Material for the Final Examination

1. Global Economics, with Fernando Quijano Material for the Final Examination Learning Objectives

2. Saving, Investment, and the Financial System 1. LEARNING OBJECTIVE Discuss the role of the financial system in facilitating long-run economic growth.

3. The process of economic growth depends on the ability of firms to expand their operations, buy additional equipment, train workers, and adopt new technologies. Firms can finance some of these activities from retained earnings, which are profits that are reinvested in the firm rather than paid to the firm’s owners. Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households. An Overview of the Financial System Financial markets Markets where financial securities, such as stocks and bonds, are bought and sold. A financial security is a document—sometimes in electronic form—that states the terms under which funds pass from the buyer of the security—who is providing funds—to the seller. Stocks are financial securities that represent partial ownership of a firm. Bonds are financial securities that represent promises to repay a fixed amount of funds.

4. The Macroeconomics of Saving and Investment The total value of saving in the economy must equal the total value of investment. To understand why, we can use some relationships from national income accounting, the methods the Bureau of Economic Analysis uses to keep track of GDP, or total production and total income in the economy. The relationship between GDP (Y) and its components, consumption (C), investment (I), government purchases (G), and net exports (NX) is: Y = C + I + G + NX In an open economy, there is interaction with other economies in terms of both trading of goods and services and borrowing and lending. In a closed economy, there is no trading or borrowing and lending with other economies, so net exports are zero and the relationship between GDP and its components is: Y = C + I + G If we rearrange this relationship, we have an expression for investment in terms of the other variables: I = Y − C − G

5. Private saving(SPrivate) is equal to what households retain of their income after purchasing goods and services (C) and paying taxes (T). Households receive income for supplying the factors of production to firms. This portion of household income is equal to Y. Households also receive income from government in the form of transfer payments (TR). SPrivate= Y + TR− C− T Public saving (SPublic) equals the amount of tax revenue the government retains after paying for government purchases and making transfer payments to households: SPublic= T − G − TR Total saving in the economy (S) is equal to the sum of private saving and public saving: S = SPrivate+ SPublic or: S = (Y + TR − C − T) + (T − G − TR)

6. or: S = Y − C − G Because the right side of this expression is identical to the expression we derived earlier for investment spending, we can conclude that total saving must equal total investment: S = I When the government spends the same amount that it collects in taxes, there is a balanced budget. When the government spends more than it collects in taxes, there is a budget deficit. In the case of a deficit, T is less than G +TR, which means that public saving is negative. Negative saving is also known as dissaving. When the government spends less than it collects in taxes, there is a budget surplus.

7. Market for loanable funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. Figure 21.3 Demand and Supply in the Loanable Funds Market The demand for loanable funds is determined by the willingness of firms to borrow money to engage in new investment projects. The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. Equilibrium in the market for loanable funds determines the real interest rate and the quantity of loanable funds exchanged. The nominal interest rate is the stated interest rate on a loan. The real interest rate corrects the nominal interest rate for the effect of inflation and is equal to the nominal interest rate minus the inflation rate.

8. Explaining Movements in Saving, Investment, and Interest Rates Figure 21.4 An Increase in the Demand for Loanable Funds An increase in the demand for loanable funds increases the equilibrium interest rate from i1to i2, and it increases the equilibrium quantity of loanable funds from L1 to L2. As a result, saving and investment both increase.

9. Figure 21.5 The Effect of a Budget Deficit on the Market for Loanable Funds When the government begins running a budget deficit, the supply of loanable funds shifts to the left. The equilibrium interest rate increases from i1to i2, and the equilibrium quantity of loanable funds falls from L1to L2. As a result, saving and investment both decline. Crowding out A decline in private expenditures as a result of an increase in government purchases.

10. The Business Cycle 2. LEARNING OBJECTIVE Explain what happens during the business cycle.

11. Some Basic Business Cycle Definitions The fluctuations in real GDP per capita shown in Figure 21.1 reflect the underlying fluctuations in real GDP. Since at least the early nineteenth century, the U.S. economy has experienced business cycles that consist of alternating periods of expanding and contracting economic activity. During the expansion phase of the business cycle, production, employment, and income are increasing. The period of expansion ends with a business cycle peak. Following the business cycle peak, production, employment, and income decline as the economy enters the recession phase of the cycle. The recession comes to an end with a business cycle trough, after which another period of expansion begins.

12. Figure 21.6 The Business Cycle Panel (b) shows the actual movements in real GDP for 2005 to 2011. The recession that began following the business cycle peak in December 2007 was the longest and the most severe since the Great Depression of the 1930s. Panel (a) shows an idealized business cycle, with real GDP increasing smoothly in an expansion to a business cycle peak and then decreasing smoothly in a recession to a business cycle trough, which is followed by another expansion. The periods of expansion are shown in green, and the period of recession is shown in red.

13. How Do We Know When the Economy Is in a Recession? The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) defines a recession as a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale–retail trade. The NBER typically announces that the economy is in a recession well after it has begun. Table 21.1 The U.S Business Cycle

14. What Happens during the Business Cycle? Figure 21.7 The Effect of the Business Cycle on Boeing Panel (a) shows movements in real GDP for each quarter from the beginning of 1990 through the end of 2010. Panel (b) shows movements in the number of passenger aircraft shipped by Boeing for the same years. The effects of the recessions on Boeing are typically more dramatic than the effects on the economy as a whole, although Boeing suffered a relatively mild decline in deliveries during the 2007–2009 recession.

15. Figure 21.8 The Effect of Recessions on the Inflation Rate Toward the end of a typical expansion, the inflation rate begins to rise. Recessions, marked by the shaded vertical bars, cause the inflation rate to fall. By the end of a recession, the inflation rate is significantly below what it had been at the beginning of the recession.

16. The Effect of the Business Cycle on the Unemployment Rate Figure 21.9 How Recessions Affect the Unemployment Rate Unemployment rises during recessions and falls during expansions. The reluctance of firms to hire new employees during the early stages of a recovery means that the unemployment rate usually continues to rise even after the recession has ended.

17. Is the “Great Moderation” Over? Figure 21.10 Fluctuations in Real GDP, 1900–2010 Fluctuations in real GDP were greater before 1950 than they have been since then.

18. The recession that began in December 2007 has been referred to as the Great Contraction. Whether the Great Moderation would return with its end could take years to determine. Table 21.2 Until 2007, the Business Cycle Had Become Milder • Note: The World War I and World War II periods have been omitted from the computations in the table. • The expansion that began in June 2009 is not included.

19. Will the U.S. Economy Return to Stability? • Economists have offered several explanations for why the U.S. economy experienced a period of relative stability from 1950 to 2007: • The increasing importance of services and the declining importance of goods.Because durable goods are usually more expensive than services, during a recession households will cut back more on purchases of durables than they will on purchases of services. • The establishment of unemployment insurance and other government transfer programs that provide funds to the unemployed. Government programs enacted after the 1930s have made it possible for workers who lose their jobs during recessions to have higher incomes and, therefore, to spend more than they would otherwise. • Active federal government policies to stabilize the economy. In the years since World War II, the federal government has actively tried to use macroeconomic policy measures to end recessions and prolong expansions. • The increased stability of the financial system. During the years after the Great Depression, institutional changes resulted in increased stability in the financial system.

20. What Is Monetary Policy? 3. LEARNING OBJECTIVE Define monetary policy and describe the Federal Reserve’s monetary policy goals.

21. The Federal Reserve System Figure 25.3 The United States is divided into 12 Federal Reserve districts, each of which has a Federal Reserve bank. The real power within the Federal Reserve System, however, lies in Washington, DC, with the Board of Governors, which consists of 7 members appointed by the president. Monetary policy is carried out by the 14-member Federal Open Market Committee.

22. Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals. The Goals of Monetary Policy The Fed has four main monetary policy goals that are intended to promote a well-functioning economy: 1. Price stability 2. High employment 3. Stability of financial markets and institutions 4. Economic growth

23. Price Stability Figure 26.1 The Inflation Rate, January 1952–August 2011 For most of the 1950s and 1960s, the inflation rate in the United States was 4 percent or less. During the 1970s, the inflation rate increased, peaking during 1979–1981, when it averaged more than 10 percent. After 1992, the inflation rate was usually less than 4 percent, until increases in oil prices pushed it above 5 percent during the summer of 2008. The effects of the recession caused several months of deflation—a falling price level—early in 2009. Note: The inflation rate is measured as the percentage change in the consumer price index (CPI) from the same month in the previous year.

24. How Interest Rates Affect Aggregate Demand With the exception of government purchases, changes in interest rates will affect the components of aggregate demand in the following ways: • Consumption. Lower interest rates lower the cost of durable goods and reduce the return to saving, leading households to save less and spend more. Higher interest rates raise the cost of consumer durables and increase the return to saving, leading households to save more and spend less. • Investment. Higher interest rates make it more expensive for firms and households to borrow, thereby decreasing investment. Lower interest rates increase the demand for stocks and make it less expensive for firms and households to borrow, thereby increasing investment.

25. • Net exports. If interest rates in the United States rise relative to interest rates in other countries, the value of the dollar will rise and net exports will fall. If interest rates in the United States decline relative to interest rates in other countries, the value of the dollar will fall and net exports will rise. The Effects of Monetary Policy on Real GDP and the Price Level The Fed can use monetary policy to affect the price level and, in the short run, the level of real GDP, allowing it to attain its policy goals of high employment and price stability. In the basic version of the aggregate demand and aggregate supply model, we assume that there is no economic growth, so the long-run aggregate supply curve doesn’t shift.

26. Can the Fed Eliminate Recessions? A lag, or delay, can occur before the Fed recognizes that a recession has begun because it takes months for economic statistics to be gathered by the Commerce Department, the Census Bureau, the Bureau of Labor Statistics, and the Fed itself. By the time the FOMC analyzes the data and concludes that the economy is in recession, it may begin an expansionary monetary policy when it is not needed if the recession has already ended and an expansion has begun. In that case, the increase in aggregate demand caused by the Fed’s lowering interest rates is likely to push the economy beyond potential real GDP and cause a significant acceleration in inflation. In sum, the Fed has inadvertently engaged in a procyclical policy, which increases the severity of the business cycle, as opposed to a countercyclical policy, which is meant to reduce its severity and is what the Fed intended to use. Making this mistake is less likely in a long and severe recession such as that of 2007–2009.

27. Expansionary monetary policy The Federal Reserve’s decreasing interest rates to increase real GDP. Contractionary monetary policy The Federal Reserve’s increasing interest rates to reduce inflation.

28. Figure 26.8 The Effect of a Poorly Timed Monetary Policy on the Economy The upward-sloping straight line represents the long-run growth trend in real GDP. The curved red line represents the path real GDP takes because of the business cycle. If the Fed is too late in implementing a change in monetary policy, real GDP will follow the curved blue line. The Fed’s expansionary monetary policy results in too great an increase in aggregate demand during the next expansion, which causes an increase in the inflation rate.

29. A Summary of How Monetary Policy Works Table 26.1 Expansionary and Contractionary Monetary Policies The arrows point to the steps involved in the policy that occur relative to what would have happened without the policy.

30. What Is Fiscal Policy? 4. LEARNING OBJECTIVE Define fiscal policy.

31. Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. What Fiscal Policy Is and What It Isn’t Economists typically use the term fiscal policy to refer only to the actions of the federal government. State and local governments sometimes change their taxing and spending policies to aid their local economies, but these are not fiscal policy actions because they are not intended to affect the national economy. Automatic Stabilizers versus Discretionary Fiscal Policy Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle. The word automatic in this case refers to the fact that changes in these types of spending and taxes happen without actions by the government. With discretionary fiscal policy, the government takes actions to change spending or taxes.

32. An Overview of Government Spending and Taxes • Federal government expenditures include purchases plus all other federal government spending. • In addition to purchases, there are three other categories of federal government expenditures: • Interest on the national debt, which represents payments to holders of the bonds the federal government has issued to borrow money. • Grants to state and local governments, which are payments made by the federal government to support government activity at the state and local levels. • Transfer payments, which include Social Security, Medicare, unemployment insurance, and programs to aid the poor, is the largest and fastest-growing category of federal expenditures.

33. A Summary of How Fiscal Policy Affects Aggregate Demand Countercyclical Fiscal Policy Table 27.1 The table isolates the effect of fiscal policy by holding constant monetary policy and all other factors affecting the variables involved. In other words, we are again invoking the ceteris paribuscondition. A contractionary fiscal policy causes the price level to rise by less than it would have without the policy. Don’t Let This Happen to You Don’t Confuse Fiscal Policy and Monetary Policy Though their goals are the same, their effects on the economy differ as governments use fiscal policy to affect spending and taxation, while central banks use monetary policy to affect interest rates.

34. American Recovery and Reinvestment Act of 2009 The 2009 Stimulus Package Figure 27.13 Congress and President Obama intended the spending increases and tax cuts in the stimulus package to increase aggregate demand and help pull the economy out of the 2007–2009 recession. Panel (a) shows how the increases in spending were distributed, and panel (b) shows how the tax cuts were distributed.

35. How Can We Measure the Effectiveness of the Stimulus Package? To judge the effectiveness of the stimulus package, we have to measure its effects on real GDP and employment, holding constant all other factors affecting real GDP and employment. CBO Estimates of the Effects of the Stimulus Package Table 27.2

36. Budget deficit The situation in which the government’s expenditures are greater than its tax revenue. Budget surplus The situation in which the government’s expenditures are less than its tax revenue.

37. The Federal Budget Deficit, 1901–2011 Figure 27.14 During wars, government spending increases far more than tax revenues, increasing the budget deficit. The budget deficit also increases during recessions, as government spending increases and tax revenues fall. Note: The value for 2011 is an estimate prepared by the Congressional Budget Office in June 2011.

38. How the Federal Budget Can Serve as an Automatic Stabilizer Discretionary fiscal policy can increase the federal budget deficit during recessions by increasing spending or cutting taxes to increase aggregate demand. Most of the increase in the federal budget deficit during a typical recession takes place without Congress and the president taking any action, but is instead due to the effects of the automatic stabilizers. Deficits occur automatically during recessions for two reasons: During a recession, wages and profits fall, causing government tax revenues to fall. The government automatically increases its spending on transfer payments when the economy moves into recession. Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

39. When the government runs a budget deficit, national saving will decline unless private saving increases by the amount of the budget deficit, which is unlikely. As the saving and investment equation (S = I + NFI) shows, the result of a decline in national saving must be a decline in either domestic investment or net foreign investment. If the federal government runs a budget deficit, the U.S. Treasury must raise an amount equal to the deficit by selling bonds. To attract investors, the Treasury may have to raise the interest rates on its bonds. Higher interest rates will discourage some firms from borrowing funds to build new factories or to buy new equipment or computers. Higher interest rates on financial assets in the United States will attract foreign investors who buy U.S. dollars to purchase bonds in the United States. The value of the dollar will increase their value relative to foreign currencies, causing U.S. exports to fall and imports to rise. Net exports and, therefore, net foreign investment will fall. When a government budget deficit leads to a decline in net exports, the result is sometimes referred to as the twin deficits. A government budget deficit will also lead to a current account deficit.

40. Figure 29.4 The Twin Deficits, 1978–2010 During the early 1980s, large federal budget deficits occurred at the same time as large current account deficits, but twin deficits did not occur in most other periods during these years.

41. MakingtheConnection Why Is the United States Called the “World’s Largest Debtor”? The following graph shows the current account balance as a percentage of GDP for the United States for the period 1950–2010.. At the end of 2010, foreign investors owned about $2.5 trillion more of U.S. assets—such as stocks, bonds, and factories—than U.S. investors owned of foreign assets, which is why the United States is sometimes called “the world’s largest debtor.”

42. The International Sector and National Saving and Investment 5. LEARNING OBJECTIVE Explain the saving and investment equation

43. Net Exports Equal Net Foreign Investment Current account balance + Financial account balance = 0 or: Current account balance = – Financial account balance or: Net exports = Net foreign investment Domestic Saving, Domestic Investment, and Net Foreign Investment National saving = Private saving + Public saving or S= Sprivate + Spublic Private saving = National income – Consumption – Taxes or Sprivate= Y – C – T Government saving = Taxes – Government spending or Spublic= T – G

44. Finally, remember the basic macroeconomic equation for GDP or national income: Y = C + I + G + NX Saving and investment equation An equation that shows that national saving is equal to domestic investment plus net foreign investment. National saving = Domestic investment + Net foreign investment S = I + NFI This equation is an identity because it must always be true, given the definitions we have used. A country’s saving will be invested either domestically or overseas. If you save $1,000 and use the funds to buy a bond issued by General Motors, GM may use the $1,000 to renovate a factory in the United States (I) or to build a factory in China (NFI) as a joint venture with a Chinese firm.

45. A country such as the United States that has negative net foreign investment must be saving less than it is investing domestically. S –I = NFI. If net foreign investment is negative—as it is for the United States nearly every year—domestic investment (I) must be greater than national saving (S). The level of saving in Japan has been well above domestic investment. The result has been high levels of Japanese net foreign investment. Japan needs a high level of net exports to help offset a low level of domestic investment. When exports of a product begin to decline and imports begin to increase, governments are often tempted to impose tariffs or quotas to reduce imports.

46. Monetary Policy and Fiscal Policy in an Open Economy 6. LEARNING OBJECTIVE Compare the effectiveness of monetary policy and fiscal policy in an open economy and in a closed economy

47. Monetary Policy in an Open Economy When the Federal Reserve engages in an expansionary monetary policy, it buys Treasury securities to lower interest rates and stimulate aggregate demand. In a closed economy, the main effect of lower interest rates is on domestic investment spending and purchases of consumer durables. In an open economy, lower interest rates will also affect the exchange rate between the dollar and foreign currencies. The switch from U.S. financial assets to foreign financial assets will lower the demand and value of the dollar. A lower exchange rate will decrease the price of U.S. products in foreign markets and cause net exports to increase. This additional policy channel will increase the ability of an expansionary monetary policy to affect aggregate demand. To summarize: Monetary policy has a greater effect on aggregate demand in an open economy than in a closed economy.

48. Fiscal Policy in an Open Economy To engage in an expansionary fiscal policy, the federal government increases its purchases or cuts taxes. An expansionary fiscal policy may result in higher interest rates. In a closed economy, the main effect of higher interest rates is to reduce domestic investment spending and purchases of consumer durables. In an open economy, higher interest rates will also lead to an increase in the foreign exchange value of the dollar and a decrease in net exports. Therefore, in an open economy, an expansionary fiscal policy may be less effective because the crowding out effect may be larger. In a closed economy, only consumption and investment are crowded out by an expansionary fiscal policy. In an open economy, net exports may also be crowded out. In summary: Fiscal policy has a smaller effect on aggregate demand in an open economy than in a closed economy.