ECO 3250 TAKEAWAY NOTES 02.09.12 EU debt crisis -- markets need a clear path to resolution 3.

3Consumption spending increase when HH: __________(chap2)

pp 141, 286-94

figure/chart

wealth ,

consumer confidence , disposable income , i rates

Disposable Income = to

Keys to growth -- infrastructure, skill building, tax incentives, export promotion, greater productivity
pp 237

1.29 Consistent (sustained) economic growth(chap9) (GDP), high employment, & stable prices are the most important goals of a fully functioning economy pp 237 chap
9

Measuring growth using GDP and BOP (Balance of Payments) GDP defined as C + I (p) + G + NX BOP = (EX-IM) + (CI-CO) + FXB
measuring all economic activity/transactions expenditure approach income statement

measuring value of all goods & services produced

HH buy goods/services = goods Businesses buy goods/services = goods

consumption investment

Circular relationship between [production - income spending] where spending depends on income and income on spending

Types of unemployment 1) functional (ST joblessness, people always moving into/out of labor markets) 2) seasonal (ST joblessness as a factor of weather or tourist patterns) 3) structural (LT unemployment) Price stability - single most important factor influencing consumer spending; persistent inflation very expensive to society, erodes purchasing power

ECO 3250 TAKEAWAY NOTES 02.28.12

How are leakages (money earned, but not spent) affecting the US economy today? Real rates = nominal rates - inflation Credit - Float rate hedge INFL( re-pricing whereas fixed rates maximize CF predictability; borrower sacrifice lower rates Changes in Total Spending -- a in TS causes a in EQ GDP due to pos/neg cycles of spending/income with expansions/recessions triggered typically by an increase/decrease in defense spending, oil (P), CAPX (investment spending), interest rates, tech advance, consumer sentiment where one event 's the entire economy

Classical EC Review
mkt clearing function where (P) adjusts until Q(d) = Q(s) at EQ supply creates its own demand (Say's law), i.e. firms create demand by producing output and total spending will always equal total output demand always sufficient to buy all gds/svs a fully employed society can produce full employment achieved on its own economy will operate at/near full potential on its own

Modern EC Review
Keynes -- focused on aggregate demand [C + I (p) + G + NX] observed ST disruptions1 to LT trends, advocates mix of substantial fiscal/monetary govt action to reverse a recession/depression recognized power of competitive forces in America which can focus a companys competitive advantages with subsequent productivity gains translating into higher wages argued that just as wages depend on production, the country's interests are best served by promoting the health and welfare of all its citizens in the name of compassion and self-interest

demand leads to sales leads to production cutbacks leads to layoffs leads to demand

Conclusion: the classical model cannot explain SR fluctuations because total spending total output in the SR Note: Conventional wisdom of the 1930's called for strict monetary policy and deep budget cuts which only worsened the Depression. Keynes argued that increasing demand and undoing the negative cycle of unemployment and stagnant wage growth required aggressive monetary policy paired with significant structural changes -- tax credits, tax code reform, targeted stimulus spending (infrastructure, skill-building, education, entitlement reform). Keynes said that increasing the monetary base (through central bank asset buying, for example) would not be inflationary and that austerity would further weaken an already depressed economy.

ECO 3250 LECTURE NOTES Spring 2012

Professor Jonathan M. Gold

We defined the Marginal Propensity to Consume (MPC) as the amount by which Consumption Spending Increases () when Disposable Income (). We also identified the Autonomous Consumption Function as the part of consumption spending independent of income and noted that an increase ()in this type of spending can shift the consumption function upward(), e.g. more wealth or the perception of it leads to more spending, along with the vertical intercept. We discussed Total Spending using the Expenditure Approach [ TS = C + Ip + G + NX ] as opposed to the Balance of Payments Method [ BOP = (EX-IM) + (CI-CO) + FXB). We examined the components of TS and saw that when TS increases, companies produce more and spend more, e.g. CAPX, with investment spending leading to a chain reaction of increased spending and income. We observed the circular relationship between Spending, Income and Production and used the Expenditure Approach to derive GDP, adding up the value of all goods

and services produced and including any changes in stock / inventory where GDP = TS + in Stock. We saw how a change in stock is the key element indicating when GDP is in equilibrium, e.g. when TS = GDP, or not in equilibrium when the change in stock > 0. Finally, we saw that when TS < GDP, we can expect output to fall in the future as firms have produced more than they are currently selling. Similarly, when TS > GDP, we expect production to increase in the future with output rising in anticipation of greater demand. To quantify the equilibrium GDP effect of a positive spending shock to the economy, we can consider, for example, Federal stimulus checks supplying tens of millions of US consumers with additional income of $1,000. If the consumption rate or MPC = .6, we know that $600 will be spent and $400 will be saved. Applying the Expenditure Multiplier, ( 1/1-MPC ), we calculate as follows [ 1/(1-.6) = 2.5 ] the multiple by which GDP is expected to rise [ 2.5 x $1,000 = $2,500 ]. Naturally, an increase in spending causes equilibrium GDP to rise by a multiple of that change, a decrease in spending causes equilibrium GDP to fall by a multiple of that change, as well. We see that in the LR, fiscal policy change in Federal spending or taxes is not an effective tool to change Equilibrium GDP, but in the SR causes a multiplier effect on Equilibrium GDP as first observed during the Great Depression and remains a cornerstone of Keynesian or modern economics. Classical economic theory tells us that the economy operates automatically at its potential GDP due to the market clearing function which assures sufficient demand is always available. While we know this is true in the long

run (LR), the theory overlooks short term disruptions to longer term trends. In the short run (SR), we see the economy can operate above or below its equilibrium level, e.g. its potential as charted on the Production Possibilities Frontier (PPF), because of spending changes which cause expansions and contractions. A positive spending shock can push output beyond its PPF while a negative spending shock can push the economy below its In the LR, we know that Household (HH) savings contribute to economic growth by making money available to companies for growth through the capital markets, but can indeed be negative in the SR as reduced spending leads to lower levels of output. The Federal Reserve can increase the money supply by buying securities in the open market via "open market purchases" and conversely can decrease the money supply by selling government securities via "open market sales." Of course, the Federal government reserves the right, as well, to increase or decrease the supply of USDs in the global marketplace via FX transactions or, as has been noted in class, by simply printing more money. We consider the role of interest rates as a critical variable driving all capital market transactions with higher interest rates attracting investment and savings while lower rates attract borrowers and stimulate spending. An increase in the money supply will send interest rates lower with HH's and companies more willing to borrow "cheap money" just as a decrease in the money supply will send interest rates higher and, thus, make money more expensive. The critical point here is that changes in interest rates have a dramatic effect on interest rate
6

sensitive expenditures for companies and HH's alike whether on PP&E, CAPX, new home construction, or consumer spending.

ConsSpend =HH wealth;cons confi; disposable inc ; int(% Real GDP per capita %Productivity + % Avg Hrs + % EPR) sustained economic (g); high emp; & stable (p)= fully (f) economy GDP=C+I(p)+G +NX expenditure approach value goods & services produced BOP=(EX-IM)+(CI-CO) +FXB income statement economic activity/transactions CAP outflow/inflow HH buy gds/svs=consumption goods Businesses buy gds/svs=investment goods ProdINCSPEND where spending on INC/INC on spending Func. UnEmp- ST joblessness, moving into/out of Labor mkts) Season-ST jobless, i.e.weather/tourist patterns Structural -LT UNEMP Price stability Prime Factor consumer spending; persistent INFL expensive$$$= purchasing power PP Distributional choices Which, How, Who, Where gds/svs prdcd. Thry Rsrce Allctn=finite, all prod opp. Cost Rsrce allctn specialization & exchange higher living standards comp adv - produce at a lower opp. cost (Intl trade) MUTL BNFCL TRD GNS= comparative, NOT abs adv Real r = nom r infL; inTS = in EQ GDP cycles spending/income; EXPANSIONS=defense spending, falling oil $P, new CAPX (investment spending), drop in i rates, tech advance; GDP / > =amtspend: expdtre mltplr =(1/1-MPC) MPC=(Cons/DispsInc) Fed repo mktST i rate, $supply MS & fed buy TRSHRY IN liquidity/selling TRSHRY OUT liquidity; Fed sterilization neutralize/offset infl Capital = selling Treasuries gets CFS domestic capital monetary base MS= I ; HH borrow $cheap MS=I HH borrow $exp PPF+=output beyond PPF-=output -