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Study of choices we make as we confront scarcity (mismatch between limitless wants and limited means)

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Economics

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Theories for consumer and company decision making • Study of individual units • Analysis of individual consumers, individual firms, or individual markets

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Microeconomics

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Focuses on growth, inflation, and employment • Study of economy as a whole • Overall levels of income, output, prices, employment, etc. • FOCUS ON LONG RUN GROWTH & SHORT TERM BOOM AND BUST CYCLES

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Macroeconomics

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1. People make rational economic decisions. 2. people respond to economic incentives. 3. Optimal decisions are made at the margin.

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3 Key Assumptions

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Since societies have limited numbers of workers, machines, and finite natural resource levels, more of one good=less of another.

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Microeconomics and Tradeoffs

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What you give up to permit you to perform a certain activity (e.g. Opportunity cost=1 hour of studying in order to play games with your friend) • The highest valued alternative that must be given up to gain another activity

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Opportunity Costs

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1776 • Markets are run by self-interested people and they push society toward desirable ends. • Invisible hand: takes market signals and delivers outcomes that match peoples' desires • Solves microeconomic questions

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Adam Smith's Invisible Hand

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• Markets can fail and governments must remedy things • Invisible hand, not infallible hand • Fiscal and monetary policy

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John Maynard Keynes

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• Run by government • "From each, according to his ability. To each according to his need."-Karl Marx • "We pretend to work, they pretend to pay us." -Soviet workers

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Centrally Planned Economics

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• "To get rich is glorious" (1980s) • Ushered in China's era of economic boom and settled its export position in the world

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Deng Xiaoping

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• Europe and US governments provide health care, pensions, and defense, but generally allow people to buy and sell as they please-->mixed economy!!!

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Modern Day Mixed Economics

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1. What determines income and output levels? 2. What determines growth rates for output? 3. What determines the level of employment? 4. What determines the inflation rate?

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Macroeconomic Questions

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High income per capita Low unemployment High growth rate of income Low inflation

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Societal Objectives

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• Monetary policy: raise or lower interest rates? • Fiscal policy: size of government as a share of total economy? Raise or cut federal taxes and/or federal spending? • How do these policy tools work or not work?

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Major Macroeconomic Policy Issues

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Useful measure to determine nation's long run performance

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Income per capita

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Economy will be many times larger by the time you will retire

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Compounding

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John Maynard keynes: 1. Mathematician 2. Historian 3. Statesman 4. Philosopher He must study the PRESENT in light of the PAST for the purposes of the FUTURE

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Good Economist

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• Canadian and American economist who focused on the influence that large corporations have on market power. "There are only two kinds of economists in the world. Those who know they don't know. And those who don't know they don't know."

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J.K. Galbraith

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1. Levels of income • Personal income, income per capita • Corporate Profits, earnings per share 2. Levels and Growth Rates of Output • Real GDP, unemployment rate, inflation rate 3. Interest Rates and Stock Markets

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Key Macroeconomic Variables

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• Short run movements in key macroeconomic variables • Measures quarterly or annual movements

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Business Cycles

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• Long run movements in key macroeconomic variables • Measures observations at widely spaced points in time (e.g. 1900 vs. 2000) and averages over long periods of time (e.g. the last 50 years)

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Long-term Trends

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• Product: all final goods and services produced • Domestic: produced on US soil • Gross: investment goods are included, without attention to wear and tear Measured in $

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GDP (Gross Domestic Product)

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Sum of the money value of the final output of all goods and services in the domestic economy measured in CURRENT dollars

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Nominal GDP

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Price x Output

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Money Value

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• Goods and services purchased by final or ultimate users • Ignores purchases of intermediate goods to avoid double counting

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Final Output

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• Bathtub analogy • GDP is a flow • Stock/flow ratio exists (e.g. value of fleet vs. GDP, a flow)

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Flows vs. Stocks

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1. Expenditure Approach: add all final goods and services produced 2. Factor Income Approach: add all payments to providers of input 3. Value Added Approach: add all additional value produced along output chain

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GDP Measuring Methods

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Affect: 1. Output • GDP, income, cyclical sectors 2. Employment • Job growth, unemployment 3. Inflation • Oil prices, core goods and services, wages 4. Financial Markets • Interest rates, stock markets

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Business Cycle Swings

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• Expansion: 2+ consecutive quarters of positive growth of Real GDP • Recession: 2+ consecutive quarters of negative growth of Real GDP *** Official arbiter: National Bureau of Economic Research (determines if economy is in recession or not) *** • If real income is rising, economy is in expansion and vice versa

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Expansion vs. Recession

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Number of workers unemployed/ Labor force • Declines slowly after recessions • Soaring unemployment=broken invisible hand

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Unemployment Rate

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• Indicates a change in the price level; implicit price deflator for GDP • If rate of inflation >0 then price level is rising and the cost of living is rising (inflation) • If rate of inflation <0 then price level is falling and the cost of living is falling (deflation)

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Inflation Rate

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• Interest rates rise then plunge • Stock markets plunge then soar • Treasury borrowing rates tend to rise late in expansions and plunge in recessions • Shares plunge on the eve of economic downturns

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Business Cycle Turning Points

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Depiction of maximum output combinations 1. Engineers: establish optimal use of inputs (operate along PPF) 2. Economists: ASSUME optimal use of inputs (evaluate tradeoffs along PPF) 3. Entrepreneurs: revolutionize use of inputs (shift PPF outward) Technology=key to growth

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Production Possibilities Frontier

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The ability to produce more of a good than competitors using the same inputs

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Absolute Advantage

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Gains from trade exist even is one group is inferior on all fronts The ability to produce a good or service at a lower opportunity cost than a competitor

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Comparative Advantage

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• Gains from trade are the pervasive force in free market economies (POSITIVE SUM GAME) • Free market forces are effective because both sides gain

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Adam Smith's Invisible Hand 2

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Trade is hampered if ownership is ambiguous • Businesses struggle amid weak property rights (China's farm policies, US mortgages, Latvian lumber)

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Property Rights

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Relate prices to quantity consumed (how consumer demand responds to prices) 1. Lower prices-->higher demand for goods. 2. New products or technology can change the relationship 3. Higher prices lead to big shifts in demand sometimes. 4. Other times, higher prices lead to smaller demand shifts.

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Demand Curves

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Relate prices to quantity supplied by firms (how firms respond to prices) 1. Higher prices-->higher supply of goods. 2. New products of technologies can change the relationship 3. Higher prices lead to big shifts in supply sometimes. 4. Other times, higher prices lead to smaller shifts.

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Supply Curves

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Where demand equals supply ("MARKETS CLEAR") 1. At some prices, supply don't equal demand. 2. Shifts in supply and demand have different effects. 3. These effects depend on the slope of the curves.

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Equilibrium

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• Flatter curve=elastic • Steeper curve=inelastic

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Demand Curve Steepness

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• Comprehensive basket of goods and services • Inflation rate is the speed with which the overall price level is changing ***Must subtract inflation to calculate constant dollar GDP (real GDP)

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Overall Price Level

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• Seasonally adjusted: separates signal from noise • Collects 3 months of data and multiplies by 4 • BEA: the annual growth rate would occur if the quarterly percent change was replicated for a full year For 1 quarter: ((Q4/Q3)^4 - 1) x 100.

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Quarterly Annualized Estimates

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GDP based on location; GNP based on ownership GNP-depreciation=NNP=Y Final Sales=GDP-inventory investment Final sales to domestic purchasers=GDP-inventories-NX

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GNP and GDP

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Big tax cut-->stronger consumer spending Sharp rise for interest rates-->stronger dollar Strong spending+strong dollar=surging imports

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Surging Imports

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• Financial investments • Purchases or sales of existing or used houses

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What Investment Does Not Include

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• Transfer payments (money sent to retirees for social security; medicare; etc.)

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What Federal Government Does Not Include

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GDP=C+I+G+NX

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GDP Model

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• Expectations drive decision makers but the future is UNCERTAIN • Inventories are the buffer when plans go awry. • Inventory swings explain periods in which production was too big or too small • Inventory swings over time drive the economy back toward equilibrium • Assumes: ignore inflation and financial markets; swings in economy are completely captured by swings in output; weak demand doesn't lower the overall level of prices; no interest rates, stock prices, or any other Wall Street dynamics • AE=C+I+G+NX

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Aggregate Expenditure Model

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• Assume no government and no foreign sector • AE=C+I (at equilibrium) • Income or output=aggregate expenditure or aggregate spending • GDP Identity: Y=C+I(a)=C+I+I(u) • 45º line: AE=GDP, inventories are unchanged, macroeconomic equilibrium • AE below 45º line: AEGDP; unplanned inventory fall (GDP and jobs increase in the next period)

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AE Model

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Shifts along the curve: • Current disposable income Shifts of the curve: -Changes in MPC (slope): • Expected future disposable income • Wealth • Interest Rates -Changes in autonomous expenditures (intercept): • Consumer's State of Confidence

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Drivers of Consumption

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• Falling sentiment: drives autonomous spending down • Plunging wealth: drives MPC down

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Falling Sentiment and Plunging Wealth

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C = C(Ydis) = Cbar + bYdis Cbar: autonomous real consumption expenditure; determined by the state of consumer confidence

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Consumption Function

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Ydis=Y-Tx+TR

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Disposable Income

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MPC=change in consumption/change in disposable income= b

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Marginal Propensity to Consume

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MPC+MPS=1 If you get one more dollar of income, how much more do you save?

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Marginal Propensity to Save

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Essential purchases and consumer confidence (will still need food, clothes, etc.)

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Why do consumers spend even when their income is zero?

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• Beginning with C, if there were no other expenditures, macroeconomic equilibrium would be where the consumption function crossed the 45º line • Assuming that they are not affected by income and that they are predetermined, we add planned investment, government purchases, and net exports • Y=C+I+G+NX (top most line=aggregate expenditure function)

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AE Model 2

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3 Uses for the Price Index: 1. Separate price changes from output shifts. 2. Guard against accelerating inflation pressures. 3. Guard against deflationary pressures • Percentage increase in the price level from one year to the next=inflation • A decrease in the price level=deflation • If inflation slows, from one year to the next=disinflation Inflation rate= (CPI*-CPIº)/CPIº)X100

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Inflation

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To calculate the CPI in a given year, we need: 1. A basket of goods 2. The cost to purchase the basket of goods in a base year 3. The prices in the current year CPI in the current year: the cost to purchase the basket of goods this year divided by the cost in the base year

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CPI

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Combines population statistics with survey responses (household survey of 60,000 individuals and payroll survey of 300,000 companies' payrolls)

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BLS Household Survey

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Economist from 1960's that came up with a relationship between change in output and unemployment change

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Art Okun

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The change in output that the economy can sustain over the long haul LTSG=Labor Force+ Labor Productivity Assumed to be 2.2% for the US (LF=0.5%, LP=1.7%)

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LTSG

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∆Y=LTSG- ß(∆U) where ß=2 • In long term equilibrium, the unemployment rate is steady and so the change in U is zero and ∆=LTSG • Strong recoveries are associated with strong productivity and rebounds for the labor force participation rate

answer

Okun's Law

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