macro midterm two

natural rate of unemployment

unemployment that the economy normally experiences

cyclical unemployment

year-to-year fluctuations in unemployment around the natural rate, often associated with short-run fluctuations in economic activity

employed

workers paid as employees, work in their own businesses, workers without pay in family businesses, including full and part time workers

unemployed

those who are not employed, are available for work, and had tried to find employment recently (within the last four weeks)

not in the labor force

students, homemakers, retirees

unemployment rate

percentage of labor force that is unemployed

labor-force participation rate

the percentage of the adult population that is in the labor force

troubles with measuring the unemployment rate?

• difficult to distinguish between unemployed and those who are not in the labor force

• frequent movements in and out of the labor force

• new entrants: young workers looking for employment

• discouraged workers

• people working under the table to avoid taxation

discouraged workers

individuals who would like to work but have given up looking for a job and don’t show up in employment statistics

why does unemployment exist?

unemployment never falls to zero, but instead fluctuates around the natural rate of unemployment

• frictional unemployment

• structural unemployment

frictional unemployment

unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills

• arises from the process of the job search

• inevitable — labor marker in constant state of churn

• shorter-term

what are some factors of churn or change that can impact frictional unemployment?

• changes in consumer preference

• regional booms

• sectoral shifts = changes in the composition of demand among industries/ regions

• changing patterns of international change

what can policy do to impact the process of the job search?

• government-run employment agencies that provide information about job vacancies

• public training programs

  • ease workers transition away from declining to growing industries

  • help disadvantaged groups escape poverty

• advocates:

  • keeps labor force more fully employed and reduces the inequities inherent in a constantly changing market economy

• critics:

  • better to let the private market match workers and jobs

  • government involvement is likely worse at disseminating the right information to the right workers and deciding what kinds of worker training would be most valuable

unemployment insurance

a government program that partially protects the incomes of workers who become unemployed

— increases frictional unemployment = workers have less incentive to search or take jobs while they are eligible to receive unemployment benefits

what are the benefits of unemployment insurance?

• reduces income uncertainty

• unemployed have more time to search

• unemployed can look for jobs that better suit their tastes and skills

• improves the ability of the economy to match each worker with the most appropriate job

structural unemployment

• unemployment that results because of the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one

• due to wages stuck above the equilibrium level

• longer-term

three reasons for structural employment:

1. minimum-wage laws

2. unions and collective bargaining

3. efficiency wages

what happens at equilibrium wage?

the quantity of labor supplied and the quantity of labor demanded are both equal to L_E

minimum-wage laws unemployment

if the wage is forced to remain above the equilibrium level (possibly due to a minimum-wage law), the quantity of labor supplied rises to L_S and the quantity of labor demanded falls to L_D

L_S — L_D = surplus of labor

what are the effects of binding minimum-wage?

• matters most for those with low levels of skill and experience (like teenagers)

• causes structural unemployment

• quantity of labor supplied exceeds the quantity of labor demanded

• worker are unemployed because they are waiting for jobs to open up

union

a worker association that bargains with employers over wages, benefits, and working conditions

• exert their market power to negotiate higher wages for workers

  • less than 11% of US workers today belong to unions

what happens when unions raise the wage above equilibrium level?

• higher quantity of labor supplied

• smaller quantity of labor demanded

• unemployment

• better off: employed workers (insiders)

• worse off: unemployed (outsiders)

efficiency wages

above-equilibrium wages paid by firms to increase worker productivity, allowing the firm to operate more efficiently

• could be more profitable for firms to keep wages high despite having a surplus of labor

efficiency wage theory benefits:

1. worker health

• more nutritious diet — healthier and more productive workers

• especially prevalent in less developed countries

2. worker turnover

• hiring and training new workers is costly — try to reduce turnover

3. worker quality

• higher wages attract better job applicants and increase the quality of the firm’s workforce

4. worker effort

• workers have discretion over how hard to work, and some may choose to work as little as possible

4. worker morale

• high wages improve worker morale; content workers are more productive

• workers aer less productive if they think they’re being treated unfairly

what causes structural unemployment?

structural unemployment, when the quantity of labor demanded is smaller than the quantity of labor supplied, is caused by minimum-wage laws, the market power of unions, and efficiency wages.

barter

the exchange of one good or service for another

• relies on a double coincidence of wants, which is an unlikely occurrence that two people’s wants align exactly for an exchange

money

the set of assets in an economy that people regularly use to buy good and services

• not the same as the common understanding of money, which is conflated with wealth

• includes only the few types of wealth that sellers regularly accept in exchange for goods and services

what are the functions of money?

the functions of money distinguish it from other assets:

1. medium of exchange

2. unit of account

3. store of value

what does it mean for money to be a medium of exchange?

it’s an item that buyers give to sellers when they want to purchase goods and services

• transfer of money that allows the transactions to take place

• relates to liquidity

liquidity

the ease with which an asset can be converted into the economy’s medium of exchange

• money is the most liquid asset available because it is the economy’s medium of exchange

what does it mean for money to be a unit of account?

money is the yardstick that people use to post prices and record debts, being a measure and record of economic value

what does it mean to call money a store of value?

it’s an item that people can use to transfer purchasing power from the present to the future

• wealth refers to the total of all stores of value, both monetary/ nonmonetary

what are the kinds of money?

• commodity money = money that takes the form of a commodity with intrinsic value (item would have value even if it weren’t used as money, like gold)

• fiat money = money without intrinsic value that is used as money by government decree (paper dollars)

money stock

the quantity of money circulating in the economy

currency

paper bills and coins in the hands of the public

demand deposits

balances in bank accounts; depositors can access on demand by writing a check

M1

measure of a country’s money supply including:

• currency

• demand deposits

• liquid deposits (balances in savings accounts)

M2

measure of a country’s money supply including:

• everything in M1

• small-time deposits

• money market funds

the Fed

the central bank of the United States, institution designed to oversee the banking system and regulate the quantity of money in the economy

monetary policy

the setting of the money supply by policymakers in the central bank made by the Federal Open Market Committee (FOMC), which discusses the condition of the economy and considers changes in monetary policy

what are the Fed’s functions?

1. regulate banks and ensure the health of the banking system by monitoring each bank’s financial condition and facilitating bank transactions

2. act as a bank’s bank — makes loans to banks when the banks themselves need funds

3. act as a lender of last resort to maintain stability in the overall banking system

4. control the money supply

money supply

the amount of money available in the economy

Federal Open Market Committee (FOMC)

• discuss conditions of the economy

• consider changes in monetary policy

• perform open-market operations to increase or decrease the money supply

what action should the FOMC take to INCREASE the money supply?

buy government bonds, paying for new bonds with the newly created dollars means that the number of dollars in the economy increases

• some of these new dollars are held as currency and some are deposited in banks

what action should the FOMC take to REDUCE the money supply?

sell government bonds in the nation’s market, where the public pays for these bonds with its holdings of currency and bank deposits

• people withdraw from banks

• smaller quantity of bank reserves

• banks reduce their amount of lending

• reduce the money supply

• since people withdraw from banks to buy these bonds, banks have a smaller quantity of reserves

reserves

deposits that banks have received but have not loaned out

100-Percent-Reserve Banking

if banks hold all deposits in reserve, banks do NOT influence the supply of money

fractional-reserve banking

a banking system in which banks hold only a fraction of deposits as reserves, where that fraction is the reserve ratio

reserve ratio

fraction of deposits that banks holds as reserves, as determined by government regulation and bank policy

• doesn’t impact the amount in liabilities because making loans doesn’t alter (from 100-percent-reserve system) the bank’s obligation to its depositors, but now has two different types of assets

  • reserves

  • loans

reserve requirement

minimum amount of reserves that banks must hold; set by the Fed

• reducing reserve requirements would LOWER the reserve ratio and INCREASE the money multiplier

• less effective in recent years as many banks hold excess reserves

excess reserves

reserves that banks hold in excess of the reserve requirement

what happens because of fractional-reserve banking?

when banks hold only a fraction of deposits in reserve, the banking system creates money.

money multiplier

the amount of money that results from each dollar of reserves

• reciprocal of the reserve ratio = 1/R

• the higher the reserve ratio

  • the less of each deposit banks loan out

  • the smaller the money multiplier

Fed lending to bank

• the Fed’s lending to banks can INCREASE the money supply

  • banks pay an interest rate called the discount rate

  • if the Fed LOWERS the discount rate, it encourages banks to borrow more, increasing the quantity of reserves and the money supply

discount rate

interest rate on the loans that the Fed makes to banks

• higher discount rate = less bank borrowing

  • decreased quantity of reserves

  • decreased money supply

• lower discount rate = more bank borrowing

  • increased quantity of reserves

  • increased money supply

interest on reserves

the interest rate paid to banks on the reserves held in the deposit at the Fed

• an INCREASE in the interest rate on reserves

  • increases the reserve ratio

  • lowers the money multiplier

  • lowers MS

• a DECREASE in the interest rate on reserves

  • decreases the reserve ratio

  • increases money multiplier

  • decreases MS

federal funds rate

interest rate at which banks make overnight loans to one another

• if a bank finds itself short of reserves, it can borrow reserves from another bank

• decision by the FOMC to change the target for the federal funds rate are also decisions to change the money supply

• a decrease in the target for federal funds rate means an expansion in the money supply

• differs from the discount rate

• affects other interest rates

• is determined by the supply and demand in the market for loans among banks

inflation

rise in the price level

• inflation drives the price level up and the value of money down

• each dollar buys a smaller quantity of goods and services

• economy-wide problem

• concerns the value of the economy’s medium of exchange

inflation rate

the percentage change in the price index from the preceding period

deflation

decrease in the overall level of prices

hyperinflation

extraordinarily high rate of inflation

price level (P)

the number of dollars needed to buy a basket of goods and services

• when the price level rises, people have to pay more for the goods and services they buy

value of money (1/P)

the quantity of goods and services that can be bought with $1 (reciprocal of P)

• a rise in the price level: lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services

money demand

how much wealth people want to hold in liquid form (money/ monetary form)

• depends on the price level: an increase in P reduces the value of money, so more money is required to buy goods and services

• quantity of money demanded:

  • is positively related to the price level, other things equal

  • is negatively related to the value of money

what happens in the long run to money supply and money demand?

• the money supply curve is vertical as fixed by the Fed

• in the long run, money supply and money demand are brought into equilibrium by the overall level of prices

equilibrium price level

a model of money supply and money demand at equilibrium, where MS = MD so that the value of money (1/P) and the price level (P) are determined at the equilibrium where MS = MD

classical theory of money/ quantity theory of money

the theory asserting that the quantity of money available (MS) determines the price level and that the growth rate in the quantity of money available determines the inflation rate

velocity of money (V)

rate at which money changes hands

V = (P x Y) / M

quantity equation

M x V = P x Y

• relates the quantity of money to the nominal value of output (P x Y)

• shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables

  • the price level must rice OR

  • the quantity of output must rise OR

  • the velocity of money must fall

implications of quantity equation

1. V is relatively stable over time

2. a change in M causes nominal GDP to change by the same percentage

3. a change in M does not affect Y

4. therefore, P changes by the same percentage as (P x Y) and M

5. rapid money supply growth causes rapid inflation

the classical dichotomy

the theoretical separation of nominal and real variables in the long run

• nominal variables: measured in monetary units ($ prices)

• real variables: measured in physical units (amounts of goods and services)

monetary developments affect nominal variables but not real variables

what happens if the central bank doubles the money supply?

• then all nominal variables, including prices, will double

• BUT, all real variables, including relative prices, will remain unchanged

monetary neutrality

proposition that changes in the money supply do not affect real variables

• most economists believe that the classical dichotomy and neutrality of money describe the economy in the long run, but not the short-run effects

Fisher Effect

one-for-one adjustment of nominal interest rate to inflation

• when the Fed increases the rate of money growth, long-run result is:

  • higher inflation rate

  • higher nominal interest rate

inflation tax

revenue the government raises by creating (printing) money

• like a tax on everyone who holds money

• when the government prints money

  • the price level rises

  • the dollars in your wallet are less valuable

why do countries experience hyperinflation?

the governments of these countries are using money creation as a way to pay for their spending

inflation fallacy

“inflation robs people of the purchasing power of his hard-earned dollars”

• when prices rise

  • buyers pay more

  • sellers get more

• inflation does not in itself reduce people’s real purchasing power

shoeleather costs

avoiding the inflation tax by holding less money (and going to the bank more often)

• resources wasted when inflation encourages people to reduce their money holdings

• can be substantial in countries in hyperinflation

menu costs

• costs of changing prices

• inflation increases menu costs that firms must bear

• deciding on new prices

• printing new price lists and catalogs

• sending the new price lists and catalogs to dealers and customers

• advertising the new prices

• dealing with customer annoyance over price changes

relative-price variability

• firms don’t all raise prices at the same time, so relative prices can vary

• the higher the inflation rate, the greater this swing in relative prices

• inflation distorts relative prices

  • consumer decisions are distorted

  • markets are less able to allocate resources to their bet use

inflation-induced tax distortions

• inflation-induced tax distortions:

  • inflation makes NOMINAL income grow faster than REAL income

  • taxes are based on nominal income, and som aren’t adjusted for inflation

  • inflation causes people to pay more taxes even when their real incomes don’t increase

confusion and inconvenience

inflation changes the yardstick we use to measure transactions

• complicates long-range planning and the comparison of dollar amounts over time

  • difficult to judge the costs of the confusion and inconvenience that arise from inflation

arbitrary redistributions of wealth

unexpected inflation

• redistributes wealth among the population

  • not by merit

  • not by need

  • inflation is more volatile/ uncertain, especially when the average rate of inflation is high

what’s worse: inflation or deflation?

deflation