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SENIOR OUTCOMES SEMINAR

(BU385)

ECONOMICS (cont)

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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

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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

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Gross Domestic Product (GDP)

• Final goods and services• Nominal and real• Domestic economy• Produced over a year

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Gross National Product (GNP):

GDP - + = GNP

Final goods & services produced

by foreign

producers

Final goods & services produced

by Americanproducers

abroad

For the U.S. economy, GDP ≈ GNP

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Deflators of GDP

Consumer Price Index (CPI) = Nominal GDP/Real GDP

More comprehensive deflator =

Consumer Price Index (CPI) + Producer Price Index (PPI)

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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

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Logic of Computing Real GDP

The essence of the logic:

Only Nominal GDP is a directly observable variable.

Deflators and Real GDP are not directly observable variables. They are constructed based on the statistics of Nominal GDP.

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Difficulties with understanding deflators and real GDP

stem from the fact that elements of deflators and real GDP are not physically observable. They are economic models fitted by real-life statistics.

In sharp contrast, elements of nominal GDP are physically observable. 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

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Potential GDP

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

Potential GDP Actual real GDP

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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 rate chances of inflation and recession are 50:50.

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The idea behind potential GDP

Neutrality means that under 4% unemployment rate chances of inflation and recession are 50:50.

Employment at 4% unemployment rate is called full employment

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Recessions

• Units of measurement: real GDP• Time units: quarters• Dynamics: reduction of absolute value of real GDP during a quarter

Definition:Recession is reduction of absolute value of real GDP during three consecutive quarters

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Interpretation of recessions

• Negative growth of real GDP.

• This negative growth can coexist with positive growth of nominal GDP.

• Elimination of surplus production capacities. These capacities are surplus relative to existing demand.

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Interpretation of recessions (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.

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Types of unemployment

Frictional: people who are fired/left on their own possess marketable skills, whichmake 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.

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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.

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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 unemployment is close to a tragedy.

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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.

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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.

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Standard stabilization policy for fighting inflation

P

AD, AS

P is absolute price level =deflator of GDP = index of inflation

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Standard stabilization policy for softening recession

P

AD, AS

P is absolute price level =deflator of GDP = index of inflation

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Trade-off between inflation and unemployment in the short run when

AS curve is relatively flat

P

AD, AS (real GDP=G)

P2

P1

G1 G2

Increase in inflation

P1 to P2

Increase in employment

G1 to G2

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Trade-off between inflation and unemployment in the long run

when AS curve is steep

P

AD, AS (real GDP=G)

P2

P1

G1G2

Increase in inflation

P1 to P2

Increase in employment

G1 to G2

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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.

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Reagan’s supply-side alternative to standard stabilization policy

P

AD, AS (real GDP=G)

P1

P2

G1 G2

Decrease in inflation

P1 to P2

Increase in employment

G1 to G2

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Reagan’s supply-side alternative to standard stabilization policy (cont)

• Rightforward shift of AS curve is achieved through accelerated investments

• Accelerated investments are 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

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Final results of Reagan’s supply-side alternative: increased employmentincreased incomes shift of AD curve rightward

P

AD, AS (real GDP=G)

P1

P2

G1 G2 G3

Increase in inflation

P2 to P1

Increase in employment

G2 to G3

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Final results of supply-side alternative: inflation remains on the previous level,

employment significantly increases

P

AD, AS (real GDP=G)

P1

P2

G1 G2 G3

Increase in inflation

P2 to P1

Increase in employment

G2 to G3

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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.

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Growth policy

stimulates accumulation of Kt, increase in Lt, and acceleration of Ht such that Yt in production function

Yt=F (Kt, Lt, Ηt)

grows on average about 4% per year.

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Equilibrium of aggregate demand and supply

P

P*

AD, AS (real GDP)

AD(P*)=AS(P*)

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iR = iN – E[Inf],

where iR:=real interest rate,

iN:=nominal interest rate,

E[Inf]:= expected inflation

Real interest rate

Real interest rate is a price of credit adjusted for expected inflation

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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

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Inflation

Inflation is a persistent increase in the absolute price level

Main causes:

• Excess demand (demand inflation)

• Excessive increase (wage inflation) in wages

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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

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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 expectations prevent 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.

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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 financing of Ameri-

can businesses (up to 45-50% of all new financing).

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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.

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Fiscal policy deals with taxation

of businesses & population

• 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%.

Major goals:

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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:

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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

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Equilibria on the market for money

iN

MS, MD

i*

i2

i1

i*initial equilibrium

I1 equilibrium after Fed induced banks to contract lending

I2 equilibrium after Fed induced banks to increase lending