The Aggregate Expenditures Model

Chapter 29
The Aggregate Expenditures

Model
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Assumptions and Simplifications

Use the Keynesian aggregate
expenditures model
Prices are fixed
GDP = DI
Begin with private, closed economy
Consumption spending
Investment spending
LO1
29-2
Consumption and Investment
Investment
demand
curve
8
20
ID
20
Investment
(billions of dollars)
(a)
Investment demand curve
LO2
Investment Schedule
Investment (billions of dollars)
r and i (percent)
Investment Demand Curve
Investment
schedule
Ig
20
20
Real domestic product, GDP

(b)
Investment schedule
29-3
Equilibrium GDP
Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy
(2)
Real
Domestic
Output
(and
Income)
(GDP =
DI),*Billion
s
(3)
Consumption
(C),
Billions
(4)
Saving
(S),
Billions
(5)
Investment
(Ig),
Billions
(6)
Aggregate
Expenditure
(C+Ig),
Billions
(7)
Unplanned
Changes in
Inventories,
(+ or -)
(1) 40
$370
$375
$-5
$20
$395
$-25
Increase
(2) 45
390
390
20
410
-20
Increase
(3) 50
410
405
20
425
-15
Increase
(4) 55
430
420
10
20
440
-10
Increase
(5) 60
450
435
15
20
455
-5
Increase
(6) 65
470
450
20
20
470
(7) 70
490
465
25
20
485
+5
Decrease
(8) 75
510
480
30
20
500
+10
Decrease
(9) 80
530
495
35
20
515
+15
Decrease
(10) 85
550
510
40
20
530
+20
Decrease
(1)
Possible
Levels of
Employment,
Millions
(8)
Tendency of
Employment,
Output, and
Income
Equilibrium
* If depreciation and net foreign factor income are zero, government is ignored and it is assumed that all saving occurs in the household sector of the
economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP
LO3
29-4
Equilibrium GDP
(C + Ig = GDP)
Equilibrium
point
Aggregate
expenditures
C + Ig
C
Ig = $20 billion
C = $450 billion
LO3
29-5
Changes in Equilibrium GDP

(C + Ig)1
(C + Ig)0
(C + Ig)2
Increase in
investment
Decrease in
investment
LO5
29-6
Adding International Trade

Include net exports spending in
aggregate expenditures
Private, open economy
Exports create production,
employment, and income
Subtract spending on imports
Xn can be positive or negative
LO6
29-7
The Net Export Schedule

Two Net Export Schedules (in Billions)
LO6
(1)
Level of GDP
(2)
Net Exports,
Xn1 (X > M)
(3)
Net Exports,
Xn2 (X < M)
$370
$+5
$-5
390
+5
-5
410
+5
-5
430
+5
-5
450
+5
-5
470
+5
-5
490
+5
-5
510
+5
-5
530
+5
-5
550
+5
-5
29-8
Net Exports and Equilibrium GDP

C + Ig+Xn1
C + Ig
C + Ig+Xn2
Aggregate expenditures
with positive
net exports
with negative net
exports
Positive net exports

450
470
Negative net exports
LO6
Xn1
490
Xn2
29-9
International Economic Linkages

Prosperity abroad
Can increase U.S. exports
Exchange rates
Depreciate the dollar to increase
exports
A caution on tariffs and devaluations
Other countries may retaliate
Lower GDP for all
LO6
29-10
Adding the Public Sector

Government purchases and
equilibrium GDP
Government spending is subject to
the multiplier
Taxation and equilibrium GDP
Lump sum tax
Taxes are subject to the multiplier
DI = GDP
LO7
29-11
Government Purchases and Eq.

GDP
The Impact of Government Purchases on Equilibrium GDP
(5)
Net Exports
(Xn), Billions
Imports
(M)
(6)
Government
Purchases
(G), Billions
(7)
Aggregate
Expenditures
(C+Ig+Xn+G),
Billions
(2)+(4)+(5)+(6)
$10
$10
$20
$415
20
10
10
20
430
20
10
10
20
445
420
10
20
10
10
20
460
(5) 450
435
15
20
10
10
20
475
(6) 470
450
20
20
10
10
20
490
(7) 490
465
25
20
10
10
20
505
(8) 510
480
30
20
10
10
20
520
(9) 530
495
35
20
10
10
20
535
(10) 550
510
40
20
10
10
20
550
(1)
Real Domestic
Output and
Income
(GDP=DI),
Billions
(2)
Consumption
(C),
Billions
(3)
Saving (S),
Billions
(4)
Investment
(Ig),
Billions
Exports
(X)
(1) $370
$375
$-5
$20
(2) 390
390
(3) 410
405
(4) 430
LO7
29-12
Government Purchases and Eq.

GDP
C + Ig + X n + G
C + Ig + X n
C
Government spending
of $20 billion
LO7
29-13
Taxation and Equilibrium GDP

Determination of the Equilibrium Levels of Employment, Output, and Income: Private and Public Sectors
(1)
Real
Domestic
Output
and
Income
(GDP=DI),
Billions
(7)
Net Exports
(Xn), Billions
(9)
Aggregate
Expenditures
(C+Ig+Xn
+G),
Billions
(4)+(6)+(7)+(
8)
(2)
Taxes
(T),
Billions
(3)
Disposable
Income (DI),
Billions, (1)(2)
(4)
Consumption (C),
Billions
(5)
Saving
(S),
Billions
(6)
Investment (Ig),
Billions
Exports
(X)
Imports
(M)
(8)
Government Purchases
(G),
Billions
(1) $370
$20
$350
$360
$-10
$20
$10
$10
$20
$400
(2) 390
20
370
375
-5
20
10
10
20
415
(3) 410
20
390
390
20
10
10
20
430
(4) 430
20
410
405
20
10
10
20
445
(5) 450
20
430
420
10
20
10
10
20
460
(6) 470
20
450
435
15
20
10
10
20
475
(7) 490
20
470
450
20
20
10
10
20
490
(8) 510
20
490
465
25
20
10
10
20
505
(9) 530
20
510
480
30
20
10
10
20
520
(10) 550
20
530
495
35
20
10
10
20
535
LO7
29-14
Aggregate expenditures (billions of dollars)
Taxation and Equilibrium GDP

C + I g + Xn + G
Ca + Ig + Xn + G
$15 billion
decrease in
consumption
from a
$20 billion
increase
in taxes
45
490
LO7
550
Real domestic product, GDP (billions of dollars)
29-15
Equilibrium versus FullEmployment
LO8
Recessionary expenditure gap

Insufficient aggregate spending
Spending below full-employment GDP
Increase G and/or decrease T
Inflationary expenditure gap
Too much aggregate spending
Spending exceeds full-employment
GDP
Decrease G and/or increase T
29-16

AE0
AE1
530
510
Recessionary
expenditure
gap = $5 billion
490
Full
employment
45
490
510
530
Real GDP
(a)
Recessionary expenditure gap
LO8
29-17

AE2
Inflationary
expenditure
gap = $5 billion
AE0
Full
employment
LO8
29-18
Says Law, Great Depression,

Keynes
Classical economics
Says Law
Economy will automatically adjust
Laissez-faire
Keynesian economics
Cyclical unemployment can occur
Economy will not correct itself
Government should actively manage
macroeconomic instability
29-19
Chapter 30
Aggregate Demand and
Aggregate Supply
Aggregate Demand
Real GDP desired at each price level
Inverse relationship
Real balances effect
Interest effect
Foreign purchases effect
LO1
29-21
Changes in Aggregate Demand

Determinants of aggregate demand
Shift factors affecting C, I, G, Xn
2 components involved
Change in one of the determinants
Multiplier effect
LO2
29-22
Consumer Spending
LO2
Consumer wealth
Household borrowing
Consumer expectations
Personal taxes
29-23
Investment Spending
Real interest rates
Expected returns
Expectations about future business
conditions
Technology
Degree of excess capacity
Business taxes
LO2
29-24
Government Spending
Government spending increases
Aggregate demand increases (as
long as interest rates and tax rates
do not change)
More transportation projects
Government spending decreases
Aggregate demand decreases
Less military spending
LO2
29-25
Net Export Spending

National income abroad
Exchange rates
Dollar depreciation
Dollar appreciation
LO2
29-26
Aggregate Supply
Total real output produced at each
price level
Relationship depends on time horizon
Immediate short run
Short run
Long run
LO3
29-27
AS: Immediate Short Run
Price level
Immediate-short-run
aggregate supply
P1
0
LO3
ASISR
Qf
Real domestic output, GDP
29-28
Aggregate Supply: Short Run
AS
Price level
Aggregate supply
(short run)
Qf

LO3
29-29
Aggregate Supply: Long Run
Price level
ASLR
Long-run
aggregate
supply
Qf

LO3
29-30
Changes in Aggregate Supply

Determinants of aggregate supply
Shift factors
Collectively position the AS curve
Changes raise or lower per-unit
production costs
LO4
29-31
Input Prices
Domestic resource prices
Labor
Capital
Land
Prices of imported resources
Imported oil
Exchange rates
LO4
29-32
Productivity
Real output per unit of input
Increases in productivity reduce
costs
Decreases in productivity increase
costs
total output
Productivity =
total inputs
Per-unit production cost
LO4
total input cost

total output
29-33
Legal-Institutional Environment
Legal changes alter per-unit costs of
output
Taxes and subsidies
Extent of government regulation
LO4
29-34
Price level (index numbers)
Equilibrium
AS
100
92
Real
Output
Demanded
(Billions)
Price Level
(Index
Number)
Real
Output
Supplied
(Billions)
$506
108
$513
508
104
512
510
100
510
512
96
507
514
92
502
AD
0
502
510 514

LO5
29-35
Changes in Equilibrium
Price level
AS
P2
P1
AD2
AD1
0
LO6
Qf
Q1 Q2
29-36
Decreases in AD: Recession

Prices are downwardly inflexible
Fear of price wars
Menu costs
Wage contracts
Efficiency wages
Minimum wage law
LO6
29-37
Decreases in AS: Cost-Push

Inflation
Price level
AS2
P2
P1
AS1
b
a
AD
0
LO6
Q1 Qf
29-38
Increases in AS: Full-Employment
Price level
AS1
P3
P2
P1
AS2
b
a
AD2
AD1
0
Q1
Q 2 Q3

LO6
29-39
Stimulus and the Great Recession

Housing collapse triggers bank
failures which leads to recession
Federal Reserve intervenes
Lowers short-term interest rates
Federal Government begins largest
peacetime program of spending
29-40
Stimulus and the Great Recession

GDP growth has been disappointing
High debt load due to low interest
rates
High rate of savings
Unequal impact
Price increases rather than output
gains
29-41
Chapter 31
Fiscal Policy, Deficits, and
Debt
Fiscal Policy
Deliberate changes in:
Government spending
Taxes
Designed to:
Achieve full-employment
Control inflation
Encourage economic growth
LO1
29-43
Expansionary Fiscal Policy

Use during a recession
Increase government spending
Decrease taxes
Combination of both
Create a deficit
LO1
29-44
Contractionary Fiscal Policy

Use during demand-pull inflation
Decrease government spending
Increase taxes
Combination of both
Create a surplus
LO1
29-45
Policy Options: G or T?
To expand the size of government
If recession, then increase
government spending
If inflation, then increase taxes
To reduce the size of government
If recession, then decrease taxes
If inflation, then decrease
government spending
LO1
29-46
Built-In Stability
Automatic stabilizers
Taxes vary directly with GDP
Transfers vary inversely with GDP
Reduces severity of business
fluctuations
Tax progressivity
Progressive tax system
Proportional tax system
Regressive tax system
29-47
Evaluating Fiscal Policy

Is the fiscal policy
Expansionary?
Neutral?
Contractionary?
Use the cyclically adjusted budget to
evaluate
LO3
29-48
Government expenditures, G, and

tax revenues, T (billions)
Cyclically Adjusted Budgets

T
b
$500
450
GDP2
(year 2)
LO3
GDP1
(year 1)
29-49
Government expenditures, G, and

tax revenues, T (billions)
Cyclically Adjusted Budgets

T1
T2
$500
475
450
425
h
f
g
GDP4
(year 4)
LO3
GDP3
(year 3)
29-50
Fiscal Policy: The Great Recession

Financial market problems began in
2007
Credit market freeze
Pessimism spreads to the overall
economy
Recession officially began
December 2007 and lasted 18
months
LO4
29-51
Problems, Criticisms, &

Complications
Problems of Timing
Recognition lag
Administrative lag
Operational lag
Political business cycles
Future policy reversals
Off-setting state and local finance
Crowding-out effect
LO5
29-52
Current Thinking on Fiscal Policy

Let the Federal Reserve handle shortterm fluctuations
Fiscal policy should be evaluated in
terms of long-term effects
Use tax cuts to enhance work effort,
investment, and innovation
Use government spending on public
capital projects
LO5
29-53
The U.S. Public Debt

$16.4 trillion in 2012
The accumulation of years of
federal deficits and surpluses
Owed to the holders of U.S. securities
Treasury bills
Treasury notes
Treasury bonds
U.S. savings bonds
LO5
29-54
LO5
29-55

Interest charges on debt
Largest burden of the debt
2.3% of GDP in 2012
False Concerns
Bankruptcy
Refinancing
Taxation
Burdening future generations
LO5
29-56
Substantive Issues
LO6
Income distribution
Incentives
Foreign-owned public debt
Crowding-out effect revisited
Future generations
Public investment
29-57
Crowding-Out Effect
Real interest rate (percent)
16
14
12
b
10
8
Crowding-out
effect
4
2
ID1
0
LO6
Increase in
investment
demand
5
10 15 20 25 30 35
Investment (billions of dollars)
ID2
40
29-58
Social Security, Medicare

Shortfalls
More Americans will be receiving
benefits as they age
Social security shortfalls
Income during retirement
Funds will be depleted by 2033
Medicare shortfalls
Medical care during retirement
Funds will be depleted by 2024
29-59
Social Security, Medicare

Shortfalls
Possible options to fix include:
Increasing the retirement age
Increasing the portion of earnings
subject to the social security tax
Disqualifying wealthy individuals
Redirecting low-skilled immigrants to
higher-skilled, higher paying work
Defined contribution plans owned by
individuals
29-60
Chapter 32
Money, Banking, and Financial
Institutions
Functions of Money
Medium of exchange
Used to buy/sell goods
Unit of account
Goods valued in dollars
Store of value
Hold some wealth in money form
Money is liquid
LO1
29-62
Money Definition M1
M1
Currency
Checkable deposits
Institutions offering checkable deposits
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
LO2
29-63
Money Definition M2
M2
M1 plus near-monies
Savings deposits including money
market deposit accounts (MMDA)
Small-denominated time deposits
Money market mutual funds
(MMMF)
LO2
29-64
What Backs the Money

Supply?
Guaranteed by governments ability
to keep value stable
Money as debt
Why is money valuable?
Acceptability
Legal tender
Relative scarcity
LO3
29-65
What Backs the Money

Supply?
Prices affect purchasing power of
money
Hyperinflation renders money
unacceptable
Stabilizing moneys purchasing power
Intelligent management of the
money supply monetary policy
Appropriate fiscal policy
LO3
29-66
Federal Reserve - Banking

System
Historical background
Board of Governors
12 Federal Reserve Banks
Serve as the central bank
Quasi-public banks
Bankers bank
LO4
29-67
Federal Reserve Banking

System
Federal Open Market Committee
Aids Board of Governors in setting
monetary policy
Conducts open market operations
Commercial banks and thrifts
6,000 commercial banks
8,500 thrifts
LO4
29-68
Federal Reserve Functions
Issue currency
Set reserve requirements
Lend money to banks
Collect checks
Act as a fiscal agent for U.S.
government
Supervise banks
Control the money supply
LO5
29-69
Federal Reserve Independence

Established by Congress as an
independent agency
Protects the Fed from political
pressures
Enables the Fed to take actions to
increase interest rates in order to
stem inflation as needed
LO5
29-70
The Financial Crisis of 2007 and

2008
Mortgage Default Crisis
Many causes
Government programs that
encouraged home ownership
Declining real estate values
Bad incentives provided by
mortgage-backed bonds
LO6
29-71

2008
Securitization- the process of slicing
up and bundling groups of loans into
new securities
As loans defaulted, the system
collapsed
Underwater homeowners
abandoned homes and mortgages
LO6
29-72

2008
Failures and near-failures of financial
firms
Countrywide: second largest lender
Washington Mutual: largest lender
Wachovia
Other firms came close
LO6
29-73

2008
Troubled Asset Relief Program (TARP)
Allocated $700 billion to make
emergency loans
Saved several institutions from
failure
LO7
29-74

2008
The Feds lender-of-last-resort
activities
Primary Dealer Credit Facility
Term Securities Lending Facility
Asset-Backed Commercial Paper
Money Market Mutual Fund
Liquidity Facility
Commercial Paper Funding Facility
LO7
29-75

2008
Money Market Investor Funding
Facility
Term Asset-Backed Securities Loan
Facility
Interest Payments on Reserves
LO7
29-76
Post-Crisis U.S. Financial

Services
Major Categories of Financial Institutions
Commercial Banks
Thrifts
Insurance Companies
Mutual Fund Companies
Pension Funds
Securities Firms
Investment Banks
LO8
29-77
Post-Crisis U.S. Financial

Services
Wall Street Reform and Consumer
Protection Act
Passed to help prevent many of the
practices that led to the crisis
Critics say it adds heavy regulatory
costs
LO8
29-78
Too Big to Fail
Wall Street Reform and Consumer

Protection Act of 2010
Decision made not to criminally
prosecute HSBC bank because of
economic effect
29-79
Chapter 33
Money Creation
Fractional Reserve System

The Goldsmiths
Stored gold and gave a receipt
Receipts used as money by public
Made loans by issuing receipts
Characteristics:
Banks create money through
lending
Banks are subject to panics
LO1
29-81
Fractional Reserve System

Balance sheet
Assets = Liabilities + Net Worth
Both sides balance
Necessary transactions
Create a bank
Accept deposits
Lend excess reserves
LO1
29-82
A Single Commercial Bank

Transaction #1
Vault cash: cash held by the bank
Creating a Bank
Balance Sheet 1: Wahoo Bank

Assets
Cash
LO2
Liabilities and Net Worth

$250,000 Stock Shares
$250,000
29-83

Transaction #2
Acquiring property and equipment
Acquiring Property and Equipment
Assets
Cash
Property
LO2

$10,000 Stock Shares
240,000
$250,000
29-84
33-84

Transaction #3
Commercial bank functions
Accepting deposits
Making loans
Accepting Deposits

Assets
Cash
Property
LO2

Checkable
$110,000
Deposits
$100,000
240,000
Stock Shares
250,000
29-85
33-85

Transaction #4
Depositing reserves in a Federal
Reserve bank
Required reserves
Reserve ratio
Reserve
ratio
LO2
Commercial banks
Required reserves
Commercial banks
Checkable-deposit liabilities
29-86

Type of Deposit
Current
Requirement
Statutory
Limits
Checkable deposits:
$0-$12.4 Million
$12.4 - $79.5 Million
Over $79.5 Million
Noncheckable nonpersonal
savings and time deposits
LO2
0%
3
10
3%
3
8-14
0-9
The Fed can establish and vary the

reserve ratio within limits set by
Congress
Required reserves help the Fed control
lending abilities of commercial banks
29-87

Transaction #4
Assume the bank deposits all cash
on reserve at the Fed
Depositing Reserves at the Fed
Assets
Cash
Reserves
$0 Checkable
110,000
Deposits
$100,000
Property
240,000 Stock Shares
250,000
29-88

Excess reserves
Actual reserves - required reserves
Required reserves
Checkable deposits x reserve ratio
Example:
Checkable deposits $100,000
Reserve ratio 20%
LO2
29-89

Transaction #5
Clearing a check
$50,000 check reduces reserves and
checkable deposits
Clearing a Check

Assets
Reserves
Property
LO2

Checkable
$60,000
Deposits
$50,000
250,000
29-90
Money Creating Transactions

Transaction #6a
Granting a loan
$50,000 loan deposited to
checking
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank
Assets
Reserves
Loans
Property
LO3

$60,000 Checkable
Deposits
50,000
$100,000
250,000
29-91

Transaction #6b
Using the loan
$50,000 loan cashed
After a Check is Drawn on the Loan

Balance Sheet 6b: Wahoo Bank
Assets
Reserves
Loans
Property

$10,000 Checkable
Deposits
50,000
$50,000
250,000
A single bank can only lend an amount

equal to its preloan excess reserves
LO3
29-92

Transaction #7
Bank buys government securities
from a dealer
Deposits payment into checking
Buying Government Securities
Assets
Reserves
Securities
Property

$60,000 Checkable
Deposits
50,000
New money is created

LO3
$100,000
250,000
29-93
Profits, Liquidity, and the Fed

Funds Market
Conflicting goals
Earn profit
Make loans to earn interest
Buy securities to earn interest
Maintain liquidity
Alternative?
Overnight bank loans
Federal funds rate
LO3
29-94
The Banking System

Multiple-deposit expansion
Assumptions:
20% required reserves
All banks loaned up
Banks lend all of their excess
reserves
A $100 bill is found and deposited
Multiple deposits can be created
LO4
29-95
The Monetary Multiplier

Monetary
multiplier
LO5
1
required reserve ratio
1
R
29-96
The Monetary Multiplier

Maximum amount of new money
created by a single dollar of excess
reserves
Higher R, lower m
Reversibility
Making loans creates money
Loan repayment destroys money
29-97
Banking, Leverage, and

Financial Instability
Leverage is the use of borrowed
money to magnify profits and losses
Modern banks use lots of leverage
Thus small losses can drive banks
into insolvency
29-98
Chapter 34
Interest Rates and Monetary
Policy
Interest Rates
LO1
The price paid for the use of money

Many different interest rates
Speak as if only one interest rate
Determined by the money supply
and money demand
29-100
Demand for Money
LO1
Why hold money?

Transactions demand, Dt
Determined by nominal GDP
Independent of the interest rate
Asset demand, Da
Money as a store of value
Varies inversely with the interest
rate
Total money demand, Dm
29-101
Interest Rates
Equilibrium interest rate
Changes with shifts in money supply
and money demand
Interest rates and bond prices
Inversely related
Bond pays fixed annual interest
payment
Lower bond price will raise the
interest rate
LO1
29-102
Federal Reserve Balance Sheet
Assets
Securities
Loans to commercial banks
Liabilities
Reserves of commercial banks
Treasury deposits
Federal Reserve Notes
outstanding
29-103
Tools of Monetary Policy

Open market operations
Buying and selling of government
securities (or bonds)
Commercial banks and the general
public
Used to influence the money supply
When the Fed sells securities,
commercial bank reserves are
reduced
LO3
29-104

Fed buys bonds from commercial
banks
Federal Reserve Banks
Assets
+ Securities
+ Reserves of Commercial
Banks
(a) Securities
Assets
(b) Reserves
Commercial Banks
-Securities (a)
+Reserves (b)
LO3
29-105

Fed sells bonds to commercial banks
Federal Reserve Banks
Assets
- Securities
- Reserves of Commercial
Banks
(a) Securities
Assets
(b) Reserves
Commercial Banks
+ Securities (a)
- Reserves (b)
LO3
29-106
Open Market Operations
Fed buys $1,000 bond from a

commercial bank
New Reserves
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
LO3
29-107
Open Market Operations
Fed buys $1,000 bond from the

public
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
Reserves
$1000
Initial
Checkable
Deposit
Total Increase in the Money Supply, ($5000)

LO3
29-108
LO3
The reserve ratio

Changes the money multiplier
The discount rate
The Fed as lender of last resort
Short term loans
Term auction facility
Introduced December 2007
Banks bid for the right to borrow
reserves
29-109

Open market operations are the most
important
Reserve ratio last changed in 1992
Discount rate was a passive tool
Interest on reserves
LO3
29-110
The Federal Funds Rate
Rate charged by banks on
overnight loans
Targeted by the Federal Reserve
FOMC conducts open market
operations to achieve the target
Demand curve for Federal funds
Supply curve for Federal funds
29-111
Monetary Policy
Expansionary monetary policy
Economy faces a recession
Lower target for Federal funds rate
Fed buys securities
Expanded money supply
Downward pressure on other
interest rates
LO4
29-112
Monetary Policy
Restrictive monetary policy
Periods of rising inflation
Increases Federal funds rate
Increases money supply
Increases other interest rates
LO4
29-113
Taylor Rule
Rule of thumb for tracking actual
monetary policy
Fed has 2% target inflation rate
If real GDP = potential GDP and
inflation is 2%, then targeted Federal
funds rate is 4%
Target varies as inflation and real
GDP vary
LO4
29-114
Monetary Policy, Real GDP,

Price Level
Affect on real GDP and price level
Cause-effect chain
Market for money
Investment and the interest rate
Investment and aggregate demand
Real GDP and prices
Expansionary monetary policy
Restrictive monetary policy
LO5
29-115
(a)
The market
for money
Sm1
Sm2
Sm3
AS
10
P3
P2
Dm
ID
0
$125
$150
$175
Amount of money
demanded and
supplied
LO5
(c)
Equilibrium real
GDP and the
Price level
(b)
Investment
demand
Price Level
Rate of Interest, i (Percent)
Monetary Policy and

Equilibrium GDP
$15
$20
$25
Amount of investment
Q1
Qf Q3
AD3
I=$25
AD2
I=$20
AD1
I=$15
Real GDP
29-116
Monetary Policy and Equilibrium

GDP
(d)
Equilibrium real
GDP and the
Price level
(c)
Equilibrium real
GDP and the
Price level
AS
AS
Q1
Qf Q3
AD3
I=$25
AD2
I=$20
AD1
I=$15
Real GDP
Price Level
Price Level
P2
LO5
P3
P3
P2
Q1
Qf Q3
AD3
I=$25
AD4
I=$22.5
AD2
I=$20
AD1
I=$15
Real GDP
29-117
Expansionary Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
LO5
Fed buys bonds, lowers reserve ratio, lowers the

discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
29-118
Restrictive Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Inflation
LO5
Fed sells bonds, increases reserve ratio, increases

the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
29-119
Evaluation and Issues

Advantages over fiscal policy
Speed and flexibility
Isolation from political pressure
Monetary policy is more subtle
than fiscal policy
LO6
29-120
Recent U.S. Monetary Policy

Highly active in recent decades
Responded with quick and innovative
actions during the recent financial
crisis and the severe recession
Critics contend the Fed contributed
to the crisis by keeping the Federal
funds rate too low for too long
LO6
29-121
After the Great Recession

Slow recovery especially in terms of
employment
Zero interest rate policy
Zero lower bound problem
Quantitative easing
Forward commitment
Operation Twist
LO6
29-122
The Big Picture

Input
Resources
With Prices
Productivity
Sources
LegalInstitutional
Environment
LO6
Consumption
(Ca)
Aggregate
Supply
Levels of
Output,
Employment,
Income, and
Prices
Aggregate
Demand
Investment
(Ig)
Net Export
Spending
(Xn)
Government
Spending
(G)
29-123
Chapter 35
Financial Economics
Financial Investment
Economic investment
New additions or replacements to
the capital stock
Financial investment
Broader than economic investment
Buying or building an asset for
financial gain
New or old asset
Financial or real asset
LO1
29-125
Present Value
LO2
Present day value of future returns or

costs
Compound interest
Earn interest on the interest
X dollars today=(1+i)tX dollars
in t years
$100 today at 8% is worth:
$108 in one year
$116.64 in two years
$125.97 in three years
29-126
Present Value Model

Calculate what you should pay for an
asset today
Asset yields future payments
Assets price should equal total
present value of future payments
The formula:
( 1 + i)
LO2
dollars today = X dollars in t years

29-127
Applications
Take the money and run
Lottery jackpot paid over a number
of years
Calculating the lump sum value
Salary caps and deferred
compensation
Calculating the value of deferred
salary payments
LO2
29-128
Popular Investments
Wide variety available to investors
Three features
Must pay to acquire
Chance to receive future payment
Some risk in future payments
LO3
29-129
Stocks
Represents ownership in a
company
Bankruptcy possible
Limited liability rule
Capital gains
Dividends
LO3
29-130
Bonds
Debt contracts issued by government
and corporations
Possibility of default
Investor receives interest
LO3
29-131
Mutual Funds
Company that maintains a portfolio
of either stocks or bonds
Currently more than 8,000 mutual
funds
Index funds
Actively managed funds
Passively managed funds
LO3
29-132
Calculating Investment
Returns
Gain or loss stated as percentage
rate of return
Difference between selling price and
purchase price divided by purchase
price
Future series of payments also
considered into return
Rate of return inversely related to
price
LO4
29-133
Arbitrage
Buying and selling process to
equalize average expected returns
Sell asset with low return and buy
asset with higher return at same
time
Both assets will eventually have
same rate of return
LO5
29-134
Risk
Future payments are uncertain
Diversification
Diversifiable risk
Specific to a given investment
Nondiversifiable risk
Business cycle effects
Comparing risky investments
Average expected rate of return
Beta
LO6
29-135
Risk
Risk and average expected rates of
return
Positively related
The risk-free rate of return
Short-term U.S. government bonds
Greater than zero
Time preference
Risk-free interest rate
LO6
29-136
The Security Market Line

Compensate investors for:
Time preference
Nondiversifiable risk
LO8
Average
expected
rate of return
Average
expected
rate of return
Rate that
compensates
for time
preference
if
Rate that
compensates
for risk
risk premium
29-137
SML: Applications
Feds expansionary monetary policy
led to lower interest rates
SML shifted downward
Slope of SML increased due to
increased investor risk-aversion
Stocks fell
LO8
29-138
Index Funds Versus Actively

Managed Funds
Choice of actively or passively

managed mutual funds
After costs, index funds outperform
actively managed by 1% per year
Role of arbitrage
Management costs are significant
Index funds are boring no chance
to exceed average rates of return
29-139
Chapter 36
Extending the Analysis of Aggregate
Supply
From Short Run to Long Run

Short run
Input prices inflexible
Upsloping aggregate supply
Long run
Input prices fully flexible
Vertical aggregate supply
The transition?
LO1
29-141
From Short Run to Long Run

Production above potential output:
High demand for inputs
Input prices rise
Short run aggregate supply shifts
left
Return to potential output
Production below potential output
Graphical examples
LO1
29-142
Extended AD-AS Model

Demand-Pull Inflation
Price Level
ASLR
P3
AS1
c
b
P2
P1
AS2
a
AD2
AD1
Qf Q2
Real Domestic Output
LO2
29-143

Cost-Push Inflation
AS2
Price Level
ASLR
P3
P2
AS1
b
a
P1
AD2
AD1
Q2 Qf
LO2
29-144

Recession
Price Level
ASLR
AS2
P1
P2
AS1
b
c
P3
AD1
AD2
Q 1 Qf
LO2
29-145

Explaining ongoing inflation
Ongoing economic growth shifts
aggregate supply
Ongoing increases in money supply
shift aggregate demand
Small positive rate of inflation
LO2
29-146
Economic Growth, Ongoing

Inflation
Consumer Goods
LO2
Long Run
Aggregate
Supply
Price Level
Capital Goods
Productions
Possibilities
Increase in
production
possibilities
Real GDP
Increase in long-run
aggregate supply
29-147
U.S. Growth
ASLR1
ASLR2
AS2
Price level
AS1
P2
P1
AD2
AD1
0
Q1
Q2
Real GDP
LO2
29-148
Inflation and Unemployment

Low inflation and low unemployment
rates
Feds major goals
Compatible or conflicting?
Short-run tradeoff
Aggregate supply shocks cause
both rates to rise
No long-run tradeoff
LO3
29-149
The Phillips Curve
Price Level
AS
P3
P2
AD3
P1
P0
AD2
AD1
AD0
Q0
Q1 Q2 Q3
LO3
29-150
The Phillips Curve

Demonstrates short-run tradeoff
between inflation and unemployment
Concept
Empirical Data
Annual Rate of Inflation (Percent)
Data for the 1960s
Unemployment Rate (Percent)
LO3
69
68
66
67
65
64
63
62
61
29-151
The Phillips Curve

1960s economists believed in stable,
predictable tradeoff
Phillips curve shifts over time
Adverse supply shocks 1970s
OPEC oil price shock
Stagflation
Stagflations demise 1980s
LO3
29-152
The Phillips Curve

No long-run tradeoff between
inflation and unemployment
Short-run Phillips curve
Role of expected inflation
Long-run vertical Phillips curve
Disinflation
LO4
29-153
The Phillips Curve
Annual rate of inflation (percent)
14
13
12
11
10
9
8
7
6
5
4
3
2
1
Unemployment rate (percent)

LO4
29-154
The Phillips Curve

The Misery Index, Selected Nations, 2001-2012
LO4
29-155
The Long-Run Phillips Curve

PCLR
15
PC3
12
b3
PC2
a3
b2
PC1
6
c3
a1
c2
b1
a2

LO4
29-156
Taxes and Aggregate Supply

Supply-side economics
Tax and incentives to work
Incentives to save and invest
The Laffer curve
Tax Rate (Percent)
100
n
m
LO5
m
l
Laffer Curve
Maximum
Tax Revenue
Tax Revenue (Dollars)
29-157
Taxes and Aggregate Supply

Criticisms of the Laffer curve
Taxes, incentives, and time
Inflation or higher real interest
rates
Position on the curve
Rebuttal and evaluation
LO5
29-158
Chapter 37
Current Issues in Macro
Theory and Policy
Causes of Macro Instability

Mainstream view
Held by most economists
Price stickiness
Unexpected demand shocks
Variable investment spending
Unexpected supply shocks
LO1
29-160

Monetarist view
Government interference is the
problem
Equation of exchange MV = PQ
Stable velocity
Monetary causes of instability
Inappropriate monetary policy
LO1
29-161

Real-business-cycle view
Shifts in long-run aggregate supply
Price Level
ASLR2 ASLR1
P1
AD1
AD2
Q2
LO1
Q1
29-162

Coordination failures
Fail to reach equilibrium because of
lack of coordination mechanism
Limited information
Expectations and self-fulfilling
prophecy
Unemployment equilibrium
Inflation equilibrium
LO1
29-163
Chapter 37
Current Issues in Macro
Theory and Policy
Does the Economy Self Correct?

New classical view
Rational expectations theory
Monetarists
Automatic correction will occur
Speed of adjustment
Unanticipated price-level
changes
Fully anticipated price-level
changes
LO2
29-165
Does the Economy Self

Correct?
Mainstream view
Downward wage inflexibility
Efficiency wage theory
Greater work effort
Lower supervision costs
Reduced job turnover
Insider-outsider relationships
LO2
29-166
Rules or Discretion?
In support of policy rules
Reduce macro instability
Monetary rule
Shift AD to keep up with AS
Price stability achieved
Inflation targeting
Balanced budget
LO3
29-167
Defense of discretionary stabilization
policy
Discretionary monetary policy
Velocity is not stable
Discretionary fiscal policy
Useful during recession
Policy successes
LO3
29-168
LO4
29-169
The Taylor Rule

Rules: Passive monetary policy
Discretion: Active monetary policy
Hybrid policy rule to dictate Fed
actions
Policy responds to changes in real
GDP and inflation
Fed explains deviations from the rule
Increase Fed credibility and reduce
uncertainty
29-170
Chapter 38
International Trade
Some Key Trade Facts

U.S. trade deficit in goods
$735 billion in 2012
U.S. trade surplus in services
Canada largest U.S. trade partner
Trade deficit with China
Exports are 14% U.S. output
Dependence on oil
LO1
29-172
Some Key Trade Facts

Principal U.S. exports
include:
Chemicals
Agricultural products
Consumer durables
Semiconductors
Aircraft
U.S. provides about
8.1% of worlds
exports
LO1
Principal U.S.
imports include:
Petroleum
Automobiles
Metals
Household
appliances
Computers
29-173
Economic Basis for Trade

Nations have different resource
endowments
Labor-intensive goods
Land-intensive goods
Capital-intensive goods
LO2
29-174
Comparative Advantage
Assumptions
Two nations
Same size labor force
Constant costs in each country
Different costs between countries
U.S. absolute advantage in both
Opportunity cost ratio
Slope of the curve
Vegetables sacrificed per ton of beef
LO2
29-175
Self-sufficiency output mix
Specialization and trade
Produce the good with the lowest
domestic opportunity cost
Opportunity cost of 1 ton of beef:
1 pound of vegetables in U.S.
2 pounds of vegetables in Mexico
29-176
Terms of trade
U.S. 1V = 1B
U.S. will sell 1B for more than 1V
Mexico 2V = 1B
Mexico will pay less than 2V for 1B
Settle between the two
Depends on supply/demand factors
Assume 1B = 1.5V
LO2
29-177
Gains from trade
Trading possibilities line
Slope equals terms of trade
Improved options
Complete specialization
More of both goods
More efficient resource allocation
LO2
29-178
Trade with increasing costs
Concave production curve
Resources not perfectly
substitutable
Incomplete specialization
Case for free trade
Promote efficiency
Promote competition
LO2
29-179
Supply and Demand Analysis

World price
Domestic price with no trade
World price > domestic price
Export surplus
Export supply curve
World price < domestic price
Import shortage
Import supply curve
LO3
29-180
Trade Barriers and Export

Subsidies
Tariffs
Revenue tariff
Protective tariff
Import quota
Nontariff barrier (NTB)
Voluntary export restriction
(VER)
Export subsidy
LO4
29-181
Economic Impact of Tariffs

Direct effects
Decline in consumption
Increase in domestic production
Decline in imports
Tariff revenue
Indirect effects
LO4
29-182
Economic Impact of Quotas
LO4
Decline in consumption
Increase in domestic production
Decline in imports
Quotas do not provide for any
government revenue but instead
transfer it to foreign producers
29-183
The Case for Protection
LO5
Military self-sufficiency
Diversification for stability
Infant industry
Protection against dumping
Increased domestic employment
Cheap foreign labor
29-184
Multilateral Trade Agreements

General Agreement on Tariffs and
Trade (GATT)
World Trade Organization (WTO)
European Union (EU)
North American Free Trade
Agreement (NAFTA)
LO6
29-185
GATT
Three principles:
Equal, nondiscriminatory trade
between member nations
Reduction in tariffs
Elimination of import quotas
LO6
29-186
WTO
Established by Uruguay Round of
GATT
153 member nations in 2010
Oversees trade agreements and
rules on disputes
Critics argue that it may allow
nations to circumvent environmental
and worker-protection laws
LO6
29-187
European Union
Initiated in 1958 as Common Market
Abolished tariffs and import quotas
between member nations
Established common tariff with
nations outside the EU
Created Euro Zone with one currency
LO6
29-188
NAFTA
Agreement between U.S., Canada,
and Mexico
Established a free trade zone
between the countries
Trade has increased in all countries
Enhanced standard of living
LO6
29-189
Trade Adjustment and

Offshoring
Trade Adjustment Assistance Act
Designed to help individuals hurt
by international trade
Offshoring of jobs
Shifting of work previously done by
American workers to workers
abroad
LO6
29-190
Petition of the Candlemakers

Petition of candlemakers asking for
protection from natural light
producers such as the sun
Tongue-in-cheek argument
supporting the idea of free trade
29-191
Chapter 39
The Balance of Payments,
Exchange Rates, and Trade
International Transactions
International trade
Buy/sell current goods or services
Imports and exports
International asset transactions
Buy/sell real or financial assets
Buy stock
Sell your house to a foreigner
Requires currency exchange
LO1
29-193
Balance of Payments
Sum of international financial
transactions
Current account
Balance on goods and services
Net investment income
Net transfers
Balance on current account
LO2
29-194
Balance of Payments
Capital and financial account
Capital account
Financial account
Balance of payments accounts sum
to zero
Current account deficits generate
asset transfers to foreigners
Official reserves
LO2
29-195
Official Reserves
Foreign currencies, certain reserves
with the IMF, and stocks of gold
Owned by government or central
bank
Used as balancing mechanism in
balance of payments
LO2
29-196
Flexible Exchange Rates
The Market for Foreign Currency

(Pounds)
Dollar Price of 1 Pound
S1
$3
$2
$1
Dollar
Depreciates
(Pound
Appreciates)
Exchange
Rate: $2 = 1
Dollar
Appreciates
(Pound
Depreciates)
D1
0
Q1
Quantity of Pounds
LO3
Q
29-197

Determinants of exchange rates
Factors that shift demand/supply
Changes in tastes
Relative income changes
Relative price-level changes
Purchasing-power-parity theory
Relative interest rates
Relative expected returns on assets
Speculation
LO3
29-198
The Market for Foreign Currency

(Pounds)
Dollar Price of 1 Pound
S1
c
$3
$2
Balance
Of Payments
Deficit
b D
2
Exchange
Rate:
$2 = 1
$1
Exchange
Rate:
$3 = 1
D1
0
LO3
Q1
Quantity of Pounds
Q2
Q
29-199

Eliminate balance of payments
deficit or surplus
Disadvantages of flexible exchange
rates
Volatility
Uncertainty and diminished trade
Terms-of-trade changes
Instability
LO3
29-200
Fixed Exchange Rates

Government intervention
Use of reserves
Trade policies
Exchange controls and rationing
Distorted trade
Favoritism
Restricted choice
Black markets
Macroeconomic adjustments
LO4
29-201
The Managed Float

Gold standard 1879-1934
Fixed exchange rate system
Bretton Woods 1944-1971
Fixed exchange rate system
indirectly tied to gold
Managed float 1971-present
LO5
29-202
The Managed Float

Dependence on foreign exchange
markets
Occasional intervention
In support of managed float
Concerns with managed float
LO5
29-203
U.S. Trade Deficit

Large and persistent
Causes of trade deficits
High U.S. growth (relatively)
China
Price of oil
Low U.S. saving rate
Implications of trade deficits
Increased current consumption
Increased indebtedness
LO6
29-204
Speculation in Currency Markets

Positive or negative influence?
Contributes to currency market
fluctuations
Self-fulfilling expectations
Smoothing short-term fluctuations
Absorbing risk
Futures market at work
Positive role played overall
29-205

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Chapter 29

The Aggregate Expenditures

Assumptions and Simplifications

Consumption and Investment

Investment Demand Curve

Real domestic product, GDP

Changes in Equilibrium GDP

Adding International Trade

The Net Export Schedule

Net Exports and Equilibrium GDP

Positive net exports

International Economic Linkages

Adding the Public Sector

Government Purchases and Eq.

Government Purchases and Eq.

Taxation and Equilibrium GDP

Aggregate expenditures (billions of dollars)

Taxation and Equilibrium GDP

Real domestic product, GDP (billions of dollars)

Equilibrium versus FullEmployment

Recessionary expenditure gap

Equilibrium versus FullEmployment

Equilibrium versus FullEmployment

Says Law, Great Depression,

Changes in Aggregate Demand

Net Export Spending

AS: Immediate Short Run

Real domestic output, GDP

Aggregate Supply: Short Run

Real domestic output, GDP

Aggregate Supply: Long Run

Real domestic output, GDP

Changes in Aggregate Supply

total input cost

Price level (index numbers)

Real domestic output, GDP

Real domestic output, GDP

Decreases in AD: Recession

Decreases in AS: Cost-Push

Increases in AS: Full-Employment

Real domestic output, GDP

Stimulus and the Great Recession

Stimulus and the Great Recession

Expansionary Fiscal Policy

Contractionary Fiscal Policy

Evaluating Fiscal Policy

Government expenditures, G, and

Cyclically Adjusted Budgets

Real domestic output, GDP

Government expenditures, G, and

Cyclically Adjusted Budgets

Real domestic output, GDP

Fiscal Policy: The Great Recession

Problems, Criticisms, &

Current Thinking on Fiscal Policy

The U.S. Public Debt

The U.S. Public Debt

The U.S. Public Debt

Social Security, Medicare

Social Security, Medicare

What Backs the Money

What Backs the Money

Federal Reserve - Banking