SENIOR OUTCOMES SEMINAR (BU385) ECONOMICS (cont)

1. SENIOR OUTCOMES SEMINAR (BU385) ECONOMICS (cont)

2. BASIC CONCEPTS IN ECONOMICS II • Nominal, real, and potential GDP • Recessions • Types of unemployment • Standard stabilization policy versus • Supply-side Economics • Growth policy • Equilibrium of aggregate demand and supply

3. BASIC CONCEPTS IN ECONOMICS II • Real interest rate and real wage • Inflation • Presence and absence of trade-offs • between inflation and unemployment • Fiscal policy • Monetary policy

4. Gross Domestic Product (GDP) • Final goods and services • Nominal and real • Domestic economy • Produced over a year

5. Gross National Product (GNP): • GDP - + = GNP Final goods & services produced by American producers abroad Final goods & services produced by foreign producers For the U.S. economy, GDP ≈ GNP

6. Deflators of GDP Consumer Price Index (CPI) = Nominal GDP/Real GDP More comprehensive deflator = Consumer Price Index (CPI) + Producer Price Index (PPI)

7. Logic of Computing Real GDP Step 1. Compute Nominal GDP based on statistics of sales of final goods and services in market (current) prices Step 2. Compute a deflator Step 3. Compute Real GDP = Nominal GDP/ Deflator

8. Logic of Computing Real GDP The essence of the logic: Only Nominal GDP is a directly observable variable. Deflators and Real GDP are not directlyobservable variables. They are constructed based on the statistics of Nominal GDP.

9. Difficulties with understanding deflators and real GDP stem from the fact that elements of deflators and real GDPare not physicallyobservable. They are economic models fitted by real-life statistics. In sharp contrast, elements of nominal GDP are physicallyobservable.A new edition of the old textbook, published in 2007, is a part of 2007 nominal GDP. However, one cannot physically observe this new edition when it is transformed – through deflation – into a part of 2007 real GDP

10. Potential GDP is a hypothetical real GDP produced under 4% unemployment and about 85% utilization of production capacities. Potential GDP  Actual real GDP

11. The idea behind potential GDP • It is believed that the 4% unemployment rate is neutral towards inflation and recession: • it is high enough to prevent inflation • it is low enough to prevent recession. • Neutrality means that under 4% unemployment ratechances of inflation and recession are 50:50.

12. The idea behind potential GDP • Neutrality means that under 4% unemployment ratechances of inflation and recession are 50:50. • Employment at 4% unemployment rateis called full employment

13. Recessions • Units of measurement: real GDP • Time units: quarters • Dynamics: reduction of absolute • value of real GDP during a quarter Definition: Recession isreduction of absolute value of real GDP during three consecutive quarters

14. Interpretation ofrecessions • Negative growth of real GDP. • This negative growthcan coexist • with positive growth of nominal GDP. • Elimination of surplus production • capacities. These capacities are surplus • relative to existing demand.

15. Interpretation ofrecessions (cont) • Elimination of surplus capacities tends to • produce cyclical unemployment. • In the U.S. economy, recessions tend to • be progressively less harmful. • Recessions happen in spite of all-out • efforts to prevent them.

16. Types of unemployment Frictional: people who are fired/left on their own possess marketable skills, which make finding their new employment virtually assured. At any moment of time (except recessions), approximately 50% of unemployed Americans are frictionally unemployed. Frictional unemployment is a major vehicle of mobility on the labor market.

17. Types of unemployment Structural: people who are fired because their functions are either eliminated or fulfilled through automated processes. Their skills are not marketable, and finding new employment is extremely difficult. Due to their age, most of structurally unemployed experience major difficulties with acquisition of new skills.

18. Structural unemployment At any moment of time, structurally unemployed comprise between 25 and 40% of unemployed Americans. Structural unemployment is an important positive sign of economic development. However, on a family/personal level, structural unemploymentis close to a tragedy.

19. Cyclical unemployment results from elimination of surplus capacities during recessions. For people with marketable skills, it could take a form of frictional unemp-loyment. For people without marketable skills, it could take a form of structural unemploy-ment.

20. Stabilization policy • represents government programs whose goals are • to keep inflation at bay • to soften recessions. • Standard stabilization policy is implemented through increase/decrease in aggregate demand due to increasing/decreasing government expenditures.

21. Standard stabilization policy for fighting inflation P AD, AS P is absolute price level = deflator of GDP = index of inflation

22. Standard stabilization policy for softening recession P AD, AS P is absolute price level = deflator of GDP = index of inflation

23. Trade-off between inflation and unemployment in the short run when AS curve is relatively flat Increase in inflation P1 toP2 Increase in employment G1toG2 P P2 P1 AD, AS (real GDP=G) G1 G2

24. Trade-off between inflation and unemployment in the long run when AS curve is steep Increase in inflation P1 toP2 Increase in employment G1toG2 P P2 P1 AD, AS (real GDP=G) G1G2

25. Trade-off between inflation and unemployment is • Favorable in the short run when • the AS curve is relatively flat • Unfavorable in the long run when • the AS curve is steep.

26. Reagan’s supply-side alternative to standard stabilization policy Decrease in inflation P1 toP2 Increase in employment G1toG2 P P1 P2 AD, AS (real GDP=G) G1 G2

27. Reagan’s supply-side alternative to standard stabilization policy (cont) • Rightforward shift of AS curve is achieved through accelerated investments • Accelerated investmentsare achieved through decrease in taxes and accelerated depreciation • Supply-side alternative is based on the idea that changes in fiscal policy strongly influence economic behavior

28. Final results of Reagan’s supply-side alternative: increased employment increased incomes shift of AD curve rightward P Increase in inflation P2 toP1 Increase in employment G2toG3 P1 P2 AD, AS (real GDP=G) G1 G2 G3

29. Final results of supply-side alternative: inflation remains on the previous level, employment significantly increases P Increase in inflation P2 toP1 Increase in employment G2toG3 P1 P2 AD, AS (real GDP=G) G1 G2 G3

30. Growth policy An elementary description of the process of economic growth is given by production function Yt=F (Kt, Lt, Ηt), where Yt:= real GDP at year t, Kt :=fixed capital, Lt :=hours worked, Ηt:= technological progress (residual), t:=consecutive years.

31. Growth policy stimulates accumulation of Kt, increase inLt, and acceleration of Ht such that Yt inproduction function Yt=F (Kt, Lt, Ηt) grows on average about 4% per year.

32. Equilibrium of aggregate demand and supply P P* AD, AS (real GDP) AD(P*)=AS(P*)

33. Real interest rate iR = iN – E[Inf], where iR:=real interest rate, iN:=nominal interest rate, E[Inf]:= expected inflation Real interest rate is a price of credit adjusted for expected inflation

34. Real wage rate wN:=nominal wage rate(i.e.wage per hour) wR:=real wage rate wR= wN/CPI Real wage measures the purchasing power of nominal wage

35. Inflation Inflation is a persistent increase in the absolute price level • Main causes: • Excess demand (demand inflation) • Excessive increase (wage inflation) • in wages

36. Inflation • Main consequences: • Introduces arbitrariness into movements of relative prices deformations in investment processes arbitrariness in distribution of income from investments • Very quickly becomes unmanageable and explosive

37. Inflation • Main consequences (cont): • Unmanageable and explosive inflation creates different expectations of the strength of inco-ming inflation between borrows (investors) and lenders (institutions of the saving system). • These different expectationsprevent signing of contracts between borrows and lenders b/c they cannot agree on a “fair” amount of nomi-nal interest rate charged for a loan.

38. Inflation • Main consequences (cont): • If the lending process by the U.S. saving system to the U.S. businesses is interrupted, the further development of the American industry is most seriously jeopardized. Reason: loans are the cheapest form of financing • the most popular form of financingofAmeri-can businesses(up to 45-50% of all new financing).

39. Inflation • Main consequences (cont): • People on fixed income without adjustment to inflation suffer the most. This alone is a shame for any nation. • Purchasing power (= exchange rate) of national currency is sharply reduced. • Falling inflows of new capital to the country further reduce financing of businesses.

40. Fiscal policy deals with taxation of businesses & population Major goals: • Secure financing of the government budget. Expenses from this budget finance rightward shifts of AD curve (stabilization policy). • Redistribute income in pursuit of some ideal of fairness. Currently, upper 50% of American households contribute around 90% of all tax recites. Upper 5% contribute around 30%.

41. Monetary policy deals with regulation of the quantity of money in the domestic economy • Emission of new banknotes by the government • Issuance of new loans by banks through the creation of additional deposits Two major factors of the quantity of money in the economy:

42. Issuance of new loans by banks through the creation of additional deposits Open-market operations are the most powerful levers Fed uses to induce banks to increase lending during recessions and decrease lending during booms

43. Equilibria on the market for money iN i*initial equilibrium I1 equilibrium after Fed induced banks to contract lending I2 equilibrium after Fed induced banks to increase lending i1 i* i2 MS, MD