ECO 210 -- Macroeconomics

 

Chapter 1, 3 & 4 (Baumol)

Scarcity --> Requires choices on how to best use your resources

Opportunity cost, your next best alternative.

The Productions Possibilities Frontier (PPF) -- an illustration of scarcity.  A graph representing all possible combinations of two goods that an economy can produce given its limited resources. 

- Points inside the line are attainable, but economy has unemployed resources (it can do better.)
- Points on the curve are the best the economy can do (full employment).
- Points outside of the line are unattainable given current resources.

When the PPF is linear (straight), there are no specialized resources.  When the PPF is curved, that means resources are specialized, and the Law of Increasing Costs applies (the more you shift your resources toward producing one good, the greater the opportunity cost in terms of the other good becomes).

Purpose of an Economy is to answer the questions of resource allocation: what to produce; how to produce it; for whom to produce it (who consumes it)?

  1. Capitalism -- private ownership of resources; market forces determine resource allocation.

  2. Socialism -- public (aka government) ownership of resources; central planning replaces market.

  3. The Mixed Economy -- a mix between capitalism and socialism. The US falls in this category.

  4. Communism -- not same as socialism; idealized state of organized anarchy.

Role of Government in a Mixed Economy

  1. Referee in disputes.

  2. Regulation of private sector.

  3. Redistribution of income (transfer payments, ie, welfare, etc.).

  4. Levy taxes -- to pay for services; also used as means of regulating behavior.

  5. Handling of "Market Failures" (externalities and public goods).

The Market System

  1. Profit drives all voluntary exchange. Adam Smith: the "Invisible Hand". All voluntary exchange benefits both parties involved, otherwise exchange would not take place at all.

  2. Price Mechanism serves 2 purposes: (a) rationing device -- makes sure people who value resource the most are the ones who get it; (b) communication between producer and consumer -- how the consumer tells the producer how much to make.

  3. Competition yeilds 2 benefits: (a) lower prices for consumers; (b) innovation -- making the product better than the other guys', and finding more efficient ways to produce in order to lower prices.

Measuring the economy:

    Gross Domestic Product (GDP) -- measure of the value of all goods and services produced in the economy in a given year.  Nominal GDP is stated in current $'s.  Nominal GDP can be influenced by inflation (a rise in the general price level).  Real GDP is discounted for inflation -- gives a more accurate measure of the productivity of an economy across time.  A decrease in Real GDP for 2 quarters (6 months) or longer is called a recession.

    Unemployment is the % of the workforce currently not working.  Higher unemployment is a symptom of recession.  (More about unemployment in Ch. 7.)

Chapter 5

The First Law of Demand: ceterus paribus (all else constant), if price goes up, quantity demanded goes down, i.e., if bread gets more expensive, you buy less bread. A change in price effects ONLY quantity demanded (cet. par.).

Determinants of Demand: income (make more $$, buy more stuff)... price of substitute goods (price of Coke goes up relative to Pepsi, you buy less Coke (quantity demanded) and your demand for Pepsi goes up)... price of complimentary goods (price of cereal goes up, demand for milk goes down)... number of consumers in market (more people buy more stuff)... taste/consumer preference.

Law of Supply: ceterus paribus, if price goes up, quantity supplied goes up; if the price you can get for Spam goes up, you want to start selling more Spam.

Determinants of Supply: input prices / cost of production (able to produce less at any given price)... price of substitute goods (if McD's can get a better price for chicken sandwiches than for Big Macs, they will shift their resources toward the production of chicken sandwiches)... price of complimentary goods (if the market price of shoes goes up, you make more shoes (Law of Supply), ergo, you need to start making more shoelaces)... number of suppliers in the market (more companies can make more stuff).

Chapter 6

Macroeconomics -- looking at the economy as a whole, rather than at individual decision-making.

Aggregation -- lumping all consumers and all producers together.  No need to worry about individual consumers, individual firms, specific goods & services.  Because when economy fluctuates, everybody's S & D tend to move in the same direction.

    Aggregate Demand (AD) -- Demand by all consumers for all goods and services in economy, i.e., the demand for domestic product.

    Aggregate Supply (AS) -- Supply of all producers/sellers for all goods and services in economy, i.e., the supply of domestic product.

        Graphing AD & AS:  Price level is on the vertical (y) axis, and real GDP (national output) is on the horizontal (x) axis.  When AD & AS fluctuate:

GDP revisited -- GDP for a given year includes the following:

  1. Only goods and services produced new in that year. Any good produced in a previous year and sold (or resold) in the current year only counts toward the year in which it was produced.  (Ex., a 1997 Ford pickup sold, new or used, in 1998 will only count toward 1997's GDP.)

  2. Final goods & services, i.e., that are consumer-ready.  [Intermediate goods & services (goods that are used as inputs for other goods) do not count toward GDP.]  Example: seat covers that are produced by Glen Raven and sent to BMW to be installed in their automobiles are intermediate goods.  The car is the final good, and it is all that counts.   Otherwise, the seat covers would be counted twice -- once when they were produced, then again as part of the car when it is counted.

  3. Domestic goods -- goods and services that are produced within the country.  It doesn't matter if the company is an American or a foreign company; product counts so long as it was actually produced in the US.

  4. Legal -- black market goods & services do not count toward GDP.

  5. GDP also does not include non-market activity (eg, volunteer work, homemaking).

Exam 1

Chapter 7 -- Unemployment & Inflation

Three types of unemployment:

  1. Frictional -- "between jobs"; usually people changing carreers, moving to a new city, etc.

  2. Structural -- outdated skills.  Includes "dislocation" of workers from automation.

  3. Cyclical -- having to do with the business cycles (i.e., resulting from economic fluctuations --recessions.)

Potential GDP -- the output of the economy if it were operating at Full Employment.

    Full employment -- lowest unemployment rate possible without causing inflation.  Not equal to 0% unemployment.  Currently between 4-5%.  This is due to the constant presence of frictional and structural unemployment, even in the best of economies.

Unemployment causes AD to decrease due to lower income of unemployed workers.  Drop in AD can lead to a deeper recession.  Unemployment insurance is meant to "prop up" AD to prevent this from happening (does not eliminate the cost of unemployment, only spreads it around to lessen the effects to AD).

Inflation -- rise in the general price level; money is devalued, i.e., it buys less (ergo is worth less) than before.

    Real vs. Nominal ("money") Wages -- when the price level increases and nominal wages do not, real wages decrease (eg., if you made $100/week ten years ago, and did not get a raise between then and now, that $100 would not be worth as much now as it was then, therefore, your real wage rate would have decreased, although your nominal rate would be the same.)

        Historically, nominal wages have increased when the price level increased, or have even grown faster than inflation -- therefore real wages (in terms of constant purchasing power) have for the most part remained constant or increased over the last century (due largely to increased productivity from advances in technology). 

Inflation effects:

  1. Real interest rates:  [real interest = nominal interest - inflation rate]   If real interest is negative (inflation rate exceeds nominal interest rate), then money you have in the bank is losing purchasing power.

  2. Price ceilings and regulation:  Example -- Duke Power must clear any rate increases with the Fed. gov't.  If the gov't does not allow them to raise their rates to keep up with inflation, they are losing money.  Also, Usury Laws are price ceilings placed on the interest charged for loans.  If inflation exceeds the usury limit on interest, lenders will be losing money (and may be unwilling to make loans).

  3. Taxes:  Some taxes are not indexed for inflation, for example capital gains tax.  If you buy a house in 1984 and sell it in 1999, even if the price on that house only increased by the amount of inflation, you must pay taxes on the difference in the price over what you paid for it. 

  4. Distortions in Relative Prices:  During times of inflation, all firms may not increase their prices at the same time.  Consumers, therefore may not recognize the difference between a general price change (inflation) and  a relative price change in the short run.  This will cause a temporary shift in consumption patterns as consumers move to find lower-priced goods, which causes a temporary shift in the allocation of resources.  All of this (the shift in resources as well as the "shopping around" costs borne by consumers) imposes a cost on society.  In the long-run, inflation will not affect the allocation of resources.

Discounting for inflation:    "to" year $ = "from" year $ *   ["to" year CPI / "from" year CPI]

        Example:  The textbook for this class costs (new) $57 in 1998.  To compare this price to the book's price in, say, 1984, you must convert the 1998 price into 1984 dollars.  Using the CPI number for 1998 (163) and the CPI for 1984 (100):

$57 * [100/163] = $34.97

Translation:  The real price of the textbook (in terms of 1982-84 prices) is $34.97.  In other words, $57 buys the same amount in 1998 as $34.97 bought in 1984.  [Yes, I know this is 2000, but we only have CPI numbers going up to 1998.]

In this case, the "from" year was 1998 and the "to" year was 1984.  You can use this formula to convert any year's prices into any other year's prices.  (For example, just by reversing the numbers, we could take the 1984 price and convert it into 1998 dollars.)

Chapter 8 -- Income & Spending

Breaking down AD into its basic components:

  1. Consumer Spending (C) -- spending by consumers on new, final, domestic goods and services.  (duh)

  2. Investment Spending (I) -- spending by investors on plant and equipment (capital goods).  Also includes the purchase of new homes.  (Does not include stocks, bonds, etc.  Different definition of investment.)

  3. Government Spending (G) -- spending by all levels of gov't (local, state, Fed.) for goods and services bought from the private sector -- paperclips to F-117A's.

  4. Net Exports (X-IM) -- income from goods sold to other countries minus spending on goods bought from other countries.

AD = C+I+G+(X-IM)

    National Income (Y) -- Sum of all incomes from wages, rent, interest and profit = Real GDP.

    Disposable Income (DI) -- [Y - taxes + transfer payments]  The money consumers actually get to spend.

Consumption Function -- a graph representing the relationship between DI & Consumer Spending (C).  As DI increases, C also increases, therefore, Consumption Function is an upward-sloped line.

    Marginal Propensity to Consume (MPC) -- the slope of the Consumption Function.  Tells how much of each additional $ of DI consumers spend.  Example:  if MPC = .9, this means consumers spend 90% (or 90 cents) of each additional $ of DI; the other 10 cents goes into Savings.

    Determinants of the Consumption Function (what causes the C-function to shift)

  1. Wealth (not the same as income) -- example:  Fred & Barney both work in rock quarry.  Both bring home $20,000 per year in income, but Barney has $1 million in his stock portfolio.  Barney has more wealth than Fred, so Barney's C-function will be higher than Fred's, all else equal.

  2. The Price Level -- inflation devalues wealth.  Therefore, if Bedrock has 50% inflation in a given year, Barney's $1 million in wealth will be worth less, therefore, he is less wealthy.  His C-function will decrease.

  3. Expectation of future income -- if you are certain that you are going to win $1 million in the Lottery within the next 6 months, even though your income has not changed yet, your C-function will increase. 

Chapter 9

Investment Spending (I) -- more volatile than Consumer Spending.   Determinants are:

  1. Expectation of future profits -- tend to only invest if you believe you are likely to profit from it.  Therefore, if recession is anticipated, you are less likely to invest.

  2. Demand for your product -- if demand for the good you are planning to use Capital to produce is high, you are more likely to invest.  If demand is low, so you are not even using your plant's full capacity, you are not going to invest.

  3. New technology -- tends to draw investors.

  4. **Real interest rate (this is an important one) -- if cost of borrowing $ goes up, then investors borrow less money (First Law of Demand).  Since we are assuming that all investment spending is financed by loans, this will lead to less investment.

  5. Tax Laws -- If capital gains tax rate is increased, this will eat into any profits you may get from your investment, therefore reducing your incentive to invest.

Net Exports (X-IM) determinants:

  1. National Income (GDP) of the respective countries.  [Assuming the US and Japan are the only two countries in the world, and there are no legal trade restrictions.]  i)  When income goes up, people (and countries) tend to buy more stuff.  Therefore, if US GDP goes up, all else equal, Imports (IM) will go up -- we will buy more stuff from Japan.   ii)  If Japan's GDP goes up, they will buy more from US, therefore, our Exports (X) will increase.

  2. Relative Prices -- If the price of American cars goes up, then people in Japan will buy less US cars and substitute Japanese cars, therefore, Exports go down.   Likewise, American carbuyers will substitute the relatively cheaper Japanese cars for American cars, so our Imports go up.

  3. Exchange Rates -- a strong dollar (i.e., the $ gains value against the Yen, which means it will take more Yen to buy $1) makes American goods more expensive in Japan, and makes Japanese goods cheaper in US.  Therefore, Exports go down, Imports go up.

Equilibrium GDP -- Total spending {C+I+G+(X-IM)} = total income {Y}   This is a "steady state", because, (i) if Y>spending, firms will have inventories accumulating and they will cut their production; (ii) if Y<spending, firms will see their inventories depleting and will produce more to keep up with demand.

    Equilibrium GDP is represented graphically where the Income-Expenditure diagram crosses a 45-degree line drawn out from the origin.   

Inflationary and Recessionary Gaps --

    Recall:  Potential GDP = GDP (Y) of an economy if it is operating at Full Employment.  If we mark the potential GDP on our income-expenditure graph by drawing a vertical line at the Full Employment level of Y -- suppose potential GDP = 7000:

        If the income-expenditure diagram crosses the 45-degree line to the left of potential GDP (say, 6000), then the economy has reached equilibrium below the level of full employment.  We call this a recessionary gap.

        If the income-expenditure diagram crosses the 45-degree line to the right of potential GDP (say, 8000), then the economy is above full employment (remember full employment is not 0% unemployment).   This is an inflationary gap.

Effects of Savings and Investment on GDP:

Remember:  Y = C+I+G+(X-IM)
        If we assume a closed economy (no international trade), just to make things simpler, then (X-IM) = 0,
        Therefore:  Y = C+I+G  which, with a little simple algebraic hocus-pocus:  I = Y-C-G.

Saving is what is left of income (Y) after all spending, or S = Y-C-G.   Look familiar?  Since both S&I are equal to Y-C-G, it stands to reason that, in order for the economy to be in equilibrium (total spending = total income), it must be true that S = I.
    This is logical, since we are assuming that all Investment spending is financed by borrowed money, and the source for borrowed money is Savings.  What happens if S is not equal to I?

(Remember the circular flow model...)  Saving is taken out of household income before any spending, so an increase in S is going to mean a decrease in Consumer spending.  This is why we call Saving a leakage, b/c money that is not spent is money that is being drained out of the circular flow, which will result in a decrease in total spending and thus a drop in real GDP.

We consider Investment spending to be an injection, b/c it "injects" the money taken out of the circular flow through Savings back into the circular flow.

The economy is like a bathtub.  As long as you're pouring water into the bathtub at the same rate as the water is draining out, the water level in the tub will remain constant.  If the water is draining out of the tub faster than you are pouring it in, the water level will start dropping.  Likewise, if leakages are greater then injections (S>I), then the level of income in the economy is going to drop.

The Financial System -- a group of institutions that match funds from savers with needs of investors.

    Financial Markets:

  1. The Bond Market (debt financing) -- corporations borrow money directly from savers -- a bond is a promisory note to repay the loan with a certain % interest.   (We've already discussed how the gov't does the same thing with Treasury Bonds.)   There is both a primary and secondary market for bonds.

    -Principal -- amount of the money that was borrowed (the face value of the bond)
    -Term -- length of time before the bond matures (is paid off).
    -Perpetuity -- a bond with no maturity date -- interest is paid to holder forever (thus the name).
    -Risk -- all bonds have a certain degree of risk that the issuer will default (not repay loan).  In order to compensate the buyer for this risk, the issuer must pay a higher interest rate on riskier bonds.  Junk bonds are very high-risk bonds that pay an exorbitant interest rate. 

  2. The Stock Market (equity financing) -- corporations finance Investment spending by selling off shares of ownership in the company.  Stockholders get to vote for board of directors.  They are also entitled to a periodic cut of the corporation's profits (earnings) in the form of dividends. 

    -IPO (Initial Public Offering) -- the primary market for stocks; when the firm sells the stock to the public.
    -NYSE, NASDAQ, AMEX -- the secondary market where stocks are traded.  The price of stocks on the secondary market is entirely demand-driven.
    -Stock split -- when a company offers its shareholders a dividend in the form of stock rather than $$.

    Financial Intermediaries ("middle man" between savers and investors):

  1. Mutual funds -- group of savers pool their money to buy stocks &/or bonds.  This allows "normal" people to diversify their portfolios to reduce risk and to take advantage of professional stock-pickers.

  2. Banks -- you loan the bank your savings for a certain interest rate, then the bank loans it to investors for a higher interest rate.

Chapter 10 -- The Multiplier

The concept behind The Multiplier is that one person's spending is anothers income.  If you spend a dollar, the person to whom you give that dollar will then spend part of it (depending on Marginal Propensity to Consume), and the person who gets that person's spending will spend part of it and so on.  Each time that money is spent, it is adding on to GDP, so that in the end, real GDP (Y) will increase by more than the initial increase in spending.

The Multiplier = 1 / (1-MPC) -- If MPC = .9, then The Multiplier = 10.

    Say that the gov't increases spending this year by $1 billion.  This initial increase in Gov't Spending (G) will cause Y to increase by a total of $10 billion (initial change in spending * The Multiplier, or $1 billion * 10).

        This same "multiplier effect" will apply whether the initial change in spending is Consumer spending, Gov't spending, Investment spending or Net Exports.  This is why trade deficits (where X<IM) are such a cause for concern, because a trade deficit will decrease Y by (the amount of the deficit * The Multiplier).  [Note -- a trade deficit can be made worse if, say Japan has a big recession, because this will cause our exports (X) to fall, thus reducing our GDP by (the amount of the drop in X *The Multiplier), therefore recessions can be "imported" from other countries.]

Autonomous vs. Induced changes in the income- expenditure diagram (using Consumer Spending as an example):

  1. Induced increase/decrease in C -- only caused by changes in Y -- movement along curve.  (No multiplier effect.)

  2. Autonomous increase/decrease in C -- a shift in the C-function (and thereby the Income-Expenditure line), caused by one of the determinants of the C-function (see last chapter).  An autonomous increase (shift) of the C-function means that even at the same level of income, you are willing to spend more. 

    An autonomous increase in the income-expenditure diagram (not caused by a change in the price level) will cause the Aggregate Demand curve to shift by (the amount of the initial change in spending * The Multiplier).

Chapter 11 -- Supply-side equilibrium

What we've been looking at so far in this unit has focused on Aggregate Demand.  This is the basis of Keynsian economics (more on this in next unit).  

In the Long-Run -- Aggregate Supply is fixed (vertical), since, in the L-R, the productivity of the economy is determined by the availability of resources and technology.  This vertical L-R AS curve represents what the economy can produce given its current resources.  In other words, it represents the nation's productivity at Full Employment -- we will just call it Potential GDP. Potential GDP can shift over time due to changes in population, technology and resource availability.   However, for the time being, it is a fixed line that we are going to use as a "yard stick" for measuring the economy's performance.

In the Short-Run -- AS is upward sloped.  This is what we will refer to simply as the AS curve.  Remember, in the short-run, real GDP can be affected by the price level.

Why is AS upward-sloped?

  1. Sticky Wage Theory (Keynes) -- workers do not react well to wage cuts, therefore employers will be hesitant to cut wages (due to worker resistance to wage cuts, labor contracts, & risk of decreased worker morale/productivity).  Therefore, when Price Level falls, the wage rate will not adjust to the new price level right away.  During this lag time, employers will be taking in a lower price while still having to pay their workers the higher wages.  As a result, they will have to cut their output (Qas). 
  2. Sticky Price Theory -- related to menu costs (the costs to firms of frequent price changes).  Not all firms change their prices at the same time, thus creating a short-run distortion in relative prices.  Only a relative price change affects resource allocation in the long-run, but in the short-run, producers may mistake a rise in the price level for a relative price change and increase their Qas.

Determinants of AS -- things that shift the AS curve (some of this will look familiar from Ch.4):

  1. Input prices -- includes nominal wages (remember money illusion).  Say, the minimum wage were raised to $15/hour.  This would increase the input prices to enough producers in the economy to decrease AS.  Another example of input prices is crude oil (a Land resource) -- the oil embargo of the late 70's increased production costs of pretty much every good in the economy, so AS decreased.

  2. Techonology & Productivity -- Technology refers to the productivity of capital.  When capital becomes more productive, AS increases.  Productivity refers specifically to the productivity of Labor -- this ties in with the education issue; better educated workers tend to be more productive; dumb workers tend to be less productive.  If the education system in the US gets lousy enough, AS will decrease.

  3. Availability of Labor & Capital -- Labor becomes more available as population increases; this will cause the AS curve to shift outward over time.   Capital becomes more available when there is a lot of Investment Spending (from the last couple of chapters).  The effect of Investment on AS is long-term, that is, there will be a time lag between the time that the Investment Spending occurs and when its effects show up in the nation's AS curve. 

Equilibrium -- the Price Level and National Income (Y) where Quantity AD = Quantity AS  (where the two curves intersect).

        When AS-AD equilibrium occurs to the left of potential GDP, this is a recessionary gap.  When AS-AD curves intersect to the right of potential GDP, it is an inflationary gap.

Recessionary Gap:

    May be caused by low Investment or Consumer Spending (i.e., AD is too low).  When equilibrium is below full employment, there is high unemployment, so that workers are competing with each other for jobs.  This competition will force them to offer to work for lower wages, therefore driving down the wage rate.  This decrease in nominal wages will cause AS to shift outward, bringing down the price level (deflation) and expanding Y to the full employment level.   Therefore, market will eventually move toward full employment level on its own.   (Question:  should gov't be involved in shortening the process?  More later.)

 Inflationary Gap:

        May be caused by excessive Consumer Spending, Investment or Government Spending (i.e., AD is too high).  Since equilibrium is above full employment, unemployment is very low.  In fact, employers will have to compete with each other to get workers.  This competition will force them to increase the wages they offer to pay to workers.  This increase in the wage rate will cause a decrease in AS, raising the price level (inflation) and lowering real GDP (Y) back to the level of full employment.  So, again, the economy self corrects.   (Question:  again, should the gov't get involved to speed up the process, like pulling off a band-aid?  More later...)

        Stagflation -- the term used to describe inflation with falling Y -- an inflationary recession.  Stagflation can be caused by:

  1. Excessive AD leading to an inflationary gap (the process just described above).

  2. Adverse (negative) supply shocks -- things that cause a sudden decrease in AS.  Example:  the oil embargo of the late '70's.  Price of oil (an input for just about everything) causes the AS curve to shift inward, raising prices and lowering real GDP.  Therefore, the late 1970's were a period of stagflation in the US.

"The" Multiplier and Inflation:

    We said earlier that our formula for The Multiplier [ 1 / (1-MPC) ] was "oversimplified".  One of the factors that it does not take into account is inflation. 

        Remember the end of Ch.9 when we demonstrated how an autonomous increase in C, I, or G not caused by a change in the price level will cause the AD curve to shift by the multiplier effect (see Ch.9 notes above).  However, because of the upward slope of the AS curve, any increase in AD (ceterus paribus) will cause inflation, which will partially offset the increase in real GDP caused by the shift in the AD curve.  (I still don't know how to insert drawings in an HTML document, so you'll have to look at the picture in the book.) 

Therefore:  Inflation reduces the effect of The Multiplier.

Exam 2

Chapter 12 -- Fiscal Policy

Background (some of this isn't in the book):  Prior to Great Depression, economic policy was primarily based on Classical Theory.   Classical Theory asserted:

  1. Say's Law -- "supply creates its own demand."   Expansion by industry (an increase in AS) creates more jobs, which increases AD.

  2. Normal state of the economy is at Full Employment.

  3. The Economy is self-regulating, i.e., recessions and inflation tend to work themselves out.

  4. No need for gov't interference in the economy -- "Laissez-faire" -- gov't takes hands-off approach.

John Maynard Keynes came along during the Depression and presented an alternative to Classical Theory that was followed, beginning with Franklin Roosevelt, for the next 50 years or so.  Keynes said:

  1. Focus should be on total spending (AD), not on AS.

  2. Wages tend to be "sticky" (discussed in the last chapter), so that the economy may be slow to self-correct, if it does so at all.

  3. It is possible for the economy to reach equilibrium below Full Employment (recessionary gap).

  4. Gov't intervention in the economy (fiscal and monetary policy) is necessary.

Fiscal Policy -- Gov't policy that uses gov't spending (G) and taxation to adjust the AD curve.

    Effect of taxes on Consumption Function:

  1. Fixed tax -- a tax that does not vary with income.  Example: Property taxes.  A Fixed tax increase will cause a parrallel downward shift of the consumption function.

  2. Variable tax -- a tax that varies with income.  Obvious example: income tax; other examples: sales tax and excise taxes (the more your income, the more you spend, therefore the more sales tax you pay).  A variable tax increase not only causes a downward shift of the consumption function, but it flattens it.  

When variable tax is increased, C-fuction flattens, therefore its slope (the MPC) decreases.  Suppose we start off with no taxes and MPC=.75.  That means you spend 75-cents of every dollar of additional income.  Now suppose a 20% income tax is imposed.  Now, if your income goes up by $1, you only see 80-cents of it.  You will spend 75% of that 80-cents, which = 60-cents.  Therefore, a variable tax increase decreases the effective MPC.  (A variable tax cut would do exactly the opposite.)

If MPC is decreased, then so is The Multiplier, so a variable tax increase decreases the effective multiplier as well.  (A variable tax cut would increase The Multiplier.)

    Expansionary Fiscal Policy --

If the economy is in a recessionary gap, the government can increase AD by either increasing Gov't spending (G), which will directly increase AD by the multiplier effect, and push Y to the level of full employment, and/or they can cut taxes, which will increase Consumer spending (C) (see all that stuff above), which will increase AD to full employment.

Note:  While this will cause the economy to expand out of a recession, it will also cause inflation.

    Restrictive Fiscal Policy --

If the economy is in an inflationary gap, the gov't can decrease AD by decreasing G and/or raising taxes.  This will cause a fall in the price level, and a recession.

    Problems with Keynesian Fiscal Policy:

  1. Dependent on reliability of economic forecasting.  Tax revenues (gov't income) is tied to the level of national income (Y).  If there is a recession, revenue from variable taxes will go down, disrupting gov't fiscal policy-making.

  2. Difficulty in knowing the "real" multiplier.  You need to know it so you can know how much to increase G or cut taxes to get the desired increase in AD.

  3. Moving the AD curve causes inflation or recession.

  4. Defining Full Employment.  You need to know where your target is before you start shooting.

Alternative to Keynesian Fiscal Policy -- Supply-side economics (a.k.a., "Reaganomics").

    Partial throw-back to Classical Theory, with certain concessions to Keynes.  Focus is shifted at least partially to AS curve, and not kept strictly on AD.  Some supply-side expansionary policy options:

  1. Cut personal income taxes -- increases consumers' take-home pay, thereby increasing C which increases AD.  Also increases incentive to work (since workers get to keep more of paycheck), which increases AS.  Since AD & AS both increase, there may not be the inflationary effects seen with expansionary fiscal policy.

  2. Cut capital gains taxes -- increases profitability and therefore the incentive to invest (I).  Increase in investment spending increases AD, and the resulting increase in available capital increases AS.  "Trickle-down" effect -- increases in AD and AS causes job creation, benefiting workers.

  3. Cut corporate income taxes -- similar effect as above.

    Potential problems with supply-side policies:

  1. AD may increase more or at least more quickly than AS, which will result in inflation (but will still likely be less than inflation experienced with Keynesian Fiscal Policy).

  2. "Steering a barge" -- any adjustments made to the economy take a long time to actually take effect.  There will be a lag between the time you adjust government spending or taxation and when you actually see the economy react.

  3. Income distribution -- because many of the tax cuts mentioned above are directed toward business owners and investors, supply-side economics is often blamed for the polarization of rich and poor.  One fallacy:  the assumption that economics is a "zero-sum game", i.e., that people can only get rich by taking money from other people.  In actuality, most people get rich by creating wealth, not by stealing from others, so creating an environment where businesses are able to succeed does not hurt lower-income people. 

  4. Lost tax revenue from tax cuts (according to book, Reagan tax cuts caused the deficits of the 1980's because of lost tax revenue) -- This is historically inaccurate.  One core assertion of supply-side economics is that, since cutting taxes increases national income by the multiplier effect, tax revenues can actually be increased by cutting tax rates. 

Example:  Suppose we have a 15% tax rate, and someones income is $30,000.  That yields tax revenue of $4500 (30,000*.15).  Now suppose we cut the tax rate to 10%, which will increase the consumption function and the multiplier, thus resulting in higher income.  Suppose your income after the tax cut is $50,000.   This results in tax revenue of $5000 (50,000*.1), which is greater than before the tax cut.

In reality, tax revenues increased during the 1980's following the Reagan tax cuts.  The high deficits came because goverment spending also continued to increase during this period.

Chapter 13 -- Money and Banking

Money is a commonly accepted  medium of exchange.  

    Common acceptance is what gives money its value.   Any seller knows that if he takes money as payment, he can use that money in turn to purchase whatever good or service he wants.  As such, money acts as a medium of exchange, replacing the barter system (trading good for good or service for service...).  It eliminates the inefficiency of the double coincidence of wants -- the necessity when engaging in barter to not only find someone who is willing to sell what you want to buy, but is also willing to accept what you offer in payment.

Money serves 3 basic functions:

  1. Medium of exchange.

  2. Unit of account (we tend to measure value in $'s for the sake of simplicity).

  3. Store of value -- requires that what we use as money be (a) storable/transportable (b) durable (non-perishable) (c) easily divisible (so you can have "exact change").

Two types of money:

  1. Commodity money -- has some intrinsic value, i.e., it has a valuable use other than as money.  Examples:  gold (jewelry and stuff), buckskins (from frontier days -- used for clothing, blankets and tent-making), salt (paid to Roman soldiers -- used for preserving food). 

  2. Fiat money -- has no intrinsic value, i.e., its only valuable use is as money.  Example:  paper money.

How we count money:

    M1 -- ~ $1.1 trillion.  The most narrow measure of the money supply (and the one we will use in this class).  Most liquid (easily spent) forms of money.  Includes:

  1. Currency and coin.

  2. Checkable deposits (incl. travelers' cheques).

    M2 -- ~ $3.7 trillion.  Some economists and gov't policy makers use this measure of the money supply.  Includes less liquid forms of money than M1.  M2 consists of

  1. M1

  2. Non-checkable savings (regular savings accounts) and time deposits (CD's and IRA's).

  3. Money market funds.

The Fractional Reserve Banking System -- before we can discuss how money is created, we have to look at how banks work.

    Banking regulation -- After the stock market crash in 1929, some banks began failing around the US.  People began to panic, because, since there was not deposit insurance at the time, if their bank failed, they would lose all of the money that they had deposited there.  Depositors began running on their banks demanding all of their money.  Since banks only keep a % of deposits on hand, and the rest had been loaned out, the banks had to foreclose on many mortgages to try to get the depositors' money for them.  This caused many families, especially small farmers, to lose everything when the banks reposessed their property (like the Joads in Grapes of Wrath).  The flood of reposessed property being sold on the real estate market drove down prices, so the banks were not able to get all of the money back that they had put into the loans, and they began to collapse.  This massive decrease in wealth caused a downward shift in the consumption function, which resulted in a multiplier-effect-sized decrease in National Income (Y), and resulted in the Great Depression.  To try to prevent this from happening again, the government established the following regulations:

  1. Reserve requirements -- so the banks will have enough cash on hand to handle at least small emergencies.

  2. Deposit Insurance (FDIC -- Federal Deposit Insurance Corporation) -- if a bank fails, each depositor is insured by the government for up to $100,000. 

  3. Oversight -- regulators regularly check the financial activities of banks to be sure they are not engaging in excessively risky behavior.  Banks are limited in the amount and type of the financial investments they are allowed to make.

Money Creation:  assume all money is deposited in banks (no one holds cash), required reserves = 10% of deposits.  The Federal Reserve prints $100,000.  It goes into the bank as a deposit (the left column).  Total deposits become $100,000, and the bank keeps $20,000.  It will loan $80,000, which will be deposited, so total deposits become $180,000, and so forth, until Total Reserves = $100,000 (the amount of the initial deposit).

Deposit                  

$100,000

$90,000

$81,000

....

....

Total Deposits        

$100,000

$190,000

$271,000

.....

....

Total Reserves       

$10,000

$19,000

......

......

$100,000

    How much money is created by this process depends on the % held in reserves ("r"), and the % of money people hold as cash.   To simplify matters, we will assume as in the above example that no money is held as cash.  This makes the Money Multiplier = 1 / r.

Therefore, the change in the Money Supply will = total reserves * (1/r).

Chapter 14 -- Monetary Policy

The Federal Reserve System (the "Fed") -- the central bank of the United States.  "Bank for banks".  Exercises exclusive control over monetary policy.  While the Fed is a part of the US gov't, it is completely independent of any other part of the gov't.  Made up of 12 districts:

Boston, NY, Philadelphia, Richmond (VA), Cleveland, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, & San Francisco.  [SC is in Richmond's district.]

    The Fed is controled by the Board of Governors.   The board is made up of 7 members, appointed by the president of the US, each of whom serves a 14-year term.  The board is led by the Chairman, who is appointed by the Prez, and confirmed by Congress, to a 4-year term (no term limits).  The current Chairman is Alan Greenspan.  The Chairman of the Board of Governors can only be removed from office by impeachment (if he commits a crime), or when one of his 4-year terms expires, the president can choose not to reappoint him.

    The part of the Fed we hear the most about is the Federal Open Market Committee (FOMC).  This is made up of 13 members -- (7) the Board of Governors, (4) the presidents of four of the Fed district banks (on a rotating basis), and (1) the president of the Federal Reserve of NY.  The Chairman of the Board of Governors presides over this body as well.  The FOMC meets 8 times per year.  We will discuss what they do shortly.

The Fed performs four primary functions:

  1. Prints all US currency (paper money) -- coins are minted by the US Treasury, a seperate part of the gov't.

  2. Lends money to banks that are members of the Federal Reserve system (often denoted by the word "National" somewhere in the bank's name).  The Fed charges these banks interest on the loan, called the discount rate -- this rate is set by the Board of Governors.

  3. Holds part of member banks' reserves (rather than the banks keeping their entire reserves in their own vault where robbers can get to it).  The Fed does not pay interest on this money.

  4. Sets reserve requirements.

The FOMC -- conducts "open market operations", which consists of buying and selling Treasury (gov't) bonds on the secondary market. 

Quick digression:  Explaining Treasury bonds -- The gov't sells bonds to individuals in order to finance deficit spending; essentially, the gov't is borrowing money from you, and the bond is a note promising you that the gov't will pay you back.  In addition to paying you back the face value of the bond in a certain number of years, the gov't will pay you a % of the face value of the bond per year in interest.   --  When the Treasury sells you a bond, this is the primary market.  However, people also buy and sell Treasury bonds among each other in the Bond Market the same way stocks are traded on the Stock Market -- this is the secondary (as in "second hand") market.

Now, on the secondary market, bond prices are determined by supply and demand, so even though a bond may have a $10,000 face value (i.e., printed on its face), you may either wind up paying more or less than $10,000 for it, depending on market conditions.  However, the interest payment, which is paid to whoever happens to be holding the bond at the time, will be the same in $ terms regardless of the selling price on the secondary market (since it's based on the face value). 

Let's say you purchase a bond for $9000 which pays $900/year in interest.   $900 is 10% of $9000. Now suppose you are later able to sell the bond for $10,000.   The interest payment is still going to be $900/year to the new owner, but $900 is only 9% of $10,000 (following me?).  Therefore, we would say that the "yield" (the effective interest rate) of the bond has gone down.  On the bond market, therefore, price and interest rates are negatively related (one goes up, the other goes down).

Interest rates in the Bond Market effect the interest rates banks charge customers.  Remember, banks invest part of their deposits in the Bond Market.   In effect, when you go to the bank for a loan, you have to compete with the bond market for their money.  If yields go up on the bond market, you have to be willing to pay a higher interest rate on your loan in order to compete.

    Now, back to the FOMC:

Money Supply & Demand (MS & MD)

    When drawing the MS & MD graph, the x-axis will be M1 (i.e., the quantity of money in circulation), and the y-axis will be interest rate (the "price" of money). 

    MS -- the Money Supply curve is upward sloped.  This is because when interest rates are high, loaning money becomes attractive to banks, so they will loan more, therefore making money more readily available (i.e., increase the quantity supplied of money).  When interest rates are low, loaning out their money will be less attractive, so they will loan less and keep more in excess reserves (quantity supplied of money decreases). 

        The Fed is the only thing that can shift the MS curve.

    MD -- the Money Demand curve is downward sloped.  The First Law of Demand applies -- when interest rates (the price of borrowing money) is high, the quantity demanded of loans is low, therefore, less money tends to be in circulation.   When interest rates are low, borrowing money is cheap, so more money is in circulation.

        The MD curve is shifted by changes in nominal GDP (nominal income).  When people have higher incomes, they buy more stuff.   If you want to buy something, you need money to buy it.  Therefore, when people have high incomes they will demand more money at any given interest rate than they would when their incomes are lower.

Summary:  Expansionary monetary policy => the Fed increases MS:

    MS curve shifts out  =>  interest rates fall   =>  investment spending (I) increases  =>  AD increases by the amount of the increase in I * "the" multiplier  =>  Y (national income) increases and the price level increases.

    (For restrictive monetary policy, the exact opposite.)

Notice that a natural consequence of expansionary monetary policy is inflation.   Imagine the Fed decreased the Money Supply to $10.  Since you would have the same amount of goods, services and resources in your economy as before, just less money to buy it with, the prices would have to come down in order to adjust to the new level of M1.   Likewise, whenever the Fed prints a whole lot of new money, the money already out there becomes less valuable and buys less (inflation).  So, for example, if the gov't decided to print enough money to pay off the national debt and get it overwith, this would result in major inflation, and the $ would become nearly worthless.

Chapter 16 -- The Balanced Budget & National Debt

Potential Problems from focusing on a balanced budget:

  1. Cuts in gov't spending (G) will lower the AD of the economy, as we saw in previous chapters. 

  2. Tax increases aimed at balancing the budget will also decrease AD, because of the negative effect on consumer spending (C).

  3. Cutting G or even keeping it under control is very tricky, given the nature of bureaucracy, which is to expand (see "Public Choice" in ECO 211 notes), and politics (everyone has a favorite program they don't want cut).  As a result, even in inflationary times, G has increased every year for as long as most of us can remember.

A Deficit is when the gov't spends more in a given year than it takes in through taxes.  In other words, G > tax revenue.  Deficit spending is financed by the printing and selling of Treasury Bonds (primary market -- discussed in previous chapter).  Recall that we said earlier that tax revenue is a function of national income -- nearly all taxes are related to income, so if we have an unexpected recession, the gov't will not get as much tax revenue as they budgeted for, resulting in a deficit.

    The surpluses (tax revenue > G) that the gov't is currently running are the result of unexpectedly rapid growth in our national income -- tax revenue increased faster than they had counted on, allowing it to catch up with and pass gov't spending.  However, an unexpected recession in the next few years could blow the whole deal.

National Debt is the sum of all of the past deficits that have not been paid off yet.  Essentially, national debt consists of all Treasury Bonds outstanding.  These bonds may be held by banks and other businesses, individuals, the Fed, or by foreign investors.

Arguements in favor of balancing the budget:

  1. Every year that the gov't runs a deficit, national debt is added to.   The gov't must pay interest on the bonds it uses to finance its debt (see last chapter) every year, so this money to make the interest payments must be included in each year's budget.  The bigger national debt gets, the more interest that has to be paid.    Eventually, the gov't will have to allocate so much money to pay the interest on the debt, it will not have any left to pay for national defense, education, etc., without a tax increase, and there is still only so much you can increase tax rates.

  2. Deficit spending causes inflation.  Remember tax revenue is going to grow at the same rate as national income.  So if the gov't is engaging in deficit spending, that means the gov't is growing faster than the rest of the economy (we will discuss economic growth in the next chapter).  This will cause the AD curve to increase faster than the AS curve, thus resuling in inflation.

  3. Deficit spending results in higher interest rates.  To attempt to prevent the inflation in #2 above, the Fed may raise interest rates.  This stifles investment spending (I).  Problem:  I not only decreases AD now to prevent inflation, but I represents the purchase of plant & equipment by firms, which will affect future productivity.  In essence, deficit spending comes at the expense of your economy's future productivity.

    Crowding out -- Treasury Bonds and Corporate bonds (Corporations finance some of their debt the same as the gov't does) compete with each other.   Since Corp bonds tend to be riskier than Treas. Bonds (because there is a greater chance of a corp. going bankrupt and defaulting on your bond is greater than the chance of the gov't defaulting), they must pay a higher rate.  This makes investment spending (I) by corporations more expensive, so, again, I will be lower.  Also, since Treas. Bonds will also draw some potential investors away from corp. bonds, some of the resources that would otherwise be going toward increasing the economy's future ability to produce are going toward financing the gov't's deficit spending.

Gov't often pays off old Treasury Bonds by simply selling new ones, so they don't eliminate the debt, they just roll it over.  This is called floating debt.

Chapter 17 -- Economic Growth and the Phillips Curve

Economic growth -- AD, AS & Potential GDP tend to increase from one year to the next.  This is due to increases in population (more consumers & investors, and also more workers), technology, growth of capital (from past investment spending) and productivity of labor.

    Historically, the economy shows a tendency toward increasing Y (real GDP) accompanied by inflation from year to year.  [See Fig.16-3 in book.]

As a general rule, there is a short-run tradeoff between unemployment and inflation.  This is illustrated using the Phillips Curve. 

The Phillips Curve is a negatively-sloped line with the % unemployment on the horizontal (x) axis, and % inflation on the vertical (y) axis.   This illustrates that whenever the gov't engages in expansionary fiscal or monetary policy in order to combat high unemployment, this tends to produce inflation (recall from Ch. 11 & 13).  When the gov't engages in restrictive fiscal or monetary policy in order to combat high inflation, this causes a decrease in Y, which causes higher unemployment.

In the Long Run, the Phillips Curve is vertical (straight up-and-down).  This is because the economy tends toward Full Employment in the long run (recall end of Ch.10).  Since the horizontal axis for the Phillips Curve measures the unemployment rate, the Phillips curve will have to be vertical in the long-run (i.e., fixed at the full employment rate of unemployment, ~4%). 

Rational Expectations -- the theory that people base their behavior on the best available information; in other words, they are able learn to recognize when to expect anti-inflationary policy (this doesn't mean that their always correct but just that they're not consistently wrong).  If the anti-inflationary policy is well-anticipated, it will not produce the unemployment illustrated by the short-run Phillips Curve, because the economy will adjust to the change in policy before it takes effect.  (As a result, economists who subscribe to the Theory of Rational Expectations would argue that the Phillips Curve is vertical, even in the short run.   For our purposes, though, we'll stick with the downward-sloped short-run Phillips Curve.)  Rational Expectations comes in handy in many other areas of economics, however, which we'll hopefully be able to discuss later.

Exam 3

Chapter 18 -- International Trade

Law of Comparative Advantage (long version):

Robinson Crusoe is stranded alone on a desert island.  There are only two sources of food: fish and coconuts.  RC has a specific Production Possibilities Frontier for fish & coconuts (5 fish & 0 coconuts, 0 fish & 5 coconuts, or any combination in between).  Now, one day, as the story goes, RC is walking along the beach when he spies a set of footprints that are not his own.  Turns out there's this other guy named Friday who has been living on the other side of the island. 

RC and Friday decide to join forces.  When they compare their Production Possibilities (Friday can produce 5 fish & 0 coconuts, 0 fish & 10 coconuts, or any combination in between), they discover that Friday has a lower Marginal Opportunity Cost (MOC) for producing coconuts, that is, in order to produce one more coconut, he must forego catching less fish than RC would have to give up in order to produce an additional coconut.  In other words, Friday is the lower-cost producer of coconuts.  Likewise, they discover that RC is the lower-cost producer of fish.   They decide to specialize and engage in trade.  RC will catch all the fish, since he can do so at a lower MOC than Friday, and Friday will pick all of the coconuts.  It works out that RC is able to catch 5 fish per day, while Friday is able to pick 10 coconuts.

In order to engage in trade, they have to agree on an exchange rate -- they decide that they will trade 3 coconuts for 2 fish.  So, RC trades 4 fish for 6 coconuts.  Remember that before trade, RC could only pick 5 coconuts a day, but then he would not have time to catch any fish.  Now, he's eating 6 coconuts, and 1 fish!  RC is now able to consume beyond his ability to produce on his own.   Likewise, Friday is now consuming 4 fish and 4 coconuts per day.  Friday is also consuming beyond his own production possibilities.  These are the gains from trade:  Both parties benefit -- both are able to consume at a level beyond their ability to produce on their own.

The Law of Comparative Advantage (short version) -- all parties will benefit when each specializes in the production of those goods in which they have the lower marginal opportunity cost.  [Originally stated by David Ricardo.]

Special Problems of applying to International Trade:

  1. Must take into account fluctuating international exchange rates.   For example if the Yen-to-Dollar ratio falls (i.e., it takes less yen to buy a $ or more $'s to buy a yen), Japanese goods will become more expensive in the US.  This will tend to complicate our fish & coconut example.

  2. It is difficult to move resources (land, labor and capital) between countries.  If the US were to specialize in the production of fish and Japan in the production of coconuts, you would want to shift any resources used in the production of each to the country where they are going to be needed.  That may not be so easy, though (it would be very costly to relocate an entire factory from the US to Japan for example).

  3. It's not fish & coconuts.  What we actually look at are labor-intensive goods vs. land-intensive goods vs. capital-intensive goods.  By "labor-intensive", we mean that labor is the most important resource involved in producing that good.  Land is the most important resource in producing a land-intensive good (agriculture is a good example of a land-intensive good).

Theoretically, a country that has the most productive land resources would specialize in the production of land-intensive goods.  The country with the most productive labor force would specialize in labor-intensive goods, etc.

Another way to look at this (assume free trade, that is, no trade restrictions):

Suppose Japan (a country with very little land for agriculture) were growing its own corn (a land intensive good).  Since there is so little land available for agriculture in Japan, the cost of growing corn would be very high, therefore the domestic price of corn would be high, say, $10/bushel.  Now, suppose that the world price for corn (which includes land-rich nations like the US, Canada and Russia) was $4/bushel.  Japanese growers would have to lower their price to the world price, which means that the Quantity Supplied by Japanese growers would decrease, but, since corn is now cheaper, consumers want to buy more (Qd increases).  Japan would now import the difference between domestic Qs and Qd.
Therefore:  When the world price is lower than the domestic price, a nation will reduce domestic production and import the rest.

The opposite holds when the world price is higher than the domestic price.  Domestic producers will raise the price that they charge and export the surplus.

Restrictions on International Trade:

  1. A tariff is a tax on an import.  The purpose of a tariff is to increase the cost of importing goods from other countries, which of course decreases that good's suppy curve, which raises its price to consumers.  By artificially jacking-up the price of foreign goods, the gov't protects domestic producers from competition.

  2. A quota is a limit on the quantity of a good that can be imported.  This decreases the good's supply curve simply by reducing the number imported.  This has the same effect as a tariff in that it drives up the price of the foreign good.

  3. An export subsidy is not really a trade "restriction", but its purpose is similar, so I'll include it here.  A subsidy is where the gov't gives money to a firm to enable it to produce at a lower cost.  This increases the supply curve of the domestic firm allowing it to charge a lower price than its foreign competition.

    "Free Trade" is what we call international trade without any of these restrictions.

    Trade Restrictions

    Arguments for imposing trade restrictions:

  1. National security -- (i) some goods cannot be exported by law in order to prevent their being used against the US.  (Example: encryption software, nuclear weapons technology, certain computer systems technology, stuff...)  Also, (ii) certain domestic industries (such as oil production) are necessary for the country to continue operating in the event of our being cut off from the outside world either by a blockade or by war.  To make sure we don't lose our ability to produce these goods, certain trade restrictions may be imposed to keep them from going out of business.

  2. Politics -- "trade sanctions" are often used to punish or persuade other countries whose behavior or politics we don't agree with.  Example: South Africa in the 1980's in opposition to Aparthied.  Saddam Hussain in Iraq to punish him for the Gulf War.

  3. Retaliation for trade restrictions placed on us by other countries.   This happens every few years with Japan.  When this sort of thing happens over an extended period of time, we call it a "Trade War".

  4. Protectionism -- the political philosophy that American industries and jobs must be protected against any losses due to foreign competition. 

 

Chapter 15 -- The Debate Over Stabilization Policy

Stabilization Policy is just the term referring to Monetary or Fiscal Policy used to "stabilize" Aggregate Demand (which is just what we were talking about in Ch.11 & 13). 

Automatic Stabilizers are Fiscal Policy options that increase or decrease automatically (without need for Congressional action) with changes in the economy.  For example, unemployment insurance, welfare and job training program spending go up automatically everytime there is a recession -- although the effect is small, they will have the effect of "cushioning" the AD curve just like the other Fiscal Policy options we talked about in Ch. 11. 

The rest of this chapter (at least the parts we're going to go over) only deal with Monetary Policy.

The Quantity Theory of Money -- the quantity of money in circulation (M1) determines the price level.

The Quantity Equation =>   MV = PY

M = quantity of money (M1, we just dropped the "1" to make it quicker to write).
V = velocity of money -- the number of times a $ changes hands. 
                                    V = (PY/M)
P = the price level, of course.
Y = real GDP.  (Therefore PY = nominal GDP.)

The Quantity Equation shows the relationship between M and nominal GDP.  This is really another way of stating the concept of monetary neutrality -- since Y isn't affected by changes in M in the long run, and because the velocity of money historically tends not to change a great deal:  In order to keep both sides of the MV = PY equation equal, any change in M must produce a corresponding change in P. 

Remember the example we used with Turner Field and the hotdogs?  If Turner Field were a self-contained economy, and hotdogs were the only good produced, suppose the output of hotdogs was 100 and the money supply was $100.

Y = 100 hotdogs
M = $100
therefore we would conclude that the price of hotdogs was
P = $1.

We are actually assuming that Velocity = 1 in this example, which means that each dollar is only spent once.  So the Quantity Equation in this example would look like:

MV = PY, or
$100 x 1 = $1 x 100

Now we can see the relationship between the quantity of money and the price level -- if we kept the # of hotdogs produced the same and increased the money supply to $200:

$200 x 1 = $2 x 100
so that the price of the hotdogs increased with an increase in M.

The Discretion vs. Rules Debate:

Members of the "Monetarist" school of thought (including Milton Friedman) argue that the Fed should be constrained by a "rule" that only allows them to increase M a fixed amount each year.  The reason they give for this is that giving the Fed "discretion" in controling M (for the purposes of stabilization of AD) can lead to major fluctuations in the price level and interest rates.  This makes it difficult for businesses to plan for the future (remember discussion of costs of inflation from Ch.6).

Proponents of discretion (active stabilization policy) say that the "rules" approach leaves no room for flexibility, since unanticipated inflation and changes in interest rates are still a threat because of market fluctuations even without stablilzation policy, and the rules approach would leave the Fed no options as to how to deal with these occurances.

The End