Introduction to Economics

1. Introduction to Economics Macroeconomics The US Economy

2. Quiz: Median = 32

3. 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?

4. 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?

5. Impact of the Business Cycle on the Public Sector • The University of California

6. 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?

8. How has UC Fared Over Time? • Does UC get a fair share of state money? • UC Budget Share = UC Budget/CA Gen Fund

10. 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

12. 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

14. Chapter 20

15. 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.

16. U.S. Real GDP1930-2000 • Real GDP has grown substantially over this period.

17. 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.

18. U.S. Trade Balance as a Share of GDP, 1960 - 2000

19. 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.

20. GDP as a Measure of Welfare • 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.

21. Chapter 21

22. Definitions • 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.

23. U.S. Inflation Rate, 1950-2000,Based on Chain Price Index

24. Chapter 24

25. Business Cyclesand 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%.

26. The 1990 Recession

27. Peak 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

28. The Unemployment RateDuring Recessions • During periods of recession, marked by the shaded bars, unemployment rises sharply.

29. Money, the Banking System and the Federal Reserve • What is money?

30. The Functions of Money • 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 ...”

31. Definitions of Money • 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

32. Summary of Monetary Policy

33. The Federal Reserve System: Purposes & Functions http://www.bog.frb.fed.us/ PDF format: Adobe Acrobat

34. The Federal Reserve System: Purposes & Functions http://www.bog.frb.fed.us/ PDF format: Adobe Acrobat

35. How Effective Has the Fed Been? • 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

36. Misery Index = Unemployment Rate + Inflation Rate Hoover Roosevelt Truman Ike LBJ Nixon/ Ford Reagan Bush JFK Carter Clinton

37. How Effective Has the Fed Been? • 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

38. Impact of the Supply of Reserves on the Federal Funds Rate Demand for Reserves by Banks FFR, price of reserves Supply of Reserves: Fed quantity of reserves

39. Impact of the Supply of Reserves on the Federal Funds Rate Demand for Reserves by Banks FFR, price of reserves Supply of Reserves: Fed quantity of reserves

40. Fed: Lender of Last Resort to Banks at Discount Rate, 00-02 Source: Federal Reserve Bank of Minneapolis

41. Nation’s Commercial Banks, 10/22/01 Bank Loans (credit) = $3928.8 B, WSJ 10/22/2001, p. C 2

42. What is at stake? US Postwar Expansions

45. Monetary Policy Tradeoff • 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

46. Other Measures of Fed Effectiveness • Reserve Aggregates • Excess Reserves • Free Reserves

47. Definitions • 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

48. Consumers, Firms, Banks, 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

50. Fed Sets Ratio of Minimum Bank Reserves to Bank Deposits • 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