AD/AS, Unemployment, Fiscal/Monetary Policy

What characterizes inflation? A general rise in prices which is caused by too much money in the economy. We want the economy to stabilize, so the government creates incentives for people not to spend money.

Interest is the cost of borrowing money.

What characterizes recession? A high rate of unemployment. Businesses need to let go of workers because there is less money in the economy. 

During inflation, the dollar loses its value- it becomes cheaper. Debtors benefit during an inflation because they’re paying with cheaper dollars. People with fixed incomes are hurt by inflation, as well as creditors because they’re getting back cheaper dollars.

Lenders not paying attention to the economy end up paying more than they receive in interest rates.

Nominal Interest Rate– actual interest rate being changed.

Real Interest Rate– what the lender receives to purchase goods/services.

That lender now has a lower real interest rate, because they can’t afford as much with a cheaper dollar. Someone who sees the inflation coming can add two interest rates together and the real interest rate will increase.

Nominal Income– actual money you earn.

Real Income– what you can buy in goods and services.

If income keeps up with inflation, real income is not changing.

Peak– at the top of the business cycle

Trough– when economy is at the worst part of a recession- the bottom of the cycle.

The line represents prices always rising and then being stabilized- the Ratchet Effect.

INTEREST CURVE

Interest rates demand curve is downward and to the right, meaning it has an inverse relationship. x = money borrowed, y = interest rates.

Unemployment Rate– percentage of people not working and looking for a job (part of the labor force).

Discouraged workers– individuals unemployed for so long that they quit working and are no longer part of the unemployment rate.

Unemployment has 4 categories: 

1. Frictional Unemployment– a person between jobs. They were fired or quit, and are currently looking for another job. First time job seekers are also frictionally unemployed.
   
2. Structural Unemployment– when machine replaces man- individual jobs are taken over by machines. Also a person who can’t use the machines or lacks the skills. Location-wise, when a company moves too far away for you to work with them.
3. Seasonal Unemployment– Working for a set amount of time. Examples: lifeguards, Santa’s elves, etc.
4. Cyclicable Unemployment– based on business cycle- occurs during recessionary periods.

Aggregate Demand/Supply

Aggregate– total. We’re talking about the total spending in the economy.

Aggregate supply– production of goods and services in all four sectors of the economy.

RANGE 1- KEYNESIAN RANGE

• Also known as the recessionary range. 
• Any shift by the aggregate demand curve in this range results in a change in output. This change in output also affects unemployment.
• Example: Shift in AD curve to the right means an increase in output and decrease in unemployment. Price levels remain the same.

RANGE 2- INTERMEDIATE RANGE

• Shows the direct relationship between price level and the real GDP. Once we enter this range with the AD curve, the price level begins to rise with the output. 
• As output increases, unemployment continues to decrease.

RANGE 3- CLASSICAL RANGE

• Classical economics came before Keynesian economics. We followed Say’s Law, which stated that the supply creates its own demand. 2 things get rid of supply- wages and prices. The economy itself would adjust to the economic situation. This changed during the Great Depression when high unemployment rates disproved this theory. This is where John Keynes came in. 
• At this range, we are at full production. There is full employment, the output will remain the same, and prices continue to rise.
• This is an inflationary period.

Aggregate Demand– 4 sectors of economy expenditures. If any sector increases spending, it will cause a shift in the AD curve (to the right if it’s an increase). You do not need change in all four sectors to shift the curve. What really causes it to move drastically is the consumers (C).

Demand- Pull Inflation– the demand curve is pulled into the classical range because of consumer spending (C).

The aggregate supply curve is the cousin of the production possibilities curve. If something happens to improve production (improved technology), the AS curve is shifted to the right. It is also affected by the factors of production. If less than full production, shift to the left.

• When this happens, there’s an increase in price level and unemployment.
• Called Stagflation– where there’s a stagnant economy. Characteristics of both recession and inflation.

Cost-Push Inflation– inflation caused by aggregate supply curve shifting left because of the increase in prices.

Demand Side Economy– we’re affected by changes in the aggregate demand curve.

Fiscal policy– Congress takes action to regulate economy, especially during inflation or recession.

There are 2 ways for Congress to regulate the economy: changes in taxes and/or changing in gov’t spending.

• If in a recession, DECREASE taxes, INCREASE gov’t spending (don’t do both) 
• If in an inflation, INCREASE taxes, DECREASE gov’t spending.

EXAMPLES:

(click to enlarge)

Monetary policy– exercised by the Federal Reserve System (FRS). People serving are appointed by the President, confirmed by the Senate.

• Chairman of the Board- currently Ben Bernanke, last one was Alan Greenspan. Can serve up to 14 years. 

The Federal Reserve System regulated interest rates and the money supply. They do NOT regulate consumer loan rates. By “money supply”, we mean the availability of money.

There are 3 tools used to regulate the money supply and interest rates:

1. Discount Rate Regulation
   
   • The rate of interest they charge member banks on loans made by these member banks. But why would banks need loans?
     • Required Reserves– the amount of money that must be kept in the bank regardless of account. (20%)
     • Excess Reserves– what gets loaned out/invested (80%)
     • Required + Excess = Actual Reserves of the bank. If these are depleted because of withdrawals, they need a loan.
   • Prime rate of interest– what commercial banks charge their best business customers.
   • If inflation- FRS increase the discount rate. In return, the banks increase the prime rate. It’s not required, but normally rubber-stamped. Again- the FRS does not set these things, but the interest rates are influenced by the discount rate.
   • When member banks borrow from each other, it’s called an overnight loan. Rate for overnight loans is called Federal Funds Rate.
     • This works the same way as the discount rate- FRS can raise either both or just one during a period of inflation. This leads to an increase of the prime rate, then consumer loans rates are eventually raised.
2. Increasing or decreasing the reserve requirement. 
   • Reserve requirement = money that must be kept on hand in the bank (20%).
   • If inflation- FRS raises the reserve requirement to 30%. Excess reserves becomes 70%. This lowers the money supply, so there’s less money available.
   • If recession- FRS lowers reserve requirement to 10%. Excess reserves becomes 90%. There’s more money available, and the money supply increases.
3. Buying/Selling of government securities in the open market.
   • Most influential method
   • Government securities = bonds. We are creditors, government becomes the debtor. Anybody can buy them.
     • Short term = Treasury Bill (T-Bill), 3-6 months
     • Medium term = Treasury Note (T-Note), 1-5 years
     • Long term = Treasury Bond (T-Bond), 20 years
   • Federal Open Market Committee (FOMC)– regulates buying/selling of bonds in the open market.
   • During inflation, the government sells bonds. You take money from your savings account to buy them, which lowers the excess reserves.
   • During a recession, the government buys bonds back, putting money in the bank and increasing the excess reserves.

Fractional Reserve Banking System- our banking system. They only keep a fraction of deposits (required reserves) in the bank.

*Make sure you know what happens with inflation and recession using the three tools*

Changes in marketing policy affects the AD curve and net exports. Fiscal and monetary policy are demand side economy.

EXAMPLE

These are the following conditions of the current economy:
Gross domestic product has decreased the last 4 consecutive quarters. The consumer price index is stagnant. The prime rate has decreased 3% from last year. Also, a 3% increase in unemployment rate. The index of leading economic indicators has decreased each of the last 12 months.

A) What is the economic problem in the economy?

• Recession.
  

B) Draw an accurately labeled AD/AS graph showing this economic problem.

C) What two monetary policy actions would you use to help the economic problem?

• Buy government securities on the open market, and decrease the reserve requirement from 20% to 10%. 
  

D) Why would you use these monetary policy actions?

• These monetary policy actions will stimulate the economy by increasing the money supply, and making the borrowing of money more attractive. Buying government securities gives the consumers funds to deposit in the bank, increasing excess reserves. By decreasing the reserve requirement from 20% to 10%, the excess reserves increase from 80% to 90%, increasing the money supply. 
  

E) On your properly labeled AD/AS graph, show the effects of your monetary policy actions.

F) Explain what happens to the price level, output, and unemployment.

• As a result of the aggregate demand curve shifting right from AD to AD1, the price level increases from PL to PL1 and output increases from O to O1. As output has increased, the unemployment rate has decreased. 

We use money as a medium for exchange.

Asset demand– money kept in the bank we don’t use.

Transaction demand– stuff we spend it on every day.

Store of Value– when money keeps its value over a period of time. $5000 will always buy you $5000 worth of goods/services.

We put all of these together to get a money market graph.

This graph is used to find the interest rate, and it’s the only way to show what happens to the interest rate. It shows the nominal interest rate.

• If discovering the interest rate when using fiscal policy, you can ONLY shift the demand for money curve. 
• When monetary policy is used, the supply of money curve is shifted.

Here’s the money market graph for the previous example problem:

In the same problem, lets say that Congress used fiscal policy to get out of a recession. What happens?

You cannot do monetary and fiscal policy at the same time- they will offset each other.

** THESE NEXT NOTES ARE FROM SENIOR PICNIC. I DIDN’T TAKE THEM, I GOT THEM FROM ANOTHER STUDENT. IF I’M MISSING ANYTHING, PLEASE LET ME KNOW**

AD/AS PRACTICE

The GDP has decreased from last year. The unemployment rate has increased from last year. The prime rate has tumbled from last year. The consumer price index has decreased 1% from last year, and the index of leading economic…. (notes stop here)

A) Define prime rate.

• The interest rate charged by commercial banks to their best business customers. 
  

B) Economic problem?

• Recession
  

C) Draw and label AD/AS graph.

D) What fiscal policy action would you take to resolve this problem?

• I would increase government spending and decrease taxes. 

E) Why would you take these actions?

• Increasing government spending puts more money in the economy. Decreasing taxes will increase the disposable income available to consumers, and will also put more money into the economy. 
  

F) Using correctly labeled graphs, show the effects of your fiscal actions on the economy.

G) Explain what happens to price level, output, unemployment, and interest rates.

• Due to fiscal policy actions, the aggregate demand curve will shift to the right from AD to AD1, increasing price level from PL to PL1 and output from O to O1. Because output has increase, unemployment rates have decreased. 
  

H) Explain how this fiscal policy action created a crowding out effect.

• Because we were in a recessionary period and decided to increase government spending, the interest rate also increased and “crowded out” business investments. 

I) Show how this affected business investment.

Terms:

• Expansionary fiscal policy– moving out of the recessionary range, and increasing the size of the economy.
  
• Contractionary fiscal policy– moving out of an inflationary period, and decreasing the size of the economy.
• Easy money policy– monetary policy makes money more available in recessions.
• Tight money policy– monetary policy that makes money less available in a period of inflation.
• Monetarist– believes in monetarism (monetary policy). Keynesian economics does not believe in monetary policy- they believe in fiscal policy.
• 

When the economy gets tired, it can’t continue running at full production.

Short run– how the economy is running at the current time. This is what we’ve been working with.

Long Run– when the economy gets tired and is no longer at full production. It’s the SRAS shifted to the left (decrease in productivity). These curves are all relevant to the production possibilities curve, don’t forget that.

Create an initial graph for the economy in the long run.

In the long run, the government spends less money, so the AD curve shifts to the left. There is no change in output, but the price level decreases.

Resources cost more, so the LRAS shifts left, price level increases, output decreases, and unemployment increases.

*Look in the book for more info about the LRAS in Chapter 16. *