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Introduction to Economics. Macroeconomics The US Economy. Quiz: Median = 32. Outline. Economics in the News Review of Chapters 20, 21, and 24 The banking system and the Federal Reserve Monetary Policy: Does the Fed get the timing right?. Conference Board.

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Introduction to economics l.jpg

Introduction to Economics

Macroeconomics

The US Economy



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Outline

  • Economics in the News

  • Review of Chapters 20, 21, and 24

  • The banking system and the Federal Reserve

  • Monetary Policy: Does the Fed get the timing right?


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Conference Board

  • Index of Consumer Confidence falls 14.3 points in September to lowest level since 1993!

  • Index is at 79.3 (1985=100)

  • Is consumer spending going to collapse?

  • Is it going to be a rough Christmas for retailers?



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California State Budget

  • Governor Davis Warns of a 15% Budget Cut for 2002-2003

    • Daily Nexus, Thursday October 13, 2001

  • Policy Implications: Raising Student Fees?


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How has UC Fared Over Time?

  • Does UC get a fair share of state money?

  • UC Budget Share = UC Budget/CA Gen Fund


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Trends in California Government

  • Proposition 13 (1970’s): limited local property tax, shifted fiscal power to the state

  • Gann Initiative(1970’s): tried to limit state government to constant real expenditures per person, ie limit the size of government

  • Relative Size of Government = CA Gen Fund Expenditures/ CA Personal Income


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UC Budget Forecast for 2002-2003

UC Budget, GEN FUND = UC Budget Share x Relative Size of Government x CA Personal Income

UC Budget = (UC Budget/CA Gen Fund) x ( CA Gen Fund/

CA Personal Income) x CA Personal Income

UC Budget, GEN Fund =0.045 x 0.07 x CA Personal Income



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Production, Income,and the Circular Flow

  • The circular flow diagram shows how production of goods and services generates income for households and how households purchase goods and services produced by firms.


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U.S. Real GDP1930-2000

  • Real GDP has grown substantially over this period.


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Consumption Expenditures

  • Consumption expenditures are purchases of newly produced goods and services by households. Consumption is broken down into:

  • Durable goods that last for a long time.

  • Nondurable goods that last for a short time.

  • Services that reflect work done in which people play a prominent role in the delivery.

  • Consumption comprises 67% of total purchases.



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Composition of U.S. National Income, Second Quarter 2000 (billions of dollars)

National income

7,983

Compensation of employees

5,603

Corporate profits

964

Rental income

141

Proprietor’s income

709

Net interest

566

Who Gets the Income?

  • Approximately 70% of all national income goes to workers in the form of wages and benefits.


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GDP as a Measure of Welfare (billions of dollars)

  • GDP is our best measure of the value of output produced, but not a perfect measure. There are several recognized flaws in the construction of GDP:

  • GDP ignores the underground economy, where transactions are not reported to official authorities.

  • Finally, GDP does not value changes in the environment that arise from the production of output.


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Chapter 21 (billions of dollars)


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Definitions (billions of dollars)

  • The unemployment rate is the percentage of people in the labor force who are unemployed.

  • The labor force participation rate is the fraction of the population that is over 16 years of age that is in the labor force.


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U.S. Inflation Rate, 1950-2000, (billions of dollars)Based on Chain Price Index


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Chapter 24 (billions of dollars)


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Business Cycles (billions of dollars)and Economic Fluctuations

  • A recession is a period when real GDP falls for two consecutive quarters. It starts at the peak of an increase in output, and ends at a trough, the time at which output stops falling in a recession.

  • A depression is a prolonged period of decline in output, or a severe recession. During the Great Depression, 1929 through 1933, real GDP fell by over 33%, and unemployment rose to 25%.


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The 1990 Recession (billions of dollars)


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Peak (billions of dollars)

Trough

Percent Decline in Real GDP

November 1948

October 1949

1.5

July 1953

May 1954

3.2

August 1957

April 1958

3.3

April 1960

February 1961

1.2

December 1969

November 1970

1.0

November 1973

March 1975

4.9

January 1980

July 1980

2.5

July 1981

November 1982

3.0

July 1990

March 1991

1.4

Nine Postwar Recessions


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The Unemployment Rate (billions of dollars)During Recessions

  • During periods of recession, marked by the shaded bars, unemployment rises sharply.


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Money, the Banking System and the Federal Reserve (billions of dollars)

  • What is money?


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The Functions of Money (billions of dollars)

  • medium of exchange

    • instead of barter, i.e. exchange of goods & services for goods and services, we can exchange goods & services for money and vice versa

      • eliminates the search costs & inconvenience of barter

  • store of value

    • we can hold money as an asset

      • because it is a medium of exchange, it is liquid, i.e. we can convert money into goods & assets quickly

  • unit of account

    • measure of value, “ a dollar’s worth of ...”


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Definitions of Money (billions of dollars)

  • M1(a measure of media of exchange) =

    • currency held by the public, outside of banks

    • checkable deposits

      • demand deposits

      • NOW (negotiable order of withdrawal) accounts

        • savings & loans, mutual savings banks

    • traveler’s checks

  • M2 = M1 +

    • money market accounts at banks

    • money market mutual fund accounts

    • certificates of deposit, CD’s, less than $100,000

  • M3 = M2 + CD’s over $100,000


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Summary of Monetary Policy (billions of dollars)


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The Federal Reserve System: Purposes & Functions (billions of dollars)

http://www.bog.frb.fed.us/

PDF format: Adobe Acrobat


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The Federal Reserve System: Purposes & Functions (billions of dollars)

http://www.bog.frb.fed.us/

PDF format: Adobe Acrobat


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How Effective Has the Fed Been? (billions of dollars)

  • Fed Goals: A Stable Economy

    • maximum employment

    • stable prices

    • moderate long-term interest rates

  • Fed Objectives or Targets

    • quantity of reserves

    • price of reserves: Federal Funds Rate

      • federal funds rate, FFR, is the interest rate banks charge one another for borrowing reserves for a day or so; mostly large urban banks borrowing from small suburban and rural banks


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Misery Index = Unemployment Rate + Inflation Rate (billions of dollars)

Hoover

Roosevelt

Truman

Ike

LBJ

Nixon/

Ford

Reagan

Bush

JFK

Carter

Clinton


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How Effective Has the Fed Been? (billions of dollars)

  • Fed Objectives or Targets

    • quantity of reserves

    • price of reserves: Federal Funds Rate

      • federal funds rate, FFR, is the interest rate banks charge one another for borrowing reserves for a day or so; mostly large urban banks borrowing from small suburban and rural banks


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Impact of the Supply of Reserves on the Federal Funds Rate (billions of dollars)

Demand for Reserves by Banks

FFR,

price of

reserves

Supply of Reserves: Fed

quantity of reserves


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Impact of the Supply of Reserves on the Federal Funds Rate (billions of dollars)

Demand for Reserves by Banks

FFR,

price of

reserves

Supply of Reserves: Fed

quantity of reserves


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Fed: Lender of Last Resort to Banks at Discount Rate, 00-02 (billions of dollars)

Source: Federal Reserve Bank of Minneapolis


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Nation’s Commercial Banks, 10/22/01 (billions of dollars)

Bank Loans (credit) = $3928.8 B, WSJ 10/22/2001, p. C 2


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What is at stake? (billions of dollars)

US Postwar Expansions


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Monetary Policy Tradeoff (billions of dollars)

  • Is the Fed too Inflation Oriented?

  • Note: the CPI inflation rate tends to decrease during and after recessions

    • to control inflation, the Fed may be tempted into policies that precipitate recessions and/or make them more severe

  • Note: the unemployment rate tends to increase during and after recessions

    • some critics in Congress think the Fed is too restrictive, i.e. not sufficiently expansionary in policy


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Other Measures of Fed Effectiveness (billions of dollars)

  • Reserve Aggregates

    • Excess Reserves

    • Free Reserves


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Definitions (billions of dollars)

  • Total Bank Reserves = Vault Cash + Deposits with Fed + Loans from Fed

  • Required Bank Reserves = Deposits x Required Reserve Ratio

  • Excess Reserves = Total Reserves - Required Reserves


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Consumers, Firms, Banks, (billions of dollars)and the Fed Determine Reserve Aggregates

Banks

Banks

Deposits with Fed

Loans from Fed,(OMO)

Consumers

Bank Deposits

Fed

Businesses

x

+

Fed

Bank Vault Cash

Reserve ratios

=

=

=

Excess

Reserves

-

=

Total Reserves

Required Reserves


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Fed Sets Ratio of Minimum Bank Reserves to Bank Deposits (billions of dollars)

  • Helps Prevent Liquidity Crises

  • For Example: Dec 1999

    • deposits of 0-$44.3 M (small banks)

      • required minimum reserve ratio: 3%

    • deposits of $44.3 + M (large banks)

      • required minimum reserve ratio: 10%

Cutoff: $44.3 M as of 2000


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Did the Fed Run too tight a monetary policy before 1980? (billions of dollars)

  • Kept excess reserves too low in the banking system

  • This forced banks to borrow reserves from the Fed at the discount window

  • In the 1980’s and 1990’s, the Fed allowed more excess reserves, there was less borrowing at the discount window

  • Much longer expansions ( boom times) resulted


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Fed Policy Record, 48.01-97.07 (billions of dollars)

Source: Survey

of Current Business,

January, 1995


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Fed Monetary Policy: Insufficient Excess Reserves? (billions of dollars)

  • Expansionary Policy

    • ease credit

    • provide positive free reserves

  • Contractionary Policy

    • tighten credit

    • force banks to borrow at discount window, causing negative free reserves


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Bank Reserve Aggregates, 10-19-01 (billions of dollars)

* Excess Reserves = Total Reserves - Required Reserves

** Free Reserves = Excess Reserves - Borrowed Reserves

Source: The Wall Street Journal, 10/19/2001, p.C13


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Before the 1980”s (billions of dollars)

  • Did the Fed dry up “free reserves” too much with tight monetary policy?

  • Free Reserves = Excess Reserves - Borrowed reserves

  • If banks are forced to the discount window, borrowed reserves may dominate excess reserves


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Fed Policy Record, 48.01-97.07 (billions of dollars)

Source: Survey

of Current Business,

January, 1995


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Fed Policy: 48.01-97.07 (billions of dollars)


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Fed Loans of Reserves to Banks (billions of dollars)

  • Before each recession, Fed loans peak and exceed excess reserves

  • As a consequence, free reserves are negative before each recession

    • recall: free reserves = excess reserves - Fed loans

    • negative free reserves are called “net borrowed reserves”

      • they are an index of the Fed trying to tighten credit

      • evidently the Fed was tightening credit sufficiently to contribute to the recession

  • Note: Fed keeps excess reserves low during inflationary 70’s; opposite policy in the 90’s


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Summary of Monetary Policy (billions of dollars)

  • Federal Reserve Needs to Avoid Bank Panics and Bank Failure

    • tool: FDIC

    • tool: Bank Supervision & Education

  • Federal Reserve Needs to Keep the Economy Healthy: Low Unemployment & Inflation Rates

    • tool: Open Market Policy: Fed Sells Securities to Decrease Commercial Bank Deposits and Tighten Credit


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More Review Material (billions of dollars)


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Review: Lecture Nine (billions of dollars)

  • Macroeconomic Policy

    • fiscal policy


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Fiscal Policy (billions of dollars)

  • Preventing Depressions

    • role for autonomous federal spending: the federal government as spender of last resort

      • Keynesian model

  • Automatic Stabilizers in Federal Budget

    • counter-cyclical effect

      • progressive income tax

  • Limit to Fiscal Policy from 1980 to 1998

    • the federal deficit

      • federal government income-expense statement

        • surplus(deficit) = receipts - expenditures


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Less than Full Employment Equilibrium (billions of dollars)

GDP= C+I+G

Consumption, C

Investment, I

GDP

GDP = C + I

C = C0 + mpc* Y

I

450

YFE

GDP = Y

Income, Y

Full Employment Income

Source: Lecture Six


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Less than Full Employment Equilibrium (billions of dollars)

GDP= C+I+G

Consumption, C

Investment, I

GDP

GDP = C + I

GDP+ C+I

C = C0 + mpc* Y

C= C0 +mpc*Y

I

I

450

YFE

GDP = Y

Income, Y

Full Employment Income

Source: Lecture Six


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Automatic Stabilizers (billions of dollars)

  • Progressive Income Tax Rates

    • as personal incomes rise

      • many move to a higher tax bracket

        • disposable income does not grow as fast as income because income taxes take a larger bite

    • as personal incomes fall

      • many move to a lower tax bracket

        • taxes take a smaller fraction of income and dispoable income does not fall as fast as personal income

  • Transfer Payments may grow in recession

    • entitlement program payments

      • unemployment insurance

      • Aid to Families with Dependent Children(AFDC)

      • Social Security Pensions


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Perspective:Is the economy growing less rapidly in the decade of the Nineties?

  • Growth in real GDP over time


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Midterm Review decade of the Nineties?

  • O’Sullivan and Sheffrin

    • Ch. 20, 21, 24, 25 , 27, 28, 30


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20: The Big Ideas in Macro decade of the Nineties?

  • Circular Flow

    • Labor Market

    • Goods Market

  • Measuring the Output of the Economy

    • GDP

    • National Income

  • GDP: Is it a measure of welfare?


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Measuring a Nation’s Production and Income decade of the Nineties?

  • GDP: Expenditure Perspective

    • Consumption

    • Gross Private Investment

    • Government Purchases

    • Net Exports


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21: Unemployment and Inflation decade of the Nineties?

  • What is Unemployment

  • Consumer Price Index (CPI)

  • Percentage Rate of Change of CPI: Inflation


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Review Part II: Chapter Three decade of the Nineties?

Firms

Firms

  • Conceptual Framework: Circular Flow

Supply

Goods

Demand

Goods

Income

Labor

Households

Households

Income Perspective

Expenditure Perspective


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Expenditure Perspective: Open decade of the Nineties?

Firms

Imports

(puchases)

Supply

Goods

Demand

Goods

Exports

(Sales)

Households

Government

Households: Consumption of Goods and Services

Firms: Investment in Plant and Equipment

Government: Purchase of Goods and Services

All Three: Exports - Imports = Net Exports


21 behind the economic statistics l.jpg
21: Behind the Economic Statistics decade of the Nineties?

  • Is a recession coming?

    • how would you figure that out?


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21: Behind the Economic Statistics decade of the Nineties?

  • Expenditure Perspective: GDP

    • Consumption

    • Gross Private Investment

    • Government Purchases

    • Net Exports

  • Inflation

    • what is it?

    • how do we measure it?

    • why is it a problem?


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The Inflation Rate Since 1980 decade of the Nineties?

Source: http://www.yardeni.com


21 behind the economic statistics78 l.jpg
21: Behind the Economic Statistics decade of the Nineties?

  • Expenditure Perspective: GDP

    • Consumption

    • Gross Private Investment

    • Government Purchases

    • Net Exports

  • Inflation

    • what is it?

    • how do we measure it?

    • why is it a problem?

  • Unemployment


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Unemployment Rate: unemployed/ (employed + unemployed) decade of the Nineties?

Unemployment Rate: unemployed/ (labor force)


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24: Coordinating Economic Activity decade of the Nineties?

  • If nominal GDP grows faster than real GDP, what happens?

  • If real GDP stops growing or declines, what happens?


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25: Keynesian Economics and Fiscal Policy decade of the Nineties?

  • The Keynesian Cross

  • The Basic Ideas

    • GDP = National Income (equilibrium)

    • equilibrium GDP can differ from full employment GDP

  • What Should We Do IF We Slip Into Depression?


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Less than Full Employment Equilibrium decade of the Nineties?

Consumption, C

Investment, I

GDP

GDP = C + I

C = C0 + mpc* Y

I

450

YFE

GDP = Y

Income, Y

Full Employment Income


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1998 Midterm decade of the Nineties?

Part IV ( 28 points) Answer both essay questions.

1. One reason for the Great Depression was a sharp drop in consumer

spending.

a. Assuming the economy was initially at the full employment

level of output, describe the effect of a drop in consumer

spending.

b. What was Keynes’ policy recommendation for escaping from

the Great Depression?


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2. Opinions about the US economy have been quite changeable this Fall

quarter. At the moment, the rate of growth of the economy is slowing,

but growth is still positive. How would you satisfy yourself whether

a recession might be coming or not? How would you assess whether

the likelihood of a recession in 1999 is low? or high?

a. What conceptual framework would you use to answer this

question about a prospective recession?

b. What data and which economic measures or statistics would

you look at?

c. How would you deal with the fact that you need a “crystal

ball” to see into 1999 and the future?


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Part III (20 points) Answer both questions. this Fall

1. This is a Keynesian economics diagram of the determination of

equilibrium GDP.

Aggregate

Expenditures

Full Employment

Income

45 degrees

Aggregate Income

a. Label the aggregate expenditures line


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b. Label the equilibrium condition line, for which aggregate

expenditures equals aggregate income, i.e. GDP = Y.

c. On this diagram, indicate the equilibrium level of

aggregate income, Yeq .

d. Is this equilibrium level of income higher or lower than

the full employment level of income? ________________.

e. Given your answer to part d, does this indicate a

recession or an inflationary boom? ____________________.


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2. This diagram illustrates the market for reserves and

the determination of the federal funds rate. This is the

rate which commercial banks charge one another for

borrowing, usually overnight.

Federal

Funds

Rate

Quantity of Reserves

a. Label the demand curve for reserves.


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b. Which institution(s) demand(s) reserves?______________

c. Label the supply curve for reserves.

d. Which institution(s) affect(s) the supply curve for

reserves?_______________

e. If the Federal Reserve raises the ratio of required

reserves to deposits, which curve will shift to the right,

resulting in a _______________

federal funds rate? ____________..


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