Principles of Economics Midterm 3

Good Types

Private goods, public goods, club goods, common resources

Excludable Goods

When someone can be easily excluded from using something

Rivalrous Goods

When your use of a good subtracts from another’s

Private Goods

Excludable and Rivalry, ex: cars, food, clothing

Public Goods

Not excludable, not rivalrous, ex: national defense, fireworks display, research development

Club Goods

Excludable, not rivalrous, ex: cable tv, toll roads, gorup fitness classes

Common Resources

Not excludable, rivalrous, ex: mall parking lots, traffic, unsecured wifi

Free rider problem

when someone can enjoy the benefits of a good without bearing the costs, ex: study groups, check splitting

Tragedy of the commons

the tendency to over-consume a common resource, ex: common living areas, office refrigerators

Internalize the externality

Make the public good private/assign rights

Externalities

Side effects of an activity that affects bystanders whose interests aren’t taken into account

Negative externalities

Costs, ex: 2nd hand smoke, crying babies, drunk drivers

Positive externalities

Benefits, ex: education, sports teams, star athletes, flu shot

Marginal private cost (MPC)

The extra cost paid by the seller from one extra unit

Marginal external cost (MEC)

The extra external cost imposed on bystanders from one extra unit

Marginal Social Cost (MSC)

MPC + MEC, all MC’s no matter who pays them

Marginal Private Benefit (MPB)

The extra benefit enjoyed by the buyer from one extra unit

Marginal external benefit (MEB)

The extra external benefit accruing to bystanders from one extra unit

Marginal Social Benefit (MSB)

MPB + MEB, all MBs no matter who gets them

Market outcome

The outcome that society achieves when no externalities are accounted for, mkt denotes this

Socially optimal outcome

The outcome that is most efficient for society as a whole, including the intersts of buyers, sellers, and bystanders, let opt denote this

Negative externalities in production

Ex: Pollution, the solution, overproduced and underpriced, solutions: taxes, pollution permits

Positive externalities in production

Ex: Taylor Era’s tour, the solution, underproduced, overpriced, solutions: subsides, tax breaks

Negative externalities in consumption

Ex: Smoking, solution, over-consumed, overpriced, Solutions: education, laws, taxes

Positive externalities in consumption

Ex: Education, solution, under=consumed, overpriced, solution: scholarships

GDP

The market value of all final goods and services produced within a country in a year

“Final good”

No intermediate goods or resale items

Components of GDP: Consumption

Spending by HH on final G&S, not including spending on new houses, expenditures on services, nondurable goods, durable goods, rent

Components of GDP: Investment

Spending on new capital assets that increase the economy’s productive capacity, includes both the purchase and production of long-lived assets that contribute to future production,

Components of GDP: Government purchases

Ex: teachers’ salaries, highways, aircraft carriers, transfer payments are not included, ex: social security, medicare

Components of GDP: Net exports (NX)

Exports - imports

Three ways to measure GDP

1) Total spending: add up every dollar of spending

2) Total output: add up every dollar’s worth of output produced, total sales- costs of intermediate inputs

3) Total income: add up every dollar of income earned, total wages + total profits

Limitations of GDP

Does not include:

1) Non-market activities, ex: household chores

2) Shadow economy, ex: illegal drugs, under-the-counter labor

3) Environmental degradation, ex: pollution

4) Leisure, volunteerism

Real vs nominal GDP

Nominal GDP= GDP measured in today’s prices

Real GDP= GDP measured in constant prices; excludes the effects of price changes

BLS Info

Every month conducts the Current Population Survey

60k households surveyed each month

Working age population (POP)

Those age 16+ who are not in the military or institutionalized

Employed (E)

POP who are working, self-employed, and/or temporarily absent from their job

Unemployed (U)

POP without jobs who are actively searching for a job and able to accept a job if offered

Labor Force

E + U

Not in labor force (NILF)

POP - E - U

Marginally attached

Someone who wants a job, and who has looked for a job within the past year, but who isn’t counted as unemployment because they aren’t currently looking for a job

Underemployed

Someone who has some work but wants more hours, or whose job isn’t adequate using their skills

Involuntarily partime

Someone who wants full-time work and is working part time because they haven’t found a full-time job

Discouraged workers

Not included in unemployment, someone who is available for work but has not looked for a job during the last month because they believe no jobs are available for them

Duration of unemployment spells

Long-term unemployed= people who have been unemployed for 6 consecutive months or longer

Frictional unemployment

Unemployment due to the time it takes for employers to search for workers and for workers to search for jobs

Structural unemployment

Unemployment that occurs when there are structural barriers that prevent wages from falling to the point where labor demand and supply are in e

Cyclical unemployment

Unemployment that is due to a temporary downturn in the economy

Seasonal unemployment

Unemployment caused by changing seasons

Sources of Unemployment: Frictional

1) Job-search resources

2) Skills mismatch

3) Unemployment insurance and other income support

Sources of Unemployment: Structural

1) Efficiency Wages= a higher wage paid to encourage greater worker productivity

2) Institutional Causes, ex: unions, job protection regulation, minimum wage laws

Inflation

A generalized rise in the overall prices

Deflation

A generalized decrease in the overall level of prices

Inflation rate

The annual percentage increase in the average price level of a fixed basket of G&S

Consumer price index (CPI)

An index that tracks the average price consumers pay overtime for a representative basket of G&S

CPI shortcomings

1) Substitution bias, CPI holds all quantities constant over time but that ins’t accurate

2) Increase in quality bias, overtime, most products include in the CPI improve in quality

3) New product bias, BLS updates market basket of goods every 10 years, new goods→ higher utility → cost of living goes down

4) outlet bias, G&S perchased at placed like Costco and Sam’s Club aren’t included

Core inflation

A measure of inflation that excludes food and energy

Personal consumption expenditure deflator (PCE deflator)

A measure of inflation that also includes items that you consume but don’t pay for directly and is updated continuously, ex: medical care paid for by employer

The fed sets target in terms of PCE deflator

Free of substitution bias

Producer price index (PPI)

A price index that tracks the prices of inputs into the production process

GDP deflator

A price index that tracks the price of all goods and services produced domestically

GDP deflator= (Nominal GDP/Real GDP) x 100

Nominal interest rate

Stated interest rate without correction for the effects of inflation

Real interest rate

Nominal interest rate - inflation rate

Aggregate Demand (AD)

A curve that shows relationship between the price level and the total quantity of ouptut that all buyers collectively plan to purchase

Real GDP (quantity of output) is X AXIS and Price level (GDP deflator, CPI) is Y AXIS

Variables that shift AD, change in C, I, G, and/or NX

Aggregate Expenditure (AE)

Total amount of G&S that people want to buy across the whole economy

AE= C + I + G + NX

Aggregate Supply

A curve that shows the relationship between the price level and the total quantity of output that suppliers collectively produce

SRAS

The AS curve that applies to the SR

LRAS

The AS curve that applies to the LR when prices have fully adjusted, the economy will return to producing potential output/GDP/full employment

Vertical

Due to factors of production

SR and LR Equilibrium - As P level changes

Inflation if Pe hat > Pe-level

Deflation if Pe hat < Pe-level

SR and LR Equilibrium - As real GDP changes

Economic contraction/downturn if Real GDP e hat < Real GDP e

Recession if Real GDPe hat < potential output/GDP/full employment

LR economic growth if potential output/GDP/full employment increasing

Stagflation

A combination of economic stagnation/falling output combined with high inflation

Money and its functions

Money= any asset regularly used in transactions

1) medium of exchange - eliminates double coincidence of wants, allows specialization, requires wide acceptance/faith

2) Unit of account- simplifies comparisons and eases communication, requires stability of value

3) store of value- requires easy storage and maintenance of value over time

The Fed’s Policy Goals

1) Stable prices

2) maximum sustainable employment

Target inflation= a publicly stated goal for inflation rate 2%

How does Fed set interest rates/Federal Funds Rate

1) Targeting the FFR

Definition FFR: The federal funds rate is the interest rate that the fed uses as its policy tool, which is the nominal interest rate that banks pay to borrow from each other overnight in the federal funds market

Effective FFR= actual interest rate

Monetary Policy

The process of setting interest rates in an effort to influence economic conditions; affects money supply

Expasionary Monetary Policy

When the fed cuts interest rates to increase/address low inflation and/or weak GDP

Contractionary monetary policy

When the Fed increases interest rates to address high inflation and/or high GDP

Tools of Monetary Policy

1) Fed pays interest to banks on reserves

2) Fed borrows $ overnight from banks/financial institutions

3) Fed lends directly via the discount window

4) Fed buys and sells gov’t bonds

Bank Reserves

The cash that banks need to keep on hand to make payments

In order to influence the FFR, the Fed pays interest to banks on reserves

Fed’s interest rate on banks’ reserves vs. bank’s interest rate on reserves to be leant to customers

Overnight Market Trades- Open Market Trading Desk

A trading desk at the New York Federal Reserve Bank

Traders at the desk buy and sell gov bonds (overnight)

It’s open because the Fed is required to buy and sell the bonds in the competitive open market

Bond

An IOU, a promise to pay back a loan with interest

Gov’t bonds are IOUs from gov

Overnight reverse repurchase agreement (ORRA)

when the Desk sells a gov bond to a financial institution, with an agreement to buy it back the next day at a higher price

Open market operations (OMO)

The fed’s buying and selling of gov’t bonds to influence the interest rate in the federal funds market

Technically overnight reverse repurchase agreements are a form of OMO

FOMC directs trading desk at the federal reserve bank of NY

OMOs didn’t always achieve desired FFR

Discount window

the mechanism by which the fed can lend $ directly to banks, banks sell their loans to the fed at a discount and later by them back

Discount Rate (DR)

The interest rate on loans that the Fed offers to banks through the discount window

Feds affect FFR by altering the DR

Why would banks sell/buy loans to/from the Fed

Historically stops bank runs and panics as the Fed was the “lender of last resort”

Typically DR > FFR

Expasionary Monetary Policy Tools

1) Fed’s interest rate on reserves decreases- Fed’s interest rate < bank’s interest rate to customers

2) The desk buys gov bonds from banks/financial institutions overnight

Alternatively, the desk doesn’t engage/engages less in overnight borrowing

The Fed deposits $ from purchase of the bond into the bank’s reserves

3) DR decreases

Bank borrows $ from the fed

Outcome of Expansionary Tools of Monetary Policy

Banks will loan more $ to customers

This expands the $ in circulation

This speeds up the economy

Fights recession/unemployment

Thus, I and FFR decrease

Contractionary Monetary Policy Tools

1) Fed’s interest rate on reserves increases- Fed’s interest rate > bank’s interest rate to customers

2) The desk sells gov bonds from banks/financial institutions overnight

Alternatively, the desk doesn’t engage/engages more in overnight borrowing

The Fed takes $ from the bank’s reserves to pay for the sale of the bond

3) DR increases

Banks don’t borrow/borrow less $ from the fed

Outcome of Contractionary Tools of Monetary Policy

Banks will loan less $ to customers

This decreases the $ in circulation

This slows down the economy

Fights inflation

Thus, I and FFR increase

Floor Framework

Fed’s approach of setting other interest rates to put a lower bound on how low the FFR will go

Lower bond on the FFR is achieved by paying interest on ER and the rate of return on ORRA

Output-induced response

when the Fed uses it tools of monetary policy to promote maximal employment

Output-induced expasionary monetary policy:

I decrease → c increase, I increase, NX increase → AD increase, full employment/potential GDP

Output-induced contractionary monetary policy:

I increase → c decrease, I decrease, NX decrease → AD decrease, full employment/potential GDP

Fiscal Policy

The government’s use of spending and tax policies to attempt to stabilize the economy

Discretionary Fiscal policy

Policy that temporarily changes gov’t spending or taxes to boost or slow the economy

Mandatory spending

Spending on programs that doesn’t get determined annually, instead it is set in law

Social security, medicare

Discretionary spending

Spending that congress appropriates annually

Federal agency funding, military, education, housing, environment

Income taxes

Taxes collected on all income, regardless of its source

Earned income

Wages from an employer, or net earnings from self-employment

Payroll taxes

Taxes on earned income