first year. What is the value to you today of $1 of bonus money to be paid one year in the future? A slightly different way of asking the same question: what amount would you be willing to accept today as a substitute for receiving $1 one year from now? To answer this question, begin by observing that you need less than $1 today in order to be assured of having $1 one year from now. Why? Because any money that you have today can be lent out at interest—say, by depositing it in a bank account so that the bank can then lend it out to its borrowers. This turns any amount you have today into a greater sum at the end of the year. Let’s work this out mathematically. We’ll use the symbol r to represent the interest rate, expressed in decimal terms—that is, if the interest rate is 10%, then r = 0.10. If you lend out $X, at the end of a year you will receive your $X back, plus the interest on your $X, which is $X × r. Thus, at the end of the year you will receive: (24-1) Amount received one year from now as a result of lending $X today = $X + $X × r = $X × (1 + r) The next step is to find out how much you would have to lend out today to have $1 a year from now. To do that, we just need
to set Equation 24-1 equal to $1 and solve for $X. That is, we solve the following equation for $X: (24-2) Condition satisfied when $1 is received one year from now as a result of lending $X today: $X × (1 + r) = $ 238 The present value of $1 realized one year from now is equal to $1/(1 + r ): the amount of money you must lend out today in order to have $1 in one year. It is the value to you today of $1 realized one year from now In the 1971 movie Willy Wonka and the Chocolate Factory, Veruca Salt appreciated the added value of having things in the present. She wanted a “golden-egglaying-goose NOW!” Rearranging Equation 24-2 to solve for $X, the amount you need today in order to receive $1 one year from now is: (24-3) Amount lent today in order to receive $1 one year from now = $X = $1/(1 + r) This means that you would be willing to accept today the amount $X defined by Equation 24-3 for every $1 to be paid to you one year from now. The reason is that if you were to lend out $X today, you would be assured of receiving $1 one year from now. Returning to our original question, this also means that if someone promises to pay you a sum of money one year in the future, you are willing to accept $X today in place of every $1 to be paid one year from now. Now let’s solve Equation 24-3 for the value of $X. To do this we simply need to use the actual value of r (a value determined by the financial markets). Let’s assume that the actual value of r is 10%, which means that r = 0.10. In that case: (24-4) Value of $X when r = 0.10: $X = $1/(1 + 0.10) = $1/1.10 = $0.91 So you would be willing to accept $0.91 today in exchange for every $1 to be paid to you one year from now. Economists have a special name for $X—it’s called the present value of $1. Note that the present value of any given amount will change as the interest rate changes. To see that
this technique works for evaluating future costs as well as evaluating future benefits, consider the following example. Suppose you enter into an agreement that obliges you to pay $1 one year from now—say, to pay off a car loan from your parents when you graduate in a year. How much money would you need today to ensure that you have $1 in a year? The answer is $X, the present value of $1, which in our example is $0.91. The reason $0.91 is the right answer is that if you lend it out for one year at an interest rate of 10%, you will receive $1 in return at the end. So if, for example, you must pay back $5,000 one year from now, then you need to deposit $5,000 × 0.91 = $4,550 into a bank account today earning an interest rate of 10% in order to have $5,000 one year from now. (There is a slight discrepancy due to rounding.) In other words, today you need to have the present value of $5,000, which equals $4,550, in order to be assured of paying off your debt in a year These examples show us that the present value concept provides a way to calculate the value today of $1 that is realized in a year—regardless of whether that $1 is realized as a benefit (the bonus) or a cost (the car loan payback). To evaluate a project today that has benefits, costs, or both to be realized in a year, we just use the relevant interest rate to convert those future dollars into their present values. In that way we have “factored out” the complication that time creates for decision making. Below we will use the present value concept to evaluate a project. But before we do that, it is worthwhile to note that the present value method can be used for projects in which the $1 is realized more than a year later—say, two, three, or even more years. Suppose you are considering a project that will pay you $1 two years from today. What is the value to you today of $1 received two years into the future? We can find the answer to that question by expanding our formula for present value. Let’s call $V the amount of money you need to lend today at an interest rate of r in order to have $1 in two years. So if you lend $V today, you will receive $V
× (1 + r) in one year. And if you re-lend that sum for another year, you will receive $V × (1 + r) × (1 + r) = $V × (1 + r)2 at the end of the second year. At the end of two years, $V will be worth $V × (1 + r)2. In other words: (24-5) Amount received in one year from lending $V = $V × (1 + r Va 239 The net present value of a project is the present value of current and future benefits minus the present value of current and future costs. Amount received in two years from lending $V = $V × (1 + r) × (1 + r) = $V × (1 + r)2 and so on. For example, if r = 0.10, then $V × (1.10)2 = $V × 1.21. Now we are ready to answer the question of what $1 realized two years in the future is worth today. In order for the amount lent today, $V, to be worth $1 two years from now, it must satisfy this formula: (24-6) Condition satisfied when $1 is received two years from now as a result of lending $V today: $V × (1 + r)2 = $1 Rearranging Equation 24-6, we can solve for $V: (24-7) Amount lent today in order to receive $1 two years from now = $V = $1/(1 + r)2 Given r = 0.10 and using Equation 24-7, we arrive at $V = $1/1.21 = $0.83. So, when the interest rate is 10%, $1 realized two years from today is worth $0.83 today because by lending out $0.83 today you can be assured of having $1 in two years. And that means that the present value of $1 realized two years into the future is $0.83. (24-8) Present value of $1 realized two years from now = $V = $1/(1.10)2 = $1/1.21 = $0.83 From this example we can see how the present value concept can be expanded to a number of years even greater than two. If we ask what the present value is of $1 realized any number of years, represented by
N, into the future, the answer is given by a generalization of the present value formula: it is equal to $1/(1 + r)N. Using Present Value Suppose you have to choose one of three hypothetical projects to undertake. Project A costs nothing and has an immediate payoff to you of $100. Project B requires that you pay $10 today in order to receive $115 a year from now. Project C gives you an immediate payoff of $119 but requires that you pay $20 a year from now. We’ll assume that the annual interest rate is 10%—that is, r = 0.10. The problem in evaluating these three projects is that their costs and benefits are realized at different times. That is, of course, where the concept of present value becomes extremely helpful: by using present value to convert any dollars realized in the future into today’s value, you factor out the issue of time. Appropriate comparisons can be made using the net present value of a project—the present value of current and future benefits minus the present value of current and future costs. The best project to undertake is the one with the highest net present value. Table 24.1 shows how to calculate net present value for each of the three projects. The second and third columns show how many dollars are realized and when t a b l e 24.1 The Net Present Value of Three Hypothetical Projects Project Dollars realized today Dollars realized one year from today Present value formula Net present value given r 0.10 A B C $100 −$10 $119 — $115 −$20 $100 −$10 + $115/(1 + r ) $119 − $20/(1 + r ) $100.00 $94.55 $100.82 240 fyi How Big Is That Jackpot, Anyway? For a clear example of present value at work, consider the case of lottery jackpots. On March 6, 2007, Mega Millions set the record for the largest jackpot ever in North America, with a payout of $390 million. Well, sort of. That $390 million was available only if you chose to take your winnings in the form of an “annuity,” consisting of an annual payment for the next 26 years. If you wanted cash up front, the jackpot was only $233 million and change. lending the money to the federal government). The money would have been invested in such a way that the investments would pay just enough to cover the annuity.
This worked, of course, because at the interest rates prevailing at the time, the present value of a $390 million annuity spread over 26 years was just about $233 million. To put it another way, the opportunity cost to the lottery of that annuity in present value terms was $233 million. Why was Mega Millions so stingy about quick So why didn’t they just call it a $233 million payoffs? It was all a matter of present value. If the winner had been willing to take the annuity, the lottery would have invested the jackpot money, buying U.S. government bonds (in effect jackpot? Well, $390 million sounds more impressive! But receiving $390 million over 26 years is essentially the same as receiving $233 million today. they are realized; costs are indicated by a minus sign. The fourth column shows the equations used to convert the flows of dollars into their present value, and the fifth column shows the actual amounts of the total net present value for each of the three projects. For instance, to calculate the net present value of project B, we need to calculate the present value of $115 received in one year. The present value of $1 received in one year would be $1/(1 + r). So the present value of $115 is equal to 115 × $1/(1 + r); that is, $115/(1 + r). The net present value of project B is the present value of today’s and future benefits minus the present value of today’s and future costs: −$10 + $115/(1 + r). From the fifth column, we can immediately see which is the preferred project—it is project C. That’s because it has the highest net present value, $100.82, which is higher than the net present value of project A ($100) and much higher than the net present value of project B ($94.55). This example shows how important the concept of present value is. If we had failed to use the present value calculations and instead simply added up the dollars generated by each of the three projects, we could have easily been misled into believing that project B was the best project and project C was the worst. M o d u l e 24 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Consider the three hypothetical projects shown in Table 24.1. This time, however, suppose that the interest rate is only 2%.
a. Calculate the net present values of the three projects. Which one is now preferred? b. Explain why the preferred choice is different with a 2% interest rate from with a 10% interest rate Va 241 Tackle the Test: Multiple-Choice Questions 1. Suppose, for simplicity, that a bank uses a single interest rate for loans and deposits, there is no inflation, and all unspent money is deposited in the bank. The interest rate measures which of the following? I. the cost of using a dollar today rather than a year from now II. the benefit of delaying the use of a dollar from today until a year from now III. the price of borrowing money calculated as a percentage of the amount borrowed a. I only b. II only III only c. d. I and II only I, II, and III e. 2. If the interest rate is zero, then the present value of a dollar received at the end of the year is a. more than $1. b. equal to $1. c. less than $1. d. zero. e. infinite. 3. If the interest rate is 10%, the present value of $1 paid to you one year from now is a. $0. b. $0.89. c. $0.91. d. $1. e. more than $1. 4. If the interest rate is 5%, the amount received one year from now as a result of lending $100 today is a. $90. b. $95. c. $100. d. $105. e. $110. 5. What is the present value of $100 realized two years from now if the interest rate is 10%? a. $80 b. $83 c. $90 d. $100 e. $110 Tackle the Test: Free-Response Questions 1. a. Calculate the net present value of each of the three 2. a. What is the amount you will receive in three years if you loan $1,000 at 5% interest? b. What is the present value of $1,000 received in three years if the interest rate is 5%? hypothetical projects described below. Assume the interest rate is 5%. Project A: You receive an immediate payoff of $1,000. Project B: You pay $100 today in order to receive $1,200 a year from now. Project C: You receive $1,200 today but must pay $200 one year from now
. b. Which of the three projects would you choose to undertake based on your net present value calculations? Explain. Answer (5 points) 1 point: Project A net present value: $1,000 1 point: Project B net present value: −$100 + ($1,200/1.05) = $1,042.86 1 point: Project C net present value: $1,200 − ($200/1.05) = $1,009.52 1 point: Choose project B. 1 point: It has the highest net present value. 242 Module 25 Banking and Money Creation The Monetary Role of Banks More than half of M1, the narrowest definition of the money supply, consists of currency in circulation—$1 bills, $5 bills, and so on. It’s obvious where currency comes from: it’s printed by the U.S. Treasury. But the rest of M1 consists of bank deposits, and deposits account for the great bulk of M2, the broader definition of the money supply. By either measure, then, bank deposits are a major component of the money supply. And this fact brings us to our next topic: the monetary role of banks. What Banks Do A bank is a financial intermediary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers. Banks can create liquidity because it isn’t necessary for a bank to keep all of the funds deposited with it in the form of highly liquid assets. Except in the case of a bank run—which we’ll get to shortly—all of a bank’s depositors won’t want to withdraw their funds at the same time. So a bank can provide its depositors with liquid assets yet still invest much of the depositors’ funds in illiquid assets, such as mortgages and business loans. Banks can’t, however, lend out all the funds placed in their hands by depositors because they have to satisfy any depositor who wants to withdraw his or her funds. In order to meet these demands, a bank must keep substantial quantities of liquid assets on hand. In the modern U.S. banking system, these assets take the form either of currency in the bank’s vault or deposits held in the bank’s own account at the Federal Reserve. As we’ll see shortly, the latter can be converted into currency more or less instantly. Currency in bank vaults and bank deposits held
at the Federal Reserve are called bank reserves. Because bank reserves are in bank vaults and at the Federal Reserve, not held by the public, they are not part of currency in circulation. To understand the role of banks in determining the money supply, we start by introducing a simple tool for analyzing a bank’s financial position: a T-account. A business’s T-account summarizes its financial position by showing, in a single table, the What you will learn in this Module: • The role of banks in the economy • The reasons for and types of banking regulation • How banks create money Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve. A T-account is a tool for analyzing a business’s financial position by showing, in a single table, the business’s assets (on the left) and liabilities (on the right). 243 f i g u r e 25.1 A T-Account for Samantha’s Smoothies A T-account summarizes a business’s financial position. Its assets, in this case consisting of a building and some smoothie-making machinery, are on the left side. Its liabilities, consisting of the money it owes to a local bank, are on the right side. Assets Liabilities Building Smoothie-making machines $30,000 Loan from bank $20,000 $15,000 The reserve ratio is the fraction of bank deposits that a bank holds as reserves. The required reserve ratio is the smallest fraction of deposits that the Federal Reserve allows banks to hold. business’s assets and liabilities, with assets on the left and liabilities on the right. Figure 25.1 shows the T-account for a hypothetical business that isn’t a bank—Samantha’s Smoothies. According to Figure 25.1, Samantha’s Smoothies owns a building worth $30,000 and has $15,000 worth of smoothie -making equipment. These are assets, so they’re on the left side of the table. To finance its opening, the business borrowed $20,000 from a local bank. That’s a liability, so the loan is on the right side of the table. By looking at the T-account, you can immediately see what Samantha’s Smoothies owns and what it owes. Oh, and it’s called a T-account because the lines in the table make a T-shape. Samantha’s
Smoothies is an ordinary, nonbank business. Now let’s look at the T-account for a hypothetical bank, First Street Bank, which is the repository of $1 million in bank deposits. Figure 25.2 shows First Street’s financial position. The loans First Street has made are on the left side because they’re assets: they represent funds that those who have borrowed from the bank are expected to repay. The bank’s only other assets, in this simplified example, are its reserves, which, as we’ve learned, can take the form either of cash in the bank’s vault or deposits at the Federal Reserve. On the right side we show the bank’s liabilities, which in this example consist entirely of deposits made by customers at First Street. These are liabilities because they represent funds that must ultimately be repaid to depositors. Notice, by the way, that in this example First Street’s assets are larger than its liabilities. That’s the way it’s supposed to be! In fact, as we’ll see shortly, banks are required by law to maintain assets larger by a specific percentage than their liabilities. In this example, First Street Bank holds reserves equal to 10% of its customers’ bank deposits. The fraction of bank deposits that a bank holds as reserves is its reserve ratio. In the modern American system, the Federal Reserve—which, among other things, regulates banks operating in the United States—sets a required reserve ratio, which is the smallest fraction of bank deposits that a bank must hold. To understand why banks are regulated, let’s consider a problem banks can face: bank runs. f i g u r e 25. 2 Assets and Liabilities of First Street Bank First Street Bank’s assets consist of $1,000,000 in loans and $100,000 in reserves. Its liabilities consist of $1,000,000 in deposits—money owed to people who have placed funds in First Street’s hands. Assets Liabilities Loans Reserves $100,000 $1,000,000 Deposits $1,000,000 244 The Problem of Bank Runs A bank can lend out most of the funds deposited in its care because in normal times only a small fraction of its depositors want to withdraw their funds on any given day. But what would happen if, for some reason, all or at least a large fraction of its depositors did try to withdraw their funds
during a short period of time, such as a couple of days? The answer is that if a significant share of its depositors demanded their money back at the same time, the bank wouldn’t be able to raise enough cash to meet those demands. The reason is that banks convert most of their depositors’ funds into loans made to borrowers; that’s how banks earn revenue—by charging interest on loans. Bank loans, however, are illiquid: they can’t easily be converted into cash on short notice. To see why, imagine that First Street Bank has lent $100,000 to Drive - a-Peach Used Cars, a local dealership. To raise cash to meet demands for withdrawals, First Street can sell its loan to Drive - a-Peach to someone else—another bank or an individual investor. But if First Street tries to sell the loan quickly, potential buyers will be wary: they will suspect that First Street wants to sell the loan because there is something wrong and the loan might not be repaid. As a result, First Street Bank can sell the loan quickly only by offering it for sale at a deep discount—say, a discount of 50%, or $50,000. The upshot is that if a significant number of First Street’s depositors suddenly decided to withdraw their funds, the bank’s efforts to raise the necessary cash quickly would force it to sell off its assets very cheaply. Inevitably, this leads to a bank failure: the bank would be unable to pay off its depositors in full. What might start this whole process? That is, what might lead First Street’s depositors to rush to pull their money out? A plausible answer is a spreading rumor that the bank is in financial trouble. Even if depositors aren’t sure the rumor is true, they are likely to play it safe and get their money out while they still can. And it gets worse: a depositor who simply thinks that other depositors are going to panic and try to get fyi It’s a Wonderful Banking System Next Christmastime, it’s a sure thing that at least one TV channel will show the 1946 film It’s a Wonderful Life, featuring Jimmy Stewart as George Bailey, a small -town banker whose life is saved by an angel. The movie’s climactic scene is a run on Bailey’s bank, as fearful depositors rush to take their funds out. When the movie
was made, such scenes were still fresh in Americans’ memories. There was a wave of bank runs in late 1930, a second wave in the spring of 1931, and a third wave in early 1933. By the end, more than a third of the nation’s banks had failed. To bring the panic to an end, on March 6, 1933, the newly inaugurated president, Franklin Delano Roosevelt, closed all banks for a week to give bank regulators time to shut down unhealthy banks and certify healthy ones. role in an economic crisis that swept Southeast Asia in 1997–1998 and in the severe economic crisis in Argentina, which began in late 2001. Notice that we said “most bank runs.” There are some limits on deposit insurance; in particular, currently only the first $250,000 of any bank account is insured. As a result, there can still be a rush to pull money out of a bank perceived as troubled. In fact, that’s exactly what happened to IndyMac, a Pasadena -based lender that had made a large number of questionable home loans, in July 2008. As questions about IndyMac’s financial soundness were raised, depositors began pulling out funds, forcing federal regulators to step in and close the bank. Unlike in the bank runs of the 1930s, however, most depositors got all their funds back—and the panic at IndyMac did not spread to other institutions. In July 2008, panicky IndyMac depositors lined up to pull their money out of the troubled California bank. Since then, regulation has protected the United States and other wealthy countries against most bank runs. In fact, the scene in It’s a Wonderful Life was already out of date when the movie was made. But the last decade has seen several waves of bank runs in developing countries. For example, bank runs played 245 A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. Deposit insurance guarantees that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. Reserve requirements are rules set by the Federal Reserve that determine the required reserve ratio for banks. The discount window is an arrangement in which the Federal Reserve stands ready to lend money to banks. their money out will realize that this could “break the bank.” So he or she joins the rush. In other words,
fear about a bank’s financial condition can be a self -fulfilling prophecy: depositors who believe that other depositors will rush to the exit will rush to the exit themselves. A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. Moreover, bank runs aren’t bad only for the bank in question and its depositors. Historically, they have often proved contagious, with a run on one bank leading to a loss of faith in other banks, causing additional bank runs. The FYI “It’s a Wonderful Banking System” describes an actual case of just such a contagion, the wave of bank runs that swept across the United States in the early 1930s. In response to that experience and similar experiences in other countries, the United States and most other modern governments have established a system of bank regulations that protects depositors and prevents most bank runs. Bank Regulation Should you worry about losing money in the United States due to a bank run? No. After the banking crises of the 1930s, the United States and most other countries put into place a system designed to protect depositors and the economy as a whole against bank runs. This system has three main features: deposit insurance, capital requirements, and reserve requirements. In addition, banks have access to the discount window, a source of loans from the Federal Reserve when they’re needed. Deposit Insurance Almost all banks in the United States advertise themselves as a “member of the FDIC”—the Federal Deposit Insurance Corporation. The FDIC provides deposit insurance, a guarantee that depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. Currently, the FDIC guarantees the first $250,000 of each account. This amount will be subject to change in 2014. It’s important to realize that deposit insurance doesn’t just protect depositors if a bank actually fails. The insurance also eliminates the main reason for bank runs: since depositors know their funds are safe even if a bank fails, they have no incentive to rush to pull them out because of a rumor that the bank is in trouble. Capital Requirements Deposit insurance, although it protects the banking system against bank runs, creates a well-known incentive problem. Because depositors are protected from loss, they have no incentive to monitor their bank’s financial health, allowing risky behavior by the

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