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Circular Flow

Circular Flow. The Government’s Role. Correct for :. Imperfect Information Externalities Public Goods Lack of Competition Business Cycles. Externalities. Someone outside a transaction benefits from the transaction ... and doesn’t pay Too little produced .

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Circular Flow

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  1. Circular Flow

  2. The Government’s Role Correct for: • Imperfect Information • Externalities • Public Goods • Lack of Competition • Business Cycles

  3. Externalities • Someone outside a transaction benefits from the transaction ... and doesn’t pay • Too little produced. • Someone outside a transaction incurs costs because of it ... but isn’t paid Too much produced.

  4. Public Goods • Consumption by one person does not diminish the quantity or quality available to others. • Public goods can be jointly consumed • Public goods are non-excludableEverybody has incentive to be a free rider • When everyone free rides, too little (or none) is produced.

  5. Macroeconomic Policy • Monetary Policy • Policies that influence money and credit (money supply and interest rates). • Fiscal Policy • Policies that control government spending and taxation.

  6. GDP  “Output” • Gross Domestic Product (GDP) is the market value of final goods and services produced within a country during a year. • Market Value: The worth of a thing is the price it will bring. • Only Final Goods and Services Count • GDP must be produced within our borders • Net additions to inventory are current output so they are also included in GDP.

  7. GDP as Valued-Added

  8. GDP as Expenditures: C + I + G + X

  9. GDP (GNP) as Income

  10. GDP – GNP – NNP – NI – PI – DI

  11. Real and Nominal GDP • “Real“ GDPadjusts for inflation. • Nominal GDP ($GDP) measures national output based on current prices of goods and services. • Real GDP measures of the quantity of final goods and services produced • Real GDP measures current output at constantprices

  12. Consumer Price Index (CPI) • measures the cost over time of a typical bundle of goods and services purchased by households. • Producer Price Index (PPI) • measures average prices received by producers over time for raw materials, intermediate, and final goods. • GDP Price Deflator (GDP Price Index, GDPPI) • measures average prices over time of all goods and services included in GDP.

  13. Foreign Exchange • Foreign ExchangeForeign money, including paper money and bank deposits that are denominated in foreign currency • Foreign Exchange MarketA global market in which people trade one currency for another • Exchange RateThe price of one country’s currency in terms of another country’s currency

  14. Appreciation and Depreciation • A currency appreciates when it buys more of a foreign currency. • Appreciation of a nation’s currency makes foreign goods cheaper. • Appreciation Imports Up and Exports Down. • A currency depreciates when it buys less of a foreign currency. • Depreciation makes foreign goods more expensive. • Depreciation Imports Down and Exports Up.

  15. Current Account Categories of current account transactions: • Merchandise trade-- import and export of goods • Service trade-- import and export of services • Income-- both investment income and employee compensation • Unilateral transfers-- gifts to and from foreigners

  16. Current Account vs. Financial Account • The balance of payments must balance—that is, Current Account + Financial Account = 0 • If there is a current account deficit, then there must be a financial account surplus that exactly offsets that deficit. • If we buy more goods and services from foreigners than they buy from us, we have to borrow the difference  sell them our IOUs.

  17. U.S. Real GDP(Recessions Shaded)

  18. number unemployed number in the Labor Force Unemployment The unemployment rate is the percentage of the labor force that is not working. Rate ofUnemployment = • Discouraged Workers: workers who have looked for work in the past year, but have stopped because they believe no one will offer them a job. • Underemployment: employment of workers in jobs that do not fully utilize their productive skills.

  19. Flavors of Unemployment • Seasonal Unemployment • Frictional Unemployment: searching for jobs • Structural Unemployment • Reflects imperfect match between employee skills and requirements of available jobs. • Cyclical Unemployment • Results from business cycle fluctuations.

  20. “Natural” Rate of UnemploymentA normal rate, considering both frictional and structural factors. • Also called the NAIRU (Nonaccelerating Inflation Rate of Unemployment) -- ~5% for US economy The “natural” rate can change • Potential Real GDPThe level of output when nonlabor resources are fully utilized and unemployment is at its natural rate. • GDP gap = potential real GDP – actual GDP

  21. Flavors of Price Inflation • Demand-pull inflation: • caused by increases in aggregate demand outpacing increases in aggregate supply. • Cost-push inflation: • increased production costs cause firms to raise prices. • Wage-push inflation • Energy costs and inflation • Hyperinflation: • extremely high rate of inflation. • Printing money as last resort

  22. Interest Rates • Nominal Interest Rate (i): the observed interest rate in the market. • Real Interest Rate (r): nominal rate adjusted for inflation (). • r = i - 

  23. Aggregate Demand (AD): the economy-wide demand for goods and services. • Aggregate demand curve relates aggregate expenditure for goods and services to the price level • The aggregate demand curve slopes downward owing to price-level effects: • Wealth Effect (Real Wealth/Real Balances) • Interest Rate Effect • International Trade Effect (Substitution)

  24. The Aggregate Demand Curve Changes in the price level result in changes in quantity demanded.

  25. Factors that Affect AD  Shifts in AD AD = C + I + G + NX • Government Spending • Net Exports • Domestic & Foreign Income • Domestic & Foreign Prices • Exchange Rates • Government Policy • Consumption • Income • Wealth • Interest Rates • Expectations • Demographics • Taxes • Investment • Interest Rates • Technology • Cost of Capital Goods • Capacity Utilization

  26. Shifting Aggregate Demand Curve

  27. Aggregate Supply: Short – Run & Long – Run

  28. Short-run Aggregate Supply • Aggregate Supply (AS) shows the quantity of real GDP produced at different price levels. • Short-run ASslopes upward • a higher price level (holding production costs and capital constant in the short-run) • higher profit margins • firms want to produce more.

  29. The Shape of Long-run AS (LRAS) • Resource costs are NOT fixed in the long-run. • As prices rises, workers demand and get higher wages Profits don’t rise with price • AS is set by production possibilities in the long-run • LRAS is not affected by prices • LRAS is vertical: higher prices cannot elicit more output in the long-run.

  30. Shifting the Long-Run Aggregate Supply Curve Growth occurs as the labor force and capital stock grow and as technological innovation improves production efficiency.

  31. Aggregate Demand - Aggregate Supply Equilibrium

  32. Aggregate Demand and Supply Equilibrium: Short-run and long-run responses to increase in aggregate demand

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