SEA OF ECONOMIC ACTIVITY

A ONE DAY LESSON TO MAKE SENSE OF IT ALL

Up to this point it hasn’t needed to make sense

• I realize that it has been a lot of memorization…learn this, this, this, and this. Why? Just because.

• As hard as it is to understand, until now that was all that was essentially needed. If you can recall the information, despite the usually accompanying comprehension, you can put it all together to make sense of everything in one short time.

• Right now you may feel as though you are drowning in this sea of activity.

• Being able to recall the macro content thus far puts you in the buoyancy of the Dead Sea (you can stay afloat w/ minimal effort but are aggravated that you still aren’t going anywhere).

• Our goal for today is to take you out of the water & put you at the helm of the greatest transport of our day—

the KEYNESIAN CRUISER!!!

It’s hard to understand but we are where we need to be. You cannot understand MACROECONOMICS without knowing all of the individual components. Application & mastery are afterthoughts once all the blocks are in place. But now that we have our blueprints, we can finally assemble our ship.On a side not, all attempts at humor or cuteness are over. Strictly business now.

8 SIMPLE STEPS TO MAKE SENSE OF THE TSUNAMI OF

GRIEF & FRUSTRATION(also known as Macroeconomics)

I. The economy is driven by our independent actions. • Going back to micro, we are reminded of

CONSUMER SOVEREIGNTY. As the little people we decide what happens in the economy based on what we decide to buy, sell, make, and do.

• 1,000s of small, private choices control our economy…the government simply tries to influence it.

Circular Flow Model• Everything is connected

together.• Like it or not any action

taken in our economy will indefinitely be felt throughout it.

• While we only care about our own actions, the gov’t is charged with caring about all of us together, but none of us on our own.

II. Analysis of Entire Economy

• Because the gov’t looks at us as being a group and not individuals, the measures of economic performance are geared to evaluate our strength together.

• This idea of measuring an entire country is summarized as NATIONAL PRODUCT—or simply the amount of stuff any given nation produces.

Other Specific Measures

• GDP—total value of everything produced on US soil (doesn’t matter whose it is)

• GNP—total value of everything produced by US-owned industries (doesn’t matter where it is)

• NDP—total value of everything produced after subtracting depreciation (since value was lost as stuff aged & wore out it is subtracted to clarify that the increase was not all on top of what we already had)

Nominal vs. Real• In addition, economists everywhere use the

difference here to improve accuracy.• Nominal is prices NOW—something all

people understand & see.• Real eliminates the increased value due to

inflation (compares change in quantity based on a set price of any given good)

• Real gives a more accurate assessment of change & is used almost exclusively by economists.

How do we get these numbers?• There are two different approaches to

calculating GDP—income and expenditure.• By adding up all incomes (ie. wages, rent,

interest, and profit) we are able to tally how much our country earned.

• By adding up all expenditures (ie. Consumption, Government, Investment, and Net Exports) we are able to tally how much our country has spent.

• Both numbers, though different approaches, always produce the same result.

Why does the total even matter?

• Some guy named OKUN figured out that for every 2% we fell behind potential GDP, the unemployment increased 1%.

• That is just one specific reason, but the underlying fact is that since all actions do impact everyone else, the more we have together the more we have apart. One person’s income is another’s expenditure.

III. 3 Key Indicators of Macro• The gov’t can analyze the total value all it

wants. There is some country is Africa or the Middle East somewhere that has one guy controlling like 75% of the wealth. Sure he is rich and the country’s GDP is ok, but the people are dirt poor starving to death.

• In addition to the total, we also highlight 3 other indicators—growth, inflation, and unemployment.

The Big Three• Throughout history there has never been a

“successful” US president leave office with both popularity and a weak economy.

• These three provide quantitative evidence to verify just how well we are doing.

• Ironically, despite having the economy thriving (BOY THINGS CHANGED IN A YEAR), something that usually dominates polls, President Bush is among the least popular presidents ever.

INFLATION

• Inflation is defined as a general rise in prices. Over time stuff costs more money.

• It is most commonly evaluated using a PRICE INDEX—average price of a marketbasket of goods (CPI & PPI)

• Some prices go up and some go down so in order to evaluate the cost of living, we compare the prices of a group of things together.

UNEMPLOYMENT

• Unemployment is the most obvious indicator, and most sensitive.

• When people don’t have jobs it means that you pay for them through the safety nets.

• Although we tend to think of 0% as ideally our goal, the NATURAL RATE OF UNEMPLOYMENT is between 5-6%.

• Yes it’s bad, but we actually do need some.• Right now PA is ~4.4% and the USA under

5%. (BOTH INCREASED SINCE LAST YEAR)

GROWTH• In addition to wanting stable prices and jobs

for everybody, each year we want more of them.

• Growth is probably the least sensitive of the three. It does not directly affect any of us on a personal level like the others, but is probably even more important on a national level. We have maintained a steady growth rate ~3-6% throughout most of our history, and despite imports that trend is likely to continue.

Trouble in Paradise

• We run into trouble when we realize that two of the goals have an inverse affect on the other. Philips Curve

• In order to have growth and low unemployment you automatically create inflation. To lower inflation you must do so by creating unemployment and lowering growth.

• If you cannot win the war, WHAT THEN IS OUR GOAL?

IV. Find a happy median

• Since we cannot have all 3 indicators be the best at the same time, we compromise by automatically gravitating towards the FULL EMPLOYMENT LEVEL OF OUTPUT. This does not mean everyone has a job, but anyone who wants one does.

• Considered to be the point when there is no cyclical unemployment.

Full Employment Level of Output

• The full employment line shows where the economy would be producing if all who wanted had a job.

• In the picture the economy is producing at a point under that level (want equilibrium to be at the line) & is experiencing a recession.

• It is possible, however, to be producing more that that level (inflationary gap).

V. Knowing what needs done vs. being able to get it done!• It is very evident that the gov’t is capable of

influencing the business cycle (read any editorial section).

• However, the difficult part comes from balancing what they can do, what the people want them to do, and then getting actions to have the desired effect.

• In all there are 3 methods of intervention—fiscal, monetary, and income.

Fiscal vs. Monetary

• Two different policies controlled by two different groups—the federal gov’t & the Federal Reserve (or national bank).

• The gov’t cannot enforce any monetary changes and the FED cannot influence policy. The two are separate in virtually every aspect, but it is imperative that they use their powers combined instead of apart. The power is yours! sorry

What does each control?

• Fiscal Policy—gov’t control through taxes & spending.

• Monetary Policy—FED control over the discount rate, reserve requirement, and the open market operations.

Fiscal Policy Considerations• In addition to controlling changes in taxes

& spending, the gov’t also has built-in AUTOMATIC STABALIZERS.

• When the business cycle (& our GDP) changes these policies change without anyone making them. If the economy is up, we will pay more taxes & less will get transfer payments. If down, vice versa.

• No one changed anything, but the gov’t still worked to offset & limit the impact of the business cycle.

Consideration II• When it comes to spending, sometimes the gov’t

doesn’t have a choice. MANDATORY spending is required by law. The biggest example is that of SAFETY NETS AND TRANSFER PAYMENTS. If you qualify you get it.

• Most other spending is DISCRETIONARY. If not required by law or via the Constitution, the Gov’t can choose whether or not to spend money on anything it wants to. One year you have a grant funding research the next you don’t. The military, public goods, and education are all discretionary (in this case since the states are responsible).

Monetary Policy

• The effectiveness of monetary policy, coming from a bank, is their ability to control/influence the money supply and corresponding interest rates. The underlying principle is that if money is cheaper to borrow, we will borrow more of it which will increase AD & GDP.

• If it costs more to borrow, we won’t want as much and the contrary will occur.

Money Supply GraphInterest Rate

Money Supply

An increase in the money supply causes interest rates to go down.A decrease in

the money supply causes interest rates to increase. Demand to borrow

(fixed quantity)

Money Creation• When we talk of money being “created” it doesn’t

literally mean that we are printing more. Instead it refers to our FRACTIONAL RESERVE BANKING SYSTEM.

• Since banks only have to keep a small percentage (~10%) of your deposits, loaning out the rest they can create more when the “borrowed” money is then deposited in another bank. Multiple people think they have the same physical currency, allowing us to increase the amount of currency we believe we have, having thus “created” more.

• Money supply multiplier = 1/RR

What’s the point?

• Lower taxes• Increase gov’t spending• Decrease discount rate• Decrease reserve

requirement• Buy bonds through open

market operations

• Increase taxes• Decrease gov’t spending• Increase discount rate• Increase reserve

requirement• Sell bonds through open

market operations

Boost the Economy Recede the Economy

Potential Impact• Based on the list on the preceding page, both the

Federal Gov’t & the Federal Reserve have the ability to influence the economy.

• If you boost the economy, it means that AD, GDP, inflation, and growth are all UP. Unemployment will be down.

• If you recede the economy, it means that AD, GDP, inflation, and growth are all DOWN. Unemployment will be up.

• Each group individually, and especially both together, can essentially determine where we are in the business cycle based on what they do.

VI. Things we can control

• Ultimately we have the control, but will act in predictable ways, allowing them to influence the economy how they want.

• However, things to remember that the consumer directly controls are as follows: MPC & MPS, the spending multiplier, leakages (money out) & injections (money in), and capital deepening.

MPC really all we decide• The biggest thing we will influence is MPC,

which decides the multiplier. In actuality, this doesn’t change what they can do; instead, it decides how much they need to do to produce the desired effect.

• If we spend more money it means they have to change less in order to have the same “amplified” impact”.

• If we save more, their actions are less effective & will then require a more substantial action on their part (spend $10 billion more instead of $7)

VII. HOW TO DO IT?• The next big concept of macroeconomics—

now that we know what they want to do, what we can do, and how they can do it—is to figure out HOW the gov’t should intervene in order to help establish the economy they desire.

• Essentially, this comes down to understanding the various schools of thought (classical, Keynesian, monetarists). Everyone seems to have a good grip on that plus you have the handout so we will move on to the last step.

VIII. OVERALL INTERACTION• The key to mastering macro is

understanding how the different things cause others to change. Below is a list to demonstrate some of the main interactions. When you understand them, you do not need to memorize anything for macro anymore…it will all just make sense.

• If AD THEN GDP

If AD ↑ then GDP ↑ Unemployment ↓ Inflation ↑ Growth ↑If AD ↓ then GDP ↓ Unemployment ↑ Inflation ↓ Growth ↓

If IR ↑ then GDP ↓ Unemployment ↑ Inflation ↓ Growth ↓If IR ↓ then GDP ↑ Unemployment ↓ Inflation ↑ Growth ↑

Basically it comes down to this: all of the policy changes affect the AD. If you can keep straight

which way AD changes (up or down), the impacts on the other variables are always the same. Changes in any of the policies directly

impact these variables, and vice versa.

BOTTOM LINE• The entire study of macroeconomics

revolves around a very simple process—WE RUN THE ECONOMY…AS THE GOV’T THEY TRY TO KEEP IT OUT OF TROUBLE…WHEN THEY FEEL IT NEEDS SOME FINE TUNING THEY ACT…THESE ACTIONS DIRECTLY IMPACT US (SOME GOOD, SOME BAD)…WE THEN CONTINUE ON FOR AWHILE UNTIL THINGS CHANGE & THE PROCESS STARTS ALL OVER AGAIN.