Основы экономики: Учебные материалы для занятий с иностранными студентами по основам экономических знаний

VORONEZH STATE UNIVERSITY INSTITUTE OF INTERNATIONAL EDUCATION

FUNDAMENTALS OF ECONOMICS

VORONEZH 2004

В О Р О НЕ Ж С К И Й Г О С У Д А Р С Т В Е ННЫ Й У НИ В Е Р С И Т Е Т И НС Т И Т У Т М Е Ж Д У НА Р О Д НО Г О О Б Р А ЗО В А НИ Я К А Ф Е Д Р А РУ С С К О Г О Я ЗЫ К А Д ЛЯ И НО С Т Р А ННЫ Х У ЧА Щ И ХС Я О С НО В НЫ Х Ф А К У ЛЬТ Е Т О В

О С НО В Ы ЭК О НО М И К И У чебные материалы длязанятий с ино странными студентами п о о сно вам эко но мических знаний

А вто р-со ставитель – канд. ф ило ло г ических наук, до центЛ.П . Земско ва

В о ро неж 2004

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А втор-с ос тави те л ь - канд. ф и л ол . наук, доце нт Л .П . З е мс кова О сно вы эко но мики: У че бные мате ри ал ы дл я заняти й с и нос транным и с туде нтами по ос новам эконом и че с ки хзнани й. – В ороне ж : В ГУ , 2004. – 32 с .

Научный ре дактор– докторф и л ол . наук, проф е с с орВ .Ю . Копров Ре це нзе нт – канд. ф и л ол . наук, доце нт А .П . Л е в и цкая (В ороне жс ки й гумани тарный и нс ти тут, ф и л и ал М ос ковс кого открытого соци ал ьного уни ве рс и те та)

У чебные материалы пре дназначе ны дл я заняти й с и нос транным и с туде нтами , проходящи ми обуче ни е на ос новном ф акул ьте те на англ и йс ком языке , и пре дс тавл яют с обой те зи с ыл е кци й по курс у “Ос новы экономи ки ” . П ри подготовке данных мате ри ал ов и с пол ьзованыс л е дующи е и здани я: Samuelson Paul A., Nordhaus William D. Economics. – 14th ed. – McGrawHill, Inc., 1992. – 784 c. Fischer Stanley, Dornbusch Rudiger, Schmalensee Richard. Introduction to Macroeconomics. – 2nd ed. – McGraw-Hill, Inc., 1988. – 460 c.

© И М О В Г У , 2004 3

TOPICS FOR DISCUSSION 1. What is Economics?… … … … … … … … … … … … … … … … … … … … … … 5 2. Basic Concepts and Techniques… … … … … … … … … … … … … … … … … ..7 3. Supply, Demand, and the Market… … … … … … … … … … … … … … … … … 8 4. Measuring the Macroeconomy… … … … … … … … … … … … … … … … … ..10 5. The Determination of the National Income… … … … … … … … … … … … ...12 6. Money and Banking… … … … … … … … … … … … … … … … … … … … … ...14 7. Central Banking and the Monetary System… … … … … … … … … … … … ...15 8. The Budget, Fiscal Policy, and Aggregate Demand.… … … … … … … … … .17 9. Money and the Economy… … … … … … … … … … … … … … … … … … … ...19 10. Unemployment.… … … … … … … … … … … … … … … … … … … … … … … 20 11. The Inflation Problem… … … … … … … … … … … … … … … … … … … … ...22 12. Economic Growth… … … … … … … … … … … … … … … … … … … … .… … 24 13. Developing Countries in the World Economy.… … … … … … … … … … … .25 Glossary… … … … … … … … … … ..… … … … … … … … … … … … … … … … … .28

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LECTURE 1.

WHAT IS ECONOMICS?

1. Economics is the study of how societies faced with the central problem of reconciling unlimited desires for goods and services with scarce resources that limit output decide what gets produce, how it is produced, and for whom it is produced. 2. Economics is studied for a variety of reasons: to understand problems facing the citizen and family, to help governments promote growth and improve the quality of life while avoiding depression and inflation, and to analyze fascinating patterns of social behavior. Because economic questions enter into both daily life and national issues, a basic understanding of economics is vital for sound decision making by individuals and nations. 3. Economists deal with both positive and normative questions. Positive economics seeks a scientific understanding of the workings of the economy; it deals with what is or could be. Normative economics offers prescriptions for action based on personal value judgements; it deals with what should be. The deepest disagreements among economists have to do with normative questions; most of positive economics is not controversial. 4. The production possibility frontier (PPF) shows the maximum amount of one good or service that can be produced for each given level of outputs of other goods and services. The PPF of any society will change if the quantity or quality of productive resources changes or if useful knowledge advances. 5. The PPF of an imaginary simple economy with only two possible outputs illustrates a number of basic economic principles. The opportunity cost of increasing the output of one of the goods is the amount of the other good that must be given up. Only the changes that a particular action would cause should be considered in evaluating its desirability; decisions should be made on the margin. In order to shift out the PPF, or make possible greater production tomorrow, society must reduce consumption today. Society is wasting resources if it is producing inside the PPF; it produces efficiently on the PPF. Points outside the PPF are unattainable because resources are scarce. 6. In a command economy, all decisions on “what” , “how” , and “for whom” would be made by the government. The government’s task in such an economy would almost certainly be impossible; at any rate, there are no real command economies. 7. At the other extreme, in a free-market economy, the government would play no role in the allocation of resources; the decisions of firms and households would interact through markets to make all the “what” , “how” , and “for whom” decisions. Adam Smith argued that individuals pursuing their own interests in free markets are led “as if by an invisible hand” to advance the interests of society as a whole. But there are no completely free-market economies; all real governments affect decisions about resource allocation in many ways and for many reasons. 5

8. All modern economies are mixed – intermediate between the command and free-market extremes. In mixed economies, both government decisions and market forces affect the allocation of resources. The actual roles of the government and the market vary considerably among nations; the roles each should play are frequently intensely controversial. 9. There are two main branches of economics. Microeconomics concentrates on the operation of individual markets and the interactions among them. Macroeconomics studies the economy as a whole, concentrating on such issues as inflation, unemployment, and growth in total output. The same basic principles apply in both branches. KEY TERMS Scarcity “What” , “how” , and “for whom” questions Trade-offs Positive versus normative economics Production possibility frontier (PPF) Opportunity cost Choice at the margin Economic growth Efficient production Markets Prices Command economy Free-market economy Mixed economy Microeconomics and macroeconomics PROBLEMS 1. Suppose you lived by yourself on an island. Which of the three basic economic problems would you not have to solve? 2. Describe how the invisible hand would work if a large number of college students decided to drop out and look for full-time jobs. 3. Which of the following statements is positive and which is normative? Explain. (a) The rate of inflation has fallen to close to zero. (b) The rate of inflation has fallen close to zero, and it’s time to get the economy moving again. (c) The level of income is higher in the United States than in Russia. (d) Because people should not drink, we should tax liquor more. (e) If we tax liquor more, we will reduce the amount of drinking in society. 4. Explain whether the following are statements about macroeconomics or microeconomics. (a) The price of bananas is down this month. (b) The oilprice shock in 1973-1974 caused a great deal of both inflation and unemployment in the United States. (c) Unemployment in India is high relative to the level in the United States. (d) Farmers’ plantings of wheat are high and the weather looks good, so there should be a large harvest. 6

LECTURE 2. BASIC CONCEPTS AND TECHNIQUES 1. Economic variables either influence or describe the allocation of scarce resources. Data are facts, usually numerical, that provide information about economic variables. 2. Models or theories, which are simplified descriptions of reality, are used in economics and other fields to aid understanding and to answer “what if” questions. All models are necessarily unrealistic; good models are those which give correct answers to questions of interest. Data are used both to suggest relationships that should be taken into account by models and to test and evaluate models after they have been developed. 3. The circular flow diagram provides an overview of the organization and working of the economy. Households obtain income by selling to firms the services of the factors of production they own. Firms use the factors of production to produce goods and services for sale to households, whose income makes it possible for them to buy the goods. Households and firms deal with each other in both the goods and factor markets. 4. Prices and quantities are the basic units of measurement in economics. The product of price and quantity is a dollar (ruble, euro, etc.) amount, or value. 5. The price level is the weighted average level of prices in the economy as a whole. A price index expresses the cost of a given market basket or collection of goods relative to the cost of the same goods in a base year. 6. The consumer price index (CPI) is based on the cost of a market basket of goods that reflects the purchases of a typical urban household. It is the most widely used price or cost of living index. 7. Nominal gross national product (GNP) is the total dollar value of the goods and services produced in the economy within a given period. Nominal GNP can change either because prices change or because physical production changes. Real GNP is the value of the output produced in a given year, calculated using the prices of a given base year. Real GNP is a measure of the economy’s physical quantity of production. The GNP deflator is equal to 100 times nominal GNP divided by real GNP. The GNP deflator is a measure of the price level that is based on all goods and services produced in the economy. 8. Ratios (particularly shares, relative prices, and real prices) and percentage changes (particularly growth rates and inflation rates) are widely used in economics to make comparisons over time or among economic units (such as firms, households, states, or nations) at the same time. 9. Graphs of economic data, particularly scatter diagrams, are used to reveal trends, patterns, and possible relations between economic variables. Econometric techniques are used to describe relations between economic variables in terms of numbers and equations. 10.Most economic data are not generated by controlled experiments, and so it is often difficult to test the “other things equal” predictions of theory. 7

Moreover, economics studies human behavior, which varies among people and over time. KEY TERMS Model Graph Theory Economic variable Data Circular flow of income Factors of production Dollar amount Price level Price index Consumer price index (CPI) Nominal gross national product (GNP) Real gross national product GNP deflator Relative and real prices Percentage change Growth rate Inflation rate PROBLEMS 1. You have the idea that crime may be related to economic factors. In particular, you believe it may have something to do with people not getting jobs. (a) How would you test your idea? What data would you need and why? (b) Where would you look for the data? 2. Suppose you are on the university football stadium advisory board and have to help set the price for tickets. You want to take in the maximum possible revenue for the football team. Describe the steps you take.

LECTURE 3.

SUPPLY, DEMAND AND THE MARKET

1. Most decisions concerning resource allocation in mixed economies are made through the price system. Prices are determined in markets; these markets take different forms, but their operation can be summarized with the basic model of demand and supply. 2. Quantity demanded is the amount of a good buyers are willing to buy per period (day or year, for example) in a given market. Quantity demanded depends on the price of the good and on the other factors. Chief among these

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are the prices of alternative goods, the income of buyers, their tastes, and expected future prices. 3. The demand schedule is the relationship between the quantity of a good demanded and its price, other factors held constant. The demand curve is the graphic representation of the demand schedule. Demand curves are typically downward-sloping, showing that quantity demanded increases as price falls. 4. Quantity supplied is the amount of a good sellers want to sell per period in a given market. Quantity supplied depends on the price of the good and on other factors. Chief among these are the durable productive assets (physical capital) and technology available to suppliers and the prices of variable inputs, all of which determine sellers’ costs. 5. The supply schedule is the relationship between the quantity of a good supplied and its price, other factors held constant. The supply curve – the graphic representation of the supply schedule – is typically upward-sloping, showing that quantity supplied increases when price rises. 6. The market is in equilibrium when price is at the level at which quantity demanded is equal to quantity supplied. At any price below the equilibrium price there is excess demand (or a shortage), with quantity demanded exceeding quantity supplied. At any price above the equilibrium price there is excess supply (or a surplus), with quantity supplied exceeding quantity demanded. 7. Price moves towards the equilibrium level if the market is not in equilibrium. When there is excess demand, suppliers can raise price and still sell as much as they would like to at the higher price. When there is excess supply, the pressure of unsold output leads firms to cut price. Because markets move to equilibrium, economists generally concentrate on equilibrium price and quantity when analyzing markets’ responses to changes in supply or demand. 8. Changes in the factors other than the price of the good that determine quantity demanded shift the demand curve, causing equilibrium price and quantity to change. An increase in the price of a substitute good shifts the demand curve to the right, increasing both price and quantity. Similarly, an increase in the number of consumers, a shift in tastes toward this good, or the expectation that price will rise in the next period shifts the demand curve to the right. An increase in the price of a complementary good shifts the demand curve to the left, reducing price and quantity. 9. An increase in consumers’ incomes increases the quantity demanded of a normal good, shifting the demand curve to the right and raising price and quantity. An increase in consumers’ incomes shifts the demand curve for an inferior good to the left, reducing price and quantity. 10.The position and slope of the supply curve are determined mainly by costs of production. These in turn are determined by technology and the costs of inputs. An improvement in technology, reducing the costs of production, will typically shift the supply curve to the right, causing equilibrium price to fall and output to rise. So will a reduction in the cost of an output. 11.The price system helps solve the “what” , “how” , and “for whom” problems in a free-market economy. What is determined by supply and demand in the 9

markets for different goods. How is determined by firms’ decisions about the best way to produce. For whom is determined by the ability and willingness of consumers to pay for different goods, which is determined in turn by the prices at which they can sell their labor and the value of their wealth. KEY TERMS Market Demand Quantity demanded Quantity bought Demand schedule Demand curve Supply Quantity supplied Quantity sold Supply schedule Supply curve Excess demand (shortage) Excess supply (surplus) Equilibrium quantity Substitutes Complements Normal goods Inferior goods PROBLEMS 1. Suppose cold weather makes it more difficult to catch fish. What happens to the supply curve for fish? What happens to equilibrium price and quantity? Describe other aftereffects. 2. Explain how an increase in income will affect the demand curve for an inferior good. What happens to price and quantity? 3. Explain why the price of a good starts rising this month when people expect that its price will go up next month.

LECTURE 4.

MEASURING THE MACROECONOMY

1. Gross national product is the key measure of economic activity. GNP is defined as the market value of all goods and services produced within a given period by domestically owned factors of production. 2. Gross domestic product (GDP) is the value of the output of goods and services produced in the domestic economy. It differs from GNP by an amount equal to net income from abroad. 10

3. The production of GNP generates the income earned by domestic factors of production. Because not all the value of goods and services produced accrues as incomes to the factors of production, a number of adjustments have to be made in going from GNP to national income (NI). There are two major adjustments. The first is depreciation. As the equipment and structures used in production wear out, part of output has to be set aside to replace and maintain the stock of physical capital and thus represents a deduction from income. GNP minus depreciation is net national product (NNP). The second adjustment is indirect taxes. Indirect taxes, such as a sales tax, create a difference between the market value of goods and the amount individuals receive as income for producing those goods. NNP minus indirect taxes is national income (NI). 4. NI measures total income received by domestically owned factors of production. National income in turn can be split into the returns to different productive factors: labor compensation, rental income, proprietors’ income, corporate profits, and net interest. 5. Disposable personal income is a measure of the income households actually receive. It differs from national income in the deduction of taxes and undistributed corporate profits, the addition of transfer payments, and the adjustment for interest. Over 90 percent of disposable personal income is consumed. Most of the rest is saved. 6. GNP, looked at from the expenditure side, is equal to the components of demand: consumption, investment, government spending, and net exports. 7. Real GNP is obtained by valuing the output of goods produced in each year at the prices of a given base year. Real GNP is thus a measure of the economy’s physical production of goods and services. 8. The GNP deflator, or the ratio of nominal to real GNP, is a widely used price index. 9. GNP as measured does not include all production of goods and services. Some nonmarket activities and unreported incomes are excluded. 10.Real GNP is in practice used as a measure of economic welfare, but it has major shortcomings in this role. First, the value of nuisance outputs such as pollution should be deducted. Second, the value of leisure should be added to GNP. This gives a measure of net economic welfare (NEW). NEW is not calculated on a regular basis and therefore serves mainly to remind us to be cautious in using GNP as a welfare measure. 11.Per capita GNP is often used in comparing output and standards of living in different economies. The comparisons have to be handled with care because the types of goods produced in different economies differ and because exchange rates do not provide a reliable way of comparing the real value of output in the economies. Comparisons of GNP across time (and thus growth rates) also face the difficulty that very different types of goods may have been produced in the same economy in the different periods.

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KEY TERMS Gross national product (GNP) National income (NI) Value added Imputed rent Gross domestic product (GDP) Per capita GNP Depreciation Net national product (NNP) Personal disposable income Personal saving Personal saving rate Net exports GNP deflator Net economic welfare (NEW) PROBLEMS 1. Suppose GDP is $5000 billion. Domestic residents receive factor payments from abroad equal to $150 billion. Foreigners receive factor payments from the United States equal to $90 billion. What is GNP? 2. Explain why the following nonmarket activities should or should not appear in a comprehensive measure of GNP: (a) Time spent by students in class. (b) The income of muggers. (c) Time spent by boxing match spectators. (d) The wages paid by the city to traffic wardens who issue tickets.

LECTURE 5.

THE DETERMINATION OF THE NATIONAL INCOME

1. The demand for goods comes from consumption demand by households, investment demand by firms, and the demands of the government and foreigners. 2. The consumption function shows the desired level of consumer spending at each level of income. Consumption demand is determined in large part by households’ income. The data show a strong though not perfect relationship between consumption and personal disposable income. 3. The marginal propensity to consume (MPC) is the fraction of a dollar by which consumption rises when income goes up a dollar. Leaving aside personal interest payments to firms, any part of income that is not consumed is saved. The marginal propensity to save (MPS) is the fraction of an extra dollar of income that is saved. The MPC and the MPS sum to 1, since income is either consumed or saved.

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4. In this lecture we treat investment demand as constant. Investment demand is firms’ desired additions to physical capital – machinery and buildings – and to inventories. 5. Aggregate demand is the amount all spending units in the economy plan to spend on goods. The aggregate demand schedule shows the level of aggregate demand at each level of income. 6. The goods market is in equilibrium when, at a given price level, output produced is equal to aggregate spending, or aggregate demand, Y = C + I. Equivalently, the equilibrium level of output, or income, is the level at which aggregate demand is equal to income. 7. Adjustment toward the equilibrium level of output takes place through firms’ responses to undesired or unplanned additions to inventories. When output is above the equilibrium level, the demand for goods is below output, and inventories are being accumulated. Firms therefore cut output. Similarly, when output is below the equilibrium level, inventories are being reduced, and firms increase production. 8. Equilibrium in the goods market does not mean that output is at the potential, or full-employment, level. With prices given, output may settle at some level below potential, with firms unwilling to increase production because they do not believe they will be able to sell more. 9. A $1 increase in planned investment demand causes equilibrium output to increase by more that $1. The increase is larger because the increase in output to meet higher investment demand also causes an increase in consumption demand. 10.The multiplier is the ratio of the increase in equilibrium output to the increase in demand that causes output to rise. In the model presented in this lecture, the multiplier is equal to 1/(1 – MPC), or the inverse of the marginal propensity to save. 11.The equilibrium condition that determines the level of output, or aggregate demand equal to income, can equivalently be expressed as the equality of planned saving and planned investment, S = I. 12.The paradox of thrift shows that a reduced desire to save may result in no change in saving at all and only a higher level of output. The paradox shows that increased saving at a time of insufficient aggregate demand is not a virtue, even though we think of saving as a good thing. KEY TERMS Consumption function Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Investment function Aggregate demand schedule Undesired or unplanned inventory investment Multiplier Paradox of thrift 13

PROBLEMS 1. Suppose actual output is 100, households’ planned consumption at this level of income is 70, and planned investment is 45. Is there excess supply of or excess demand for goods at this point, and how much? 2. What would happen if people decide to save a larger proportion of their income? 3. Suppose people’s incomes increase. Describe possible changes in consumption, saving, and output.

LECTURE 6.

MONEY AND BANKING

1. Money has four functions: a medium of exchange, a store of value, a standard of deferred payment, and a unit of account. The distinguishing function of money is that of a medium of exchange. 2. Money facilitates exchange because it dispenses with the need for a double coincidence of wants. In a monetary economy trading is simplified because there is no need for a seller to find a buyer who has what he wants and wants what he has. 3. There are several kinds of money. Commodity money is a good that has the same value as a monetary unit and as a commodity. Token money, by contrast, is a good that has a larger value as a money than as a commodity. Paper money, for example, is a token money. IOU monies are debts of financial institutions, such as demand deposits, which are a liability of the bank that is obliged to pay out currency on the demand of the depositor. 4. Token money is accepted either because people believe that they can in turn use it to make payments or because the government has specifically declared it to be legal tender. 5. The story of the goldsmith-banker illustrates the role of modern banks. Goldsmiths who make loans create money. They do so by releasing into circulation gold previously held in vaults. The choice of how much reserves to hold involves a trade-off between profitability and solvency. Too much lending leaves the goldsmith unable to meet calls for gold; too little means no profits. 6. Because the goldsmith-bankers held less than 100 percent reserves, they were always vulnerable to a run as depositors all tried to get their gold out before the next person. Such runs could lead to financial panics. 7. Modern commercial banks are profit-making financial intermediaries. They attract funds through deposits or borrowing and use the funds to make loans. 8. In the USA banks hold less than 10 cents of reserves for every dollar of deposit liabilities. Like the goldsmiths, banks create money when they make loans. They do so either by reducing their cash reserves or by increasing their deposits. 14

9. Money (M1) is defined as those generally acceptable means of payment which can be used for unrestricted payments, including currency, checkable deposits, and traveler’s checks. But a host of other assets are near-monies. They are highly liquid in that they can be converted into currency at short notice. They are not included in the money stock because they are not usable as a means of payment immediately and in an unrestricted way. They are part of the broader monetary aggregates, M2 and M3. KEY TERMS Money Double coincidence of wants Unit of account Store of value Commodity money Token money Legal tender IOU money Fractional reserve banking Financial intermediary Near-monies Liquidity Currency PROBLEMS 1. Which do you think is a better store of value, gold or U.S. dollars? Explain your answer. 2. Suppose gold coins are used as money. Initially gold is a commodity money, with the monetary value and the commodity value of gold the same. Explain under what conditions gold would disappear from monetary circulation. 3. Suppose that umbrellas were too inconvenient to store in the house and that a storage house opened up for them, with people picking up their umbrellas only when needed. (a) Could the owner of the storage facility safely lend out a large part of this stock of umbrellas? (b) What is the difference between this case and that of the goldsmith?

LECTURE 7.

CENTRAL BANKING AND THE MONETARY SYSTEM

1. Central banks have the two tasks of ensuring that the financial system operates smoothly and conducting monetary policy. The central bank of the United States is the Federal Reserve System (Fed). The Fed’s Board of

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Governors and 12 regional Federal Reserve banks regulate and supervise the banks. The Fed Open Market Committee (FOMC) is in charge of monetary policy. It sets the discount rate and reserve requirements and, most important, instructs the Open Market Desk on what open market operations to carry out. Open market operations involve the purchase or sale of government securities by the Fed. Such purchases or sales directly affect the money stock because they lead to a change in currency or in deposits of buyers or sellers. They also have secondary effects because they change the reserves of the banking system and thus cause further adjustments. The money multiplier tells us by how much a $1 open market operation changes the money stock. In the United States today the money multiplier is about 2.8. High powered money is defined as currency outstanding plus bank deposits at the Fed. The Fed completely controls the supply of high-powered money. Through that control it can affect the money stock. Open market operations have an impact on the money stock because they change the amount of highpowered money, or monetary base, available for the banks and the public. The money multiplier can and does change over time. Before the FDIC (Federal Deposit Insurance Corporation), banking panics could lead to large fluctuations in the multiplier. Today there is more stability. The FDIC insures bank deposits. If your bank is insured by the FDIC, then even if the bank were to go bankrupt, the FDIC would pay you the amount of your deposit. Modern economies have fiat or fiduciary monetary systems. Until the 1930s, monetary systems of the major economies operated with gold at the base of the system. Under the gold standard, the monetary base changed only as a consequence of gold purchases or sales. If gold supplies in the world grew slowly and smoothly, so would money and prices. In practice, the main benefit of the gold standard was that there were no major inflations so long as countries stayed on gold. That has led to some nostalgia for the gold standard, but there is no serious possibility it will return. Critics of the Fed have charged that it has allowed the money stock to grow too rapidly and too erratically, thereby bringing about high inflation and too much variability in economic activity. Fed monetary policy, in this view, has aggravated rather than reduced macroeconomic instability. A constant growth rate rule for money has been proposed as the right policy for the Fed to follow. Although the Fed announces monetary growth targets, it has not kept money growth constant or achieved its targets.

KEY TERMS Lender of last resort Board of Governors of the Federal Reserve System Federal Open Market Committee (FOMC) Open Market Desk Required reserve ratio 16

Discount rate Money multiplier High-powered money (monetary base) Federal Deposit Insurance Corporation (FDIC) Gold standard Money targets Constant money growth rule PROBLEMS 1. If the money multiplier suddenly falls because people become suspicious about the solvency of banks, is there anything the Fed can do to prevent the money stock from falling? 2. Discuss why in a fiduciary money system there is no limit on the amount of money the central bank can create. Then discuss in what way an ideal gold standard could make the economy perform better than the Fed might be able to. 3. Explain in what sense banks increase the money supply. Do this by showing how the money supply is affected when a person decides to deposit in a bank some currency that previously was hidden under the mattress. 4. Is a financial panic possible in a fiat money system?

LECTURE 8.

THE BUDGET, FISCAL POLICY AND AGGREGATE DEMAND

1. Government enters the circular flow by taxing income and making transfers, affecting the amount of income available for consumption and saving, purchasing goods and services. 2. The government budget deficit is the excess of spending over taxes. When taxes exceed spending or outlays, there is a budget surplus. 3. Taxes reduce the level of disposable income at each level of income or output. They therefore reduce consumption spending at each income level and thus reduce aggregate demand and output. An increase in taxes reduces income and output and reduces the budget deficit. 4. An increase in government purchases of goods and services increases aggregate demand and output and increases the budget deficit. 5. Proportional taxes lower the marginal propensity to consume out of national income, because households get only a fraction of each dollar of national income for their disposable income. Proportional taxes therefore lower the multiplier. 6. In equilibrium, and ignoring net exports, savings minus investment is equal to the government budget deficit. This relationship can be thought of in terms of borrowing and lending. Households save and lend. The borrowers are

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firms, which finance purchases of investment goods, and government, which finances its deficits. 7. The government may and does use taxes and spending to stabilize the economy through fiscal policy. Fiscal policy does not stabilize GNP perfectly because of uncertainty about the needed changes in taxes or spending and because those changes affect GNP only slowly. 8. The deficit is not a good measure of the direction of fiscal policy, since it can change merely because the level of income has changed. If the economy goes into recession, the budget deficit automatically tends to increase. 9. The full-employment budget calculates what the budget surplus or deficit would be at full employment. Changes in the full-employment budget show the direction in which fiscal policy is shifting aggregate demand. 10.Automatic stabilizers reduce fluctuations of GNP by reducing the multiplier. Income tax and unemployment benefits act as the most important automatic stabilizers. 11.The national debt grows as a result of government budget deficits. The debt is often thought of as a burden because it is the debt of everyone in the country. But the national debt is owned mostly to ourselves, and thus the burden mostly cancels out. The debt may, however, be a burden because it leads to a lower stock of physical capital and, if debt becomes very large, because interest payments can become a large part of government outlays. 12.Deficits are not necessarily bad. Particularly during recessions, any move to get rid of them would make the situation worse. But extremely large and persistent deficits create the possibility of a vicious circle in which large deficits increase the national debt, increase interest payments, and thereby lead to larger deficits. KEY TERMS Government outlays, or spending Government purchases Taxes and transfers Consumption spending Fiscal policy Budget Lump-sum taxes Proportional taxes Income tax Budget surplus or deficit Persistent deficit National debt Balanced budget multiplier Contractionary (or expansionary) policy Full(high)-employment budget Automatic stabilizers Burden of the debt 18

PROBLEMS 1. How does the national debt grow? 2. In what sense, if any, is the debt a burden on the economy? 3. Why does the federal government bother to finance itself through taxes at all when it could borrow in order to cover all its outlays? 4. What would happen to the income if the government raises the tax rate? 5. Explain why a tax rate increase reduces the budget deficit even though it reduces the level of income.

LECTURE 9.

MONEY AND THE ECONOMY

1. The demand for money is a demand for real balances. An increase in the price level raises the demand for nominal balances proportionally but leaves real money demand unchanged. 2. An increase in the opportunity cost of holding money – the excess of the interest rate on bonds over that on money – reduces the demand for real balances. An increase in real income raises real money demand. 3. The Fed determines the supply of nominal balances. In monetary equilibrium the quantity of real balances demanded equals the quantity of real balances supplied. With the price level given, the Fed determines the supply of real balances. 4. The interest rate adjusts to clear the money market. An increase in the quantity of real balances reduces the equilibrium rate of interest. Higher real income raises the equilibrium interest rate. 5. The real interest rate is the nominal, or dollar, interest rate minus the rate of inflation. Investment spending depends on the real rate of interest. The higher the real interest rate firms have to pay, the less likely that given investment projects will be sufficiently profitable to repay the loan plus interest. Therefore, higher real interest rates reduce investment. 6. When the price level is constant, the Fed affects the real interest rate through its control over the supply of money. Then monetary policy works by affecting the supply of real balances, the equilibrium interest rate, and thereby investment, aggregate demand, and output. A reduction in the real money stock through an open market sale of securities raises interest rates and reduces output. An open market purchase increases output. 7. A fiscal expansion crowds out or displaces investment because the increase in output raises the quantity of money demanded and thus interest rates. A combination of easy money and tight fiscal policy will encourage investment. A combination of tight money and tight fiscal policy will lead to a slowdown, or recession. 8. The investment tax credit, which subsidizes investment, makes it possible for fiscal policy to increase the level of investment even in the face of rising interest rates. 19

9. The analysis of aggregate demand suggests that it is relatively simple to affect the level of output and employment through active monetary and fiscal policy. However, the aggregate supply side must be brought in to understand how the price level and level of output are jointly determined. KEY TERMS Monetary mechanism Nominal balances Real balances Opportunity cost of holding money Purchasing power of money Money market equilibrium Crowding out Nominal interest rate Real interest rate Monetary-fiscal policy mix Investment tax credit Stock market Easy money Tight fiscal policy Keynesian economics Activism PROBLEMS 1. Explain the effects on the demand for (1) nominal money balances and (2) real money balances of an increase in the price level, with real income and the interest rate staying unchanged. 2. Suppose the government wants both to reduce aggregate demand and to increase investment. Can it do so? 3. Suppose the government pursues the following monetary-fiscal mix: Fiscal policy takes the form of an investment tax credit, and the monetary policy involves an open market sale of securities by the Fed. What happens to GNP and to investment? 4. Suppose firms become more optimistic about their future profit opportunities. What is the effect on the interest rates and equilibrium income?

LECTURE 10.

UNEMPLOYMENT

1. In the United States a person is defined as unemployed if he or she is out of a job and has looked for work during the past 4 weeks. This definition produces odd results in some special cases – for instance, someone waiting to take a job within the next month counts as unemployed. Labor market 20

statistics classify people into one of three groups: employed, unemployed, or out of the labor force. People who are either employed or unemployed are in the labor force. 2. Most movements in and out of the unemployment pool are brief. There is much movement not only between employment and unemployment but also in and out of the labor force. 3. Between 40 and 60 percent of unemployment is accounted for by people losing their jobs. Job loss becomes more important as a source of unemployment when the economy is in recession. About a third of unemployment is accounted for by people becoming unemployed after being out of the labor force. This source of flows into unemployment becomes smaller in recessions and larger in recoveries. 4. The unemployment rate rises when flows into unemployment exceed flows out of unemployment. The unemployment rate increases in recessions and decreases in recoveries. 5. Okun’s law describes the relation between the unemployment rate and the growth rate of real GNP. It takes a growth rate of real GNP of about 2.7 percent just to keep the unemployment rate constant. The unemployment rate falls by 1 percentage point from one year to the next for every 2 percentage points by which the GNP growth rate increases. 6. The natural rate of unemployment – or the full-employment rate of unemployment – is currently between 5.5 and 6.5 percent. When the actual rate of unemployment equals the natural rate, most unemployed workers can find jobs reasonably quickly and employers can find workers at the prevailing level of wages. 7. Although there is frequent movement of people in and out of the labor force and between employment and unemployment, much of unemployment in the United States at any time is accounted for by people who are unemployed for a large part of the year. 8. Unemployment benefits typically come to somewhat less than half the aftertax wage. Unemployment benefits are paid for only a limited period after a person loses a job. 9. Unemployment rates for blacks are about twice or more those of whites. Teenage unemployment rates are more that double those of older workers. Females have about the same unemployment rates as males of the same age and race. 10. Policies to reduce the natural rate of unemployment focus on the very high unemployment rates among teenagers. The role of the minimum wage in causing teenage unemployment is controversial; it should diminish as the minimum wage falls relative to market wages. Nonetheless, evidence suggests that the minimum wage does not raise unemployment among teenagers, as economic theory predicts. 11.There are substantial differences in unemployment rates among different nations. Until 1974, U.S. and Canadian unemployment rates were much higher that those in other large industrialized countries. Since then, 21

unemployment rates in a number of other countries have risen relative to those in the United States and Canada. KEY TERMS Unemployment rate Layoffs Quits Natural rate of unemployment Minimum wage labor force Recalls Discouraged workers Okun’s law Duration of unemployment Unemployment benefits PROBLEMS 1. Suppose the unemployment rate is 8 percent. How fast would the economy have to grow to get the unemployment rate down to 6 percent (a) in 1 year and (b) in 2 years? 2. Which of the following people is unemployed? (a) A student who would like to work but hasn’t yet gotten around to looking for a job. (b) A student who has arranged for a job to start in 6 weeks and therefore has stopped looking for a job. (c) A retired person who looks at the newspaper help-wanted advertisements every week in case some suitable job becomes available.(d) A person who searched for a job for 6 months and then gave up, deciding to wait until the economy improves. (e) A person laid off by his or her last employer, waiting to go back to the same job and not looking for another one. (f) A person who lost his or her job 3 months ago and has kept looking for another one ever since. 3. From the viewpoint of the society’s welfare, how serious do you think unemployment or being out of the labor force is in each of the cases in Problem 2? 4. Shouldn’t unemployment benefits be equal on average to a person’s previous wage, so that people don’t suffer from being unemployed?

LECTURE 11.

THE INFLATION PROBLEM

1. Economies have not always experienced inflation. For long periods in the th 19 century prices were falling rather than rising. Germany of the 1920s witnessed a period of astronomical rates of inflation. The inflation of the post-World War II period is the most serious peace-time inflation in U.S.

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2.

3. 4.

5.

6.

7. 8.

9.

history. The 1980s were a period of inflation stabilization in industrial countries, but in many developing countries inflation increased sharply. The persistence of inflation results from the slowness of wages and prices to adjust to reductions in aggregate demand. The slow adjustment of wages and prices results in part from the important role of expectations of inflation. The credibility of government promises to follow anti-inflationary policies affect inflation. The Phillips curve shows a trade-off between inflation and unemployment. The higher the rate of inflation, the lower the rate of unemployment. Because inflation reacts slowly to reductions in aggregate demand, policymakers face a painful policy choice. If they reduce aggregate demand, it will take some years of unemployment to get rid of the inflation. If they do not fight the inflation, it will not get better and may well keep rising. Inflation does have real costs. Those costs depend on two factors: first, whether the inflation is expected, and second, the extent to which the economy has adjusted its institutions to deal with inflation. As long as inflation continues, the economy learns to live with it. Adapting to inflation is a way of reducing its costs. The inflation rate is equal to the growth rate of nominal money minus the growth in real money demand. If money growth persists at high levels over long periods, inflation and nominal money growth are very closely related. The inflation tax is the cost imposed by inflation on holders of money, whose real balances lose value as the price level rises. Budget deficits financed by money creation may lead to inflation. In industrialized countries deficits are to a large extent debt-financed. A hyperinflation is a period of extremely rapid growth in nominal money and consequently rates of inflation that reach 1000 percent per year and more. Hyperinflations are caused by large budget deficits financed by money creation and result in sharp drops in real money holdings. There are proposals to reform the monetary system to prevent high money growth in the future. One such proposal is that economies should return to the gold standard, which kept inflation rates low in the 19th century.

KEY TERMS Phillips curve Stagflation Inflation rate Unexpected inflation Gold standard Indexation Hyperinflation Flight from money Inflation tax Burden of the national debt 23

PROBLEMS 1. Suppose an economy is hit by unexpected inflation of 5 percent. Identify at least three groups that gain, and show in each case who loses. 2. Which do you think is more costly, expected or surprise inflation? 3. Specify a set of government policies that would definitely stop inflation. Describe the policies exactly and indicate the risks you see in implementing them. 4. Suppose a $100 loan is made in the expectation of no inflation, with the lender receiving $105. Inflation then turns out to be 10 percent. What is the real value of the loan repayment, including interest? Who gains, who loses, and how much compared to what they had expected?

LECTURE 12.

ECONOMIC GROWTH

1. Living standards in the industrialized economies have increased rapidly and substantially over the 19th century. Per person GDP has risen by a factor of about 8 in the United States since 1870; in Japan per capita income has risen by a factor of 21. Total GDP rose by a factor of 50 in the United States over the same period. 2. The high growth rates of per capita income observed in the last 100 years cannot have been going on for very long by historical standards. They are associated with the shift from agricultural to industrial production. 3. Growth in per person GDP in the United States probably overstates the historical growth in standards of living. Long-term comparisons of living standards are made difficult by the introduction of new products. And there is no reason to think that happiness is proportional to the consumption of material goods and services. 4. The process of economic growth involves changes in the economy’s potential output, which are best understood from the viewpoint of the production function. The level of potential output increases as the quantities of inputs increase and as technical knowledge improves. 5. Invention and innovation take place largely in response to the profit motive. Firms and government finance research and development (R&D) activities. About 2.6 percent of GNP is devoted to R&D spending in the United States; about half of that is government-financed. Most government R&D spending is for defense. The United States devotes about the same share of GNP to R&D as do other industrial countries. Estimated rates of return to R&D spending are very high. 6. Over the long run, most of the increase in output per worker hour in the industrial countries has been the result of technical progress. 7. Policies to improve the rate of productivity increase focus on increasing investment in physical capital and encouraging technical progress through R&D spending. 24

KEY TERMS Production function Human capital Living standard Technical progress Per capita income Per person GDP Growth rate Depletable resources Invention and innovation Research and development (R&D) Labor productivity Productivity slowdown PROBLEMS 1. What are the difficulties in making long-term comparisons of living standards? 2. Why, if the return to R&D spending is so high, does the private sector not undertake most of it? Is there any case for government support of R&D? For what kinds of R&D, if any, is the case strongest? 3. Suppose you had the job of designing a set of policy measures to increase the economy’s growth rate. Describe steps you take and give your arguments to support them.

LECTURE 13.

DEVELOPING COUNTRIES IN THE WORLD ECONOMY

1. The distribution of income in the world is extremely uneven. Careful comparisons of average incomes in different countries and other welfare indicators all show substantial inequality between countries. 2. The discussion between rich and poor countries is put in terms of the northsouth dialogue and the south’s demand for a new international economic order (NEO). This emphasizes the differences between high-income and low-income countries regardless of political organization. 3. The south’s complaints are that (a) the markets for their primary products are controlled by the north, (b) the prospects for their being able to industrialize and thus grow fast are hampered by northern protectionism, (c) financing for the south is too expensive, and (d) it is a matter of justice that the north take practical steps to close the enormous gaps that currently exist between north and south. 4. LDCs (less developed countries) that export primary commodities face two serious problems. First, commodity prices are volatile because supply and 25

5.

6. 7.

8.

9.

demand disturbances act on markets that are very unresponsive to price in the short run. Second, the prices of primary commodities have had a downward trend over the past years. To stabilize commodity prices governments can organize buffer stock schemes that attempt to buy when price is low and sell when price is high. These have rarely succeeded over long periods. Governments also try to organize cartels, which enable them to restrict supply and raise price. The most successful such cartel – by a wide margin – has been OPEC. LDCs are increasing their exports of manufactures. In the past years their growth performance has been better than that of industrialized countries. The growth of LDC manufactures exports poses serious problems in industrialized countries and has given rise to protectionism. Nontariff barriers and quotas are rising in areas where LDCs are particularly successful. Many have argued that the industrialized nations should instead place more emphasis on adjustment to import competition. In the last 20-30 years of the past century large external debts were accumulated by middle-income countries. The sharply increased indebtedness resulted from an adverse world economy, mismanagement in LDCs, and from overlending by commercial banks. The debt crisis is a confrontation between debtors who cannot pay and creditors who cannot afford not to be paid. The opening up of trade is an important mechanism for making the south better off. Observers of some developing countries argue that aid should be used as a lever to induce the governments of those countries to adopt sensible economic policies, though that is not easy to do in practice.

KEY TERMS North-south debate LDCs (less developed countries) New international economic order International Monetary Fund (IMF) World Bank Price volatility Buffer stocks Import substitution Export-led growth New protectionism Debt rescheduling Debt crisis Aid and migration PROBLEMS 1. What are the complaints of the developing countries that have led to their call for a new international economic order (NEO)? 26

2. Discuss the origins of the debt crisis and explain why it is difficult for debtor countries to service their debts. If it is so difficult to service debts fir these countries, why did anybody lend to them in the first place? 3. Discuss the economic arguments for and against aid from the rich countries to the poor countries. Be sure to include a discussion of the view that what is needed is “trade, not aid” . 4. Use the theory of comparative advantage to explain why LDCs have been particularly successful as exporters of textiles, clothing, and leather footwear.

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GLOSSARY Aggregate demand. The amount of planned spending on domestic goods and services at each level of aggregate income. Automatic stabilizers. Mechanisms in the economy, such as the income tax, that automatically reduce response of GNP to shifts in aggregate demand. Barter economy. One without any commonly accepted medium of exchange. Goods are traded directly for other goods. Bretton Woods system. An exchange-rate system in which countries maintain a fixed exchange rate with respect to other currencies. This system was used for major currencies during the Bretton Woods period from 1944 to 1971. (Bretton Woods is a resort in New Hampshire where the international negotiations to set up the new system took place). Business cycle. The more or less regular pattern of expansion (recovery) and contraction (recession) in real output around the economy’s average or trend growth path. Currency. Money used in hand-to-hand circulation, equal in modern economies to the amount of coins and notes held by individuals and businesses aside from banks. Deflation. Occurs when average prices fall, i.e. when the inflation rate is negative. Dollar standard. Under the dollar standard, countries fixed the value of their currencies in terms of dollars. They also maintained convertibility of their currencies into dollars. Dumping. Takes place when firms sell abroad at a price below cost. European Monetary System. A system in which several European countries maintain their exchange rates against each other fixed, with occasional adjustments. Federal Reserve (Fed). The central bank of the United States; controls the money supply, lends to commercial banks, and performs other functions. Gold standard. An exchange rate and monetary system in which central banks or governments were obliged to buy and sell gold at a fixed price in terms of their currencies. Indexation. Automatically adjusting payments for the effects of inflation using a price index. International Monetary Fund (IMF). The IMF is an international institution located in Washington, D.C. It was set up in 1945 to be the central banks’ banker, as part of what is now known as the Bretton Woods system of postWorld War II international finance. Keynesian economics. The body of thought developed by John Maynard Keynes holding that a capitalist system does not automatically tend toward a full-employment equilibrium. According to Keynes, the resulting underemployment equilibrium could be cured by fiscal or monetary policies to raise aggregate demand.

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Keynesian model. In the Keynesian model, derived from the writings of John Maynard Keynes, prices and wages are fixed in the short run. The aggregate supply curve is horizontal, so that real GNP is determined entirely by the level of aggregate demand. Laissez-faire (“Leave us alone” ). The view that government should interfere as little as possible in economic activity and leave decisions to the marketplace. As expressed by classical economists like Adam Smith, this view held that the role of government should be limited to (1) maintenance of law and order, (2) national defense, and (3) provision of certain public goods that private business would not undertake (e.g., public health and sanitation). Mercantilism. A political doctrine perhaps best known as the object of Adam Smith’s attack in The Wealth of Nations. Mercantilists emphasized the importance of balance-of-payments surpluses as a device to accumulate gold. They therefore advocated tight government control of economic policies, believing that laissez-faire policies might lead to a loss of gold. Monetarism. A school of thought holding that changes in the money supply are the major cause of macroeconomic fluctuations. For the short run, this view holds that changes in the money supply are the primary determinant of changes in both real output and the price level. For the long run, this holds that prices tend to move proportionally with the money supply. Monetarists often conclude that the best macroeconomic policy is one with a stable growth in the money supply. Modern monetary economics was developed after World War II by Milton Friedman and his colleagues and followers. Monetarists challenged the Keynesian approach to macroeconomic stabilization. Monetarism is generally associated with a laissez-faire and anti-big-government political philosophy. Monopoly (or Monopolist). The only seller of a particular good or service in a market. Smith, Adam (1723-1790), a Scottish philosophy professor and one of the founders of economics, in his classical book The Wealth of Nations (1776) wrote that individuals pursuing their self-interest in a free-market economy would be led, “as if by an invisible hand” , to do things that are in the interests of others and of society as a whole. Adam Smith’s contribution was to analyze the way that markets organized economic life and produced rapid economic growth. He showed that a system of prices and markets is able to coordinate people and businesses without any central direction. Much of modern economics rests on Smith’s insight. Stagflation. A period of continuing inflation combined with a recession or stagnation of economic activity. World Bank. An international institution created in 1945 as part of the Bretton Woods system and located in Washington, D.C. Began by making loans to finance postwar reconstruction and is now an important source of development finance and of expertise and advice on development policy.

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NOTES

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