University of Colorado

Vijaya Raj Sharma, Ph.D.

Building a Macroeconomic Model:

• There are three broad markets in an economy: Goods and Services Market, Resource Markets, and Loanable Funds Market.
• Resource Market. For example, labor market. In this market, there is a demand curve for labor and a supply curve of labor (graph). The intersection of the two curves gives the competitive market wage rate. We have done analysis of this market earlier too, while discussing distribution of income.
• Loanable Funds Market. There is downward-sloping demand for loanable funds from households for purchases of houses and durable goods and from firms for purchases of investment goods (graph). The higher the real interest rate, the lower the amount of loanable funds demanded because the cost of borrowing increases. There is an upward-sloping supply of loanable funds; the supply comes from the savings of households. The higher the interest rate, the higher is the incentive to save. Interest rate here refers to the real interest rate. The intersection of the two curves is the market real interest rate. We have done analysis of this market earlier too, while discussing crowding-out effect of government budget deficit.
• Goods and Services Market. We have not analyzed this market earlier.
• Aggregate Demand (AD) of Goods and Services
• Goods and services market is a highly aggregated market; real GDP measures the aggregate output of all goods and services. There is a downward-sloping aggregate demand curve (AD) for real GDP such that the higher the price index, the lower the real GDP demanded. Draw a downward-sloping AD curve in a graph with real GDP in the horizontal axis and price index in the vertical axis. Three reasons explain the negative relationship between price index and AD.
• Real Balance Effect. When price index increases, the real value (or the purchasing power) of a fixed amount of nominal money balance decreases, lowering the amount of real GDP demanded.
• Interest Rate Effect. When price index increases, you need more money balance to maintain the same level of activity, lowering savings. This reduces supply of loanable funds, increasing real interest rate in the loanable funds market. Increase in interest rate decreases interest-sensitive expenditures, such as buying of cars, homes, and investing on machinery and equipment. Thus, the real GDP demanded is lowered.
• International Substitution Effect. When price index in U.S. increases, domestic goods become more expensive and imports become cheaper. This reduces exports and increases imports, reducing net exports and, thus, the real GDP demanded.
• Note that consumers factor in anticipated inflation in their aggregate demand. The change in AD is caused by unanticipated inflation.
• Along the AD curve, real income changes (because real GDP is changing). Taxes, transfers, and money supply are assumed fixed along the AD curve.
• Aggregate Supply (AS) of Goods and Services
• There are two types of aggregate supply: a short-run aggregate supply (SRAS) and a long-run aggregate supply (LRAS).
• Short run is the time period during which wages and prices of resource inputs are fixed by prior contracts or understanding. Any wage or input price adjustment has to wait until expiry of the current contract.
• Long run is the time period when contracts can be renegotiated and wages and resource input prices adjusted.
• SRAS is upward sloping. Show it in a graph. Note that anticipated inflation is factored in the SRAS; wages and input prices negotiated in contracts incorporate anticipated inflation. The price index changes along the SRAS are consequences of unanticipated inflation. When price index increases, prices of outputs of suppliers increase but wages and input prices are fixed by prior contracts. This raises profitability of suppliers and they are, therefore, willing to supply more real GDP (the positive relationship between price index and real GDP supplied in the short run).
• Note that labor would not be happy with unanticipated increases in price index because real wages (purchasing power of wages) go down. Labor would only wait until expiry of the wage contract to renegotiate increase in wages to compensate for unanticipated inflation. If there was an unanticipated decrease in price index, producers would not be happy. Prices of their outputs go down, wages and input prices cost more in real terms, eroding profitability. Producers would only wait until expiry of contracts to renegotiate lowering of wages and input prices to reflect the drop in general price level. In either case of price index increasing or decreasing, wages and input prices are adjusted to reflect price index changes, maintaining long run profitability at the same level. So, the real GDP supplied is fixed in the long run at the maximum level that the economy can produce. In other words, LRAS is a vertical line at the full employment level of output or at potential level GDP. Show this in a graph.
• Equilibrium in Goods and Services Market
• Short run equilibrium. This equilibrium is when real GDP demanded is equal to the real GDP supplied in the short run, the point of intersection of AD and SRAS in the graph.
• Long run equilibrium. This equilibrium is when real GDP demanded is equal to the real GDP supplied both in the short run and in the long run, the point of intersection of the three curves: AD, SRAS, and LRAS. Show this in the graph. At the long run equilibrium, the real GDP=potential GDP (full employment level of GDP). Also, actual rate of unemployment = natural rate of unemployment. In addition, actual price index = anticipated price index (the price index factored in the AD and SRAS). All the above conditions are met in the LR equilibrium.

1. Short-run Macroeconomic Equilibrium
1. In the short-run equilibrium, the goods and services market operates either above (to the right of) or below (to the left of) the full employment level of output. This equilibrium is the intersection of SRAS and AD only, away from the LRAS. If this equilibrium is below the full employment level, the economy is in recession. For example, this happens when the AD shifts to the left of the initial long-run equilibrium (draw a graph of this). On the other hand, the economy is in boom period if the equilibrium is above the full employment level. For example, this happens when the AD shifts to the right of the initial long-run equilibrium (draw a graph of this).
2. In recession, output and the number of labor employed are lower. Output goes down below the full employment level, unemployment increases above the natural rate of unemployment, price level drops below the anticipated level.
3. The short-run equilibrium in boom period increases output and labor employed. Output exceeds the full employment level, actual unemployment is below the natural rate, and price level increases above the anticipated level.
4. Note that be it recession or boom, the short-run equilibrium cannot sustain for long. We will see later how the economy bounces back to the long-run equilibrium.
2. Factors that shift LRAS and, thus, SRAS too

1. As we have already explained in earlier classes, the LRAS is the potential GDP of the economy and is determined by the Production Possibilities Curve of the economy. Therefore, the factors that shift the PPC also shift the LRAS, thereby shifts also the SRAS.
2. These factors are changes in resource endowments, changes in technology, and changes in economic institutions and work habits. For example, increase in resource endowments or improvement in technology (or productivity) shifts the LRAS and also the SRAS to the right (show this in a graph).
3. These factors cause the long-run equilibrium to change. For example, in the above graph, the new long-run equilibrium would be associated with a larger full employment level of output and lower price level. Show this in the above graph. Such increases in the LRAS represent economic growth.
4. In the United States, real GDP has increased at an average rate of 3.5 percent over the long run for many years (due to LRAS shifting). Contrary to the above model's prediction however, the actual price level has not consistently declined in the U.S. This is because this model assumes no change in money supply (see the last week's notes on the AD), which in reality has changed frequently.

1. Factors that shift only SRAS (with no change in LRAS)
1. These are the factors that change temporarily either the amount or productivity of resources (such as, good or bad weather or war) or the cost of producing goods and services (such as changes in resource prices).
2. These factors move the economy from long-run equilibrium to a short-run equilibrium. However, due to the temporary nature of these factors, the economy returns to the initial long-run equilibrium when the factor disappears.
3. If the SRAS shifts to the left, the economy goes to recession. Real GDP goes below the full employment level and price level increases. For example, this may happen with bad weather or with increase in resource prices. When the weather or resource prices return to normal, SRAS returns to its original position. Draw a graph to show this.
4. On the other hand, the economy goes to a boom period when the SRAS shifts to the right. Outputs go above the full employment level and the price level decreases. For example, this may happen with exceptionally good weather. When weather returns to normal, the SRAS returns to the original position. Draw a graph to show this.

1. Factors that shift AD
1. Changes in real wealth. Example: stock market boom or crash changes the value of the stock holding (wealth). Increase in real wealth makes people feel wealthier, increasing their consumption and, thus, AD. Decrease in real wealth would reduce AD.
2. Changes in real interest rate. Example: government borrowing from the loanable funds market can increase interest rate. An increase in interest rate suppresses interest-sensitive expenditures on consumption and investment, decreasing AD. Decrease in interest rate increases AD.
3. Consumer confidence and investor confidence, or their expectations about the economy. If consumer or investor confidence increases, consumption or investment expenditures increase, increasing AD. When confidence goes down, AD decreases.
4. Changes in expected inflation rate. If consumers expect prices to go up, they buy more now before prices go up, i.e., AD increases. If expected inflation is lower, AD decreases.
5. Changes in income of foreign countries. If foreign income decreases, foreigners buy less from us, decreasing net exports and, thus, AD. This is the concern associated with the recent global financial crisis. If foreign income increases, AD increases.
6. Changes in exchange rate. When dollar becomes stronger (more expensive vis-a-vis other currencies), American goods become more expensive to foreigners, reducing net exports and, thus, AD. A weak dollar would increase net exports, increasing AD.
2. Changes in AD and Business Cycle
1. Recession and Restoration of Full Employment
1. When an economy is in a long-run equilibrium producing full employment level of goods and services, a decrease in AD can lead the economy into a recession temporarily. During the recession, real GDP shrinks below the full employment level, actual rate of unemployment exceeds the natural rate, and price level declines below the anticipated level. Higher unemployment and lower outputs decrease household income. According to our model, these changes are temporary, and the self-correcting mechanism of the market pulls the economy back into a new long-run equilibrium of full employment level. The principal self-correcting mechanism is the flexibility of wages and resource prices. Wages and resource prices fall during recession, making resources cheaper. Cheaper resources encourage producers to use more resources to increase production for gradual restoration of long-run equilibrium.
2. Let us graph recession. Begin with an initial long-run equilibrium where LRAS, SRAS₀, and AD₀ intersect; call this intersection E₀. At E₀, the real GDP would be Y_f and let the price level be PI₀. Now shift AD₀ to the left and label it AD₁. The intersection of AD₁ and SRAS₀ is the new short-run equilibrium, label this intersection e₁. Let the output at e₁ be Y₁, this output would be lower than Y_f. Let the new price level be PI₁, which would be lower than PI₀. Thus, output reduces, unemployment increases, and price level decreases in the short run.
3. Wages and resource prices in the economy are fixed by contracts based on an anticipated price level; this anticipated price level is the actual price level when the economy is in a long-run equilibrium, i.e., PI₀ in our graph. Thus, producers and labors had been working on the presumption that PI₀ would be maintained, but they find that the price level actually declines. This decline of price level increases the real wage (the purchasing power of wage) of labor, but on the other hand, it reduces prices of outputs of producers, eroding profitability of producers. Producers would have to wait until the expiry of the current wage contract to renegotiate lowering of wages. Thus, In the long run, wages are renegotiated and decline.⁽¹⁾ Lower wages make production cheaper and increase SRAS to the right. Label the new curve SRAS₂ and draw it such that both this curve and AD₁ intersect with LRAS at the same point. Call this point, the new long-run equilibrium, E₂. At the new equilibrium, the full employment level is restored. The economy, thus, bounced back from recession. According to Classical Economics, there is no need for the government to intervene even when the economy goes into recession. The self-correcting mechanism of the market would restore full employment, although that may take some time.
2. Inflation and Restoration of Full Employment
1. When an economy is in a long-run equilibrium producing full employment level of goods and services, an increase in AD can lead the economy into inflation temporarily.⁽²⁾ During inflationary period, real GDP expands above the full employment level, actual rate of unemployment is below the natural rate, and price level is continually increasing above the anticipated level. Persistent inflation causes uncertainty, especially regarding long-term contracts and transactions. It also erodes purchasing power of those who live on fixed income, like retirees. According to our model however, these changes are temporary. The self-correcting mechanism of the market pulls the economy back into a new long-run equilibrium of full employment level. Once again, the principal self-correcting mechanism is the flexibility of wages and resource prices. Wages and resource prices increase during inflationary period, making resources more expensive and discouraging producers from the use of these resources in production. This forces gradual reduction of output to the long-run equilibrium level.
2. Let us graph inflation. Begin with an initial long-run equilibrium where LRAS, SRAS₀, and AD₀ intersect; call this intersection E₀. At E₀, the real GDP would be Y_f and let the price level be PI₀. Now shift AD₀ to the right and label it AD₁. The intersection of AD₁ and SRAS₀ is the new short-run equilibrium, label this intersection e₁. Let the output at e₁ be Y₁, this output would be higher than Y_f. Let the new price level be PI₁, which would be higher than PI₀. Thus, output increases, unemployment decreases, and price level increases in the short run.
3. Producers and labors had been working on the presumption that PI₀ would be maintained, but they find that the price level actually increases. This increase of price level decreases the real wage (the purchasing power of wage) of labor, but on the other hand, it increases prices of outputs of producers, improving profitability of producers. Labors would have to wait until the expiry of the current wage contract to renegotiate increase in wages. Thus, In the long run, wages are renegotiated and increased. Higher wages increase cost of production and reduce SRAS to the left. Label the new curve SRAS₂ and draw it such that both this curve and AD₁ intersect with LRAS at the same point. Call this point, the new long-run equilibrium, E₂. At the new equilibrium, the full employment level is restored. The economy, thus, bounced back from inflation. Again, there is no need for the government to intervene; the self-correcting mechanism of the market restores full employment, although that may take some time.

0. Stagflation and Restoration of Long-run Equilibrium
1. Stagflation is a situation of stagnant or shrinking economy but associated with high inflation. This happens when SRAS decreases. Stagflation was observed as a problem during 1970s, because of oil shocks. Oil exporting countries during this decade controlled global supply of oil to increase price of oil. It increased cost of production of virtually all goods and services worldwide, shifting SRAS to left of the initial long-run equilibrium. Draw this in a graph. In the new short-run equilibrium (where the new SRAS intersects AD), price index is higher and output smaller. This is probably the worst situation, as unemployment is higher, income is lower, and prices are increasing. Note that this type of short-run equilibrium can happen, for example, with very bad weather in a year. The economy comes back to the original long-run equilibrium when the causal factor (for example, bad weather) vanishes.
1. Temporary Supply Boom and Restoration of Long-run Equilibrium
1. This is just the opposite case of stagflation, with SRAS shifting to the right. This may happen, for example, with an exceptionally good weather in a year, increasing agriculture outputs. Draw this in a graph. In this situation, output would be greater than the full employment level and price index would be lower. This is a boom with no problems associated, except that it is temporary. There is no economic concern, and with disappearance of the causal factor (for example, the weather returns to normal next year), the economy comes back to the original long-run equilibrium.
2. Self-Correcting Mechanism
1. We saw above that the principal reason the economy is able to recover from recession or inflation is the flexibility of wages and resource prices to move up or down depending on the market conditions.
2. Market also has a mechanism to automatically dampen the swings of the economy. Households do not like swings in consumption, they tend to smooth out consumption. Households base their consumption on life-time permanent income and resist changing consumption based on transient changes of income during recession or inflation. The relative stability of household consumption expenditures (which make almost two-third of real GDP) dampens the change in AD during recession or inflation.
3. For these self-correcting mechanism, Classical Economists believed on the automatic restoration of long-run equilibrium in the economy. Therefore, they saw no role of government in correcting macroeconomic problems.

1. Note that during recession there is high unemployment, which may make it possible to negotiate wages down. However, many suspect that wages are sticky downwards as unions would be extremely reluctant to agree to lowering of wages. If true, this creates a problem for the economy to come out of recession. This was, in fact, the argument of John Maynard Keynes, a prominent British economist, to explain the Great Depression. We will talk about this later.

2. AD can increase because of any one of the six reasons discussed earlier.

VIII. The Great Depression and Keynesian Explanation

A. Classical economics was unable to explain satisfactorily the Great Depression. If the self-correcting mechanism of the market ensured restoration of full employment level, how would then one explain a prolonged and deep recession during 1929-1933? Twenty-five percent of labor force became unemployed during the Great Depression, real GDP dropped more than 30 percent, and international trade came to a virtual standstill.

B. One Classical explanation for the Great Depression can be that it takes time for the economy to recover. If so, the time period during the Great Depression was too long for the suffering it caused. John Maynard Keynes (1883-1946) challenged Classical Economics' assumption of flexibility of wages and prices. He argued that wages and prices were sticky downwards. When an economy enters into a recession, wages and prices do not adjust downwards and the economy, therefore, is likely to get stuck into recession for a long time.

IX. Keynesian Model

A. Keynes built a different model to explain the functioning of economy. I will explain the Keynesian model by using the AD-AS framework. (i)

B. Keynes assumed completely inflexible prices and wages downwards. He essentially implied an inverted L-shaped short-run supply curve. Draw a graph with Y in the horizontal axis and PI in the vertical axis. Draw the LRAS curve (a vertical line at Y_f). Draw AD₀ and let the long-run equilibrium be the point of intersection of AD₀ and LRAS. Label this point as E₀. For E₀ to be the long-run equilibrium, the SRAS must also be passing through this point. According to Keynesian assumption, SRAS is drawn as a horizontal line to the left of E₀ and as a vertical line above E₀ (the vertical part coincides with the LRAS), thus, it looks like an inverted L. The horizontal part of the SRAS is called the keynesian range of the short-run supply curve. In this model, any decline in AD (draw AD₁ to the left of AD₀) results in decline in output (Y) with no change in price level (sticky prices). On the other hand, any increase in AD (draw AD₂ to the right of AD₀) results in higher price level with no change in output.

C. When AD shifts to the left of E₀, it causes recession. Unlike in a classical model, SRAS cannot shift in this model to restore long-run equilibrium because wages and prices do not decrease over time. Thus, the economy gets stuck to the recessionary situation. This is how Keynes explained the prolonged recession during the Great Depression. The only way full employment can be restored is for the government to increase AD by increasing government expenditures (or lowering taxes). This would move AD₁ back to AD₀. Keynes even provided a formula for calculating the necessary increase in government expenditures.

D. When AD shifts to the right of E₀, it causes inflation. Again the only way to restore the long-run equilibrium is for the government to decrease AD2 to AD0 by decreasing government expenditures. We will later discuss the formula for calculating the change in government expenditures needed for restoration of full employment.

E. For Keynes, all economic fluctuations were the results of movement of AD and the management of AD was the prescription for correcting recession or inflation; he completely ignored supply.

X. Marginal Propensity to Consume and Income or Expenditure Multiplier

A. According to Keynes, consumption expenditures of a household consists of two components: autonomous consumption (independent of income) and discretionary consumption (dependent on income). C = a + b Y. Even when a household has no income, it has to spend on food, clothing, and other basic needs for survival - this is autonomous consumption. For this purpose, the household may dig on its past savings or even borrow. Other consumption expenditures are discretionary which depend on the parameter b, which is called marginal propensity to consume (MPC). MPC is the fraction of additional income a household spends on consumption. If MPC=0.75, it implies that the household spends $0.75 on consumption when its income increases by $1. This then also implies that the rest of $1, i.e., $0.25 is saved. The marginal propensity to save (MPS) = 0.25. MPS = 1 - MPC. Note that consumption and savings are interrelated.

B. In an economy an individual's expenditure becomes income of another. Let government increase its expenditure by $1. This expenditure becomes income of someone in the economy, who spends $0.75 (assuming MPC = 0.75) and saves $0.25. This expenditure of $0.75, in turn, becomes income of another person who will spend 0.75*$0.75. This chain of income and expenditure goes on in the economy, multiplying the initial government expenditure of $1 into many individuals' incomes. The term 'multiplier' is used to indicate the number of times the initial expenditure would be multiplied to obtain the total summation of the increases in income. This multiplier is called income multiplier. If MPC is 0.75 i.e., 3/4, the multiplier would be 4.

C. Income Multiplier (M) = 1 / (1-MPC).

D. The multiplier process implies that the amount by which government expenditures have to change (G) to close a GDP gap (the difference between the full employment GDP and the current GDP) is: G = GDP gap / M. Let us do an example. Suppose the full employment GDP be $1500 million and the current GDP $1100 million (recession). Thus, the GDP gap is $400 million ($1500 - $1100 = $400). Suppose MPC = 0.75, i.e., M = 4. Then, to increase GDP by $400 million, the government expenditures have to increase by $100 million. G = GDP gap / M = 400/4 = $100.

E. Note the fundamental difference between Classical Economics and Keynesian Economics on role of government in the management of economy. Classical economists believed in laissez faire, nonactivist government. According to them, self-correcting mechanism of the market solves macroeconomic problems. On the other hand, Keynes argued for activist government to manage demand to restore the full employment in the economy whenever there is a recession or inflation.

XI. Stagflation, Keynesian Model, and Reworking of SRAS

A. Keynesian model dominated macroeconomics for almost three decades. Only during 1970s its weakness became evident when it could not explain stagflation caused by oil crisis in the U.S. economy. There was rising inflation but outputs were either stagnant or declining. Note that in the Keynesian model, outputs decline during recession with no change in price level and price level increases during inflation with no change in output. The model could not explain the changes in both price level and output.

B. Classical model, on the other hand, can explain stagflation as a shift of SRAS leftward. During oil crisis, energy prices were increased by monopolistic behavior of oil exporting countries. Increase in oil prices shifted the SRAS to the left, reducing output and increasing price level.

C. Classical economists made the extreme assumption of complete flexibility of wages and prices, similarly Keynes made the extreme assumption of complete inflexibility of wages and prices. The reality lies somewhere in between; prices and wages are somewhat sticky downwards. Therefore, main stream economists have reworked on SRAS to make it realistic. In our AD-AS model, we will draw SRAS such that it is relatively flat in the keynesian range (outputs below the full employment level) but steep beyond the full employment level of output.

• Fiscal Policy
• Fiscal policy is the use of government expenditures (G) or taxes as policy tools for the purpose of achieving macroeconomic goals. Note that change in G changes AD. Also change in taxes changes disposable income, thereby consumption and, thus, AD.
• Budget deficit is the difference between tax revenue of the government and government expenditures. When government purposely plans for a budget deficit, it is called active or planned budget deficit. On the other hand, when budget deficit is not planned but economic downturn causes deficit, it is called passive budget deficit.
• For the purpose of policy analysis, we focus on active budget deficit. An increase in government expenditures increases budget deficit, and so does a decrease in taxes, and both increase AD. A decrease in government expenditures decreases budget deficit, and so does an increase in taxes, and both decrease AD. In other words, fiscal policy uses budget deficit as a policy tool. Government increases budget deficit to expand AD during recession; this is called expansionary fiscal policy. On the other hand, government decreases budget deficit to contract AD during inflationary period; this is called restrictive fiscal policy. Thus, Keynesian prescription is to follow a counter-cyclical fiscal policy: expansionary policy when the economy is contracting, restrictive policy when it is expanding.
• Inflation and Restrictive Fiscal Policy
• Draw a graph to depict inflationary period. Draw an initial long-run equilibrium where LRAS, SRAS, and AD intersect (draw SRAS very flat to the left of full employment and very steep to the right). When AD shifts to the right, the economy goes to an inflationary equilibrium: both output and price level are higher, compared to the initial equilibrium. Classical economists recommend a "do nothing" policy as wages would adjust upwards in the long run, shifting SRAS to the left and reestablishing full employment equilibrium. Keynesians, on the other hand, recommend government to implement a restrictive fiscal policy (decrease budget deficit by reducing government expenditures or increasing taxes) to shift AD back to the initial position.
• Recession and Expansionary Fiscal Policy
• Draw a graph to depict recession. Draw an initial long-run equilibrium where LRAS, SRAS, and AD intersect (draw SRAS very flat to the left of full employment and very steep to the right). When AD shifts to the left, the economy goes to recession: both output and price level are lower, compared to the initial equilibrium. Classical economists recommend a "do nothing" policy as wages would adjust downwards in the long run, shifting SRAS to the right and reestablishing full employment equilibrium. Keynesian economists, on the other hand, recommend government to implement an expansionary fiscal policy (increase budget deficit by increasing government expenditures or decreasing taxes) to shift AD back to the initial position.
• Criticisms of Fiscal Policy
• Crowding-out effect. Increase in government expenditures during recession has to be financed by borrowing from the loanable funds market. This increases the demand for loanable funds, increasing interest rate. At new higher interest rate, private sector would borrow less funds. Thus, government borrowing crowds out private investment. Draw a graph of the loanable funds market to depict this. Decrease in investment decreases AD, dampening the effect of expansionary fiscal policy. Therefore, fiscal policy may not be a powerful tool. Further, decrease in investment compromises economic growth. A symmetrical argument of "crowding in" of private investment can made in case of restrictive fiscal policy which also dampens the effect of restrictive policy.
• New Classical Criticism. According to New Classical economists, fiscal policy is completely ineffective. Current government borrowing implies higher future taxes to pay back the borrowing. According to the New Classical School, taxpayers immediately form expectation of higher future taxes and increase their savings by amount equivalent of government borrowing. Such an increase in savings, i.e., decrease in consumption decreases AD completely annulling the proposed expansion of AD by an increase in budget deficit. Thus, there is no impact of fiscal policy on the economy. Some economists offer counter criticism that New Classical assumption of complete equivalence of government borrowing and taxpayers' anticipation of increase in future taxes -- this equivalence is called Ricardian Equivalence -- is unrealistic.
• Mistiming of fiscal policy can worsen macroeconomic situation. There is a time lag before policy makers know that the economy is in trouble and needs a change in fiscal policy. There is also a time lag in formulating necessary programs and laws for changing fiscal policy through the political process. Finally, time is also lost in actually putting programs into implementation. During this period of many lags, macroeconomic situation may be changing. An economy in recession may actually be on its way to recovery on its own when the fiscal policy is actually implemented. The policy then may push AD too far up to an inflationary situation. Similarly, a restrictive fiscal policy may prove too late, too strong pushing the economy to recession from an inflationary period. Fine tuning of economy may introduce instability.
• Supply-Side Economics
• In our analysis of fiscal and monetary policy tools, the focus had been on AD management. Contrary to this, supply-side economists recommend permanent reduction in taxes to reward work, innovation, investment, and saving, and thus to shift both SRAS and LRAS to obtain a long-term growth of the economy. Show this in an AD-AS graph by shifting both LRAS and SRAS.
• Supply-side economists argue that higher taxes on income discourage labor and higher taxes on savings discourage investment. This reduces the output potential of the economy, reducing supply. If taxes are lowered, more labor would be supplied and saving would grow, increasing investment which will create more jobs, benefiting larger population. This is also sometimes referred to as trickle-down economics. President Bush once called this a voodoo economics.
• Criticism of supply side. Lower taxes may offer incentives to labor and savings. The impact on supply, however, takes sometime, whereas, lower taxes are likely to immediately increase consumption and thus AD, taking the economy to an inflationary and uncertain period. Show this in a graph by shifting AD.

Effect on tax revenue. Another concern with tax reduction is whether tax revenue of the government would reduce and be insufficient to meet expenditure obligations of the government. Arthur Laffer, an economist who advised President Reagan, argued that when tax rate is high, a reduction in tax rate can actually increase tax revenue. He expressed this using the now famous Laffer Curve. The curve shows the relationship between tax rate and tax revenue. Tax revenue would be zero at 0% tax rate and also at 100% tax rate (who would work and pay taxes when the entire income has to be paid as tax). As tax rate is low and increasing, tax revenue increases. There exists a tax rate at which tax revenue would be maximum and would reduce if tax rate is increased further (the tax rate beyond this threshold discourages people from work). Refer to the Laffer Curve I drew in the class. The threshold tax rate is not theoretically not known. A study by Lawrence Lindsay suggested it to be 43%. Prior to Reagan Presidency, the top income tax rate was 70%. President Reagan reduced the rate to 33%, and indeed tax revenue increased. However, a more research has yet to prove whether this increase in tax revenue should be attributed to the prediction of Laffer Curve or to the recovery of the economy from recession at that time. Although this threshold point maximizes tax revenue, this is not necessarily an ideal point. Remember that a tax always leads to welfare loss. Draw a demand and supply graph for cigarettes. Start with an initial equilibrium without tax. Now add a sales tax to cigarette, which will shift the supply curve to left. Because of tax, the market produces less than the efficient level, and there is a welfare loss. Refer to the graph drawn in the class. The higher the tax rate, the bigger would be the welfare loss. The threshold point also is associated with welfare loss. According a study, a $1 of tax in the U.S. is associated with $0.25 of welfare loss, amounting in aggregate to $400 to $500 billion. Note that tax rates were later increased by President Bush and President Clinton. The top tax rate is now 39.6%.

I. Functions of Money

A. Money is a medium of exchange.

B. Money is a measure of value of goods, services, assets and resources.

C. Money is a form of asset, like real estate, precious metals, etc.; however, it is a perfectly liquid asset because it can be easily and quickly transformed into other goods without an appreciable loss of nominal value and with low transaction cost.

II. Types of Money

A. Commodity money. In old days, commodities like gold, silver, leather, and even cigarettes were used as money for transaction purposes. Commodity money has low portability because of weight and cost of supplying such money is high because of intrinsic value of commodities.

B. Fiat money. Nowadays we have paper money; it has no intrinsic value. This type of money is called fiat money. It is portable and costs low to supply. When paper money started, it used to be backed up by gold, but it is no more backed up by gold; therefore, its value is based entirely on confidence people place on its worth.

III. Three Measures of Money Supply

A. M1: it is the narrowest measure and includes only coins, currency in circulation, checkable deposits and travelers' checks; these are the most liquid form of money. M1 amounted to $1,065.2 billion in 1997 in the U.S.

B. M2: besides M1, it includes little less liquid form of money also. For example, small saving deposits, money market deposits, and overnight loans and deposits. M2 amounted to $3,904.1 billion in 1997 in the U.S.

C. M3: besides M2, it includes still less liquid form of money. For example, large saving deposits (exceeding $100,000).

Note: Credit card is not money because credit card has no purchasing power, it simply enables to obtain credit and defer payment.

IV. Banking Industry and Federal Reserve System

A. Banking industry in the U.S. consists of commercial banks, savings and loans and credit unions. Federal Reserve Bank (more simply referred to as Fed) is responsible to oversee the operations of the banking system. It is the central bank, or the Government's and bankers' bank. Unlike other banks, Fed can issue money and is also responsible for conducting monetary policy of the country.

B. U.S. is divided into 12 federal reserve districts, and each district has one Federal Reserve Bank for the district. Colorado belongs to the district of Federal Reserve Bank of Kansas City. Each Fed in the district is headed by a president. All 12 federal banks are governed by a Board of Governors that consists of seven governors (see the handout on the structure of the Fed distributed in the class); these governors are appointed by the President of the U.S. and approved by the U.S. Congress for 14-year term. The President designates one of the governors as Chair for a 4-year term. Alan Greenspan is the current chairman of the Fed, he was appointed by President Reagan. The appointment system of governors ensures independence of Fed from political manipulations.

C. Another important wing of the Fed is its open market committee (OMC), which consists of all seven governors and includes five Fed Reserve Bank Presidents. Of those five presidents, one is always the President of the New York Reserve Bank, the rest alternate from other districts. The Committee sits every five to eight weeks for deciding monetary policy of the country.

D. All earnings of Fed above its operating expenses belong to the Treasury.

V. Fractional Reserve Banking and Creation of Money by Commercial Banks

A. Like any other private companies, commercial banks also want to maximize profit from their operations of accepting deposits from customers and lending to borrowers. They strive for fully loaning out money collected from depositors except for some amount that banks must hold to meet occasional withdrawal demands of depositors; any deposit not loaned out is a potential profit foregone. To meet the occasional withdrawal demands of depositors, to have a uniform banking system and to exercise control over monetary policy, Fed prescribes a minimum amount of reserve commercial banks must hold in the form of cash and/or reserve with the Fed. This legally mandated amount is called the required reserve, it is mandated as a fraction of demand deposits of a bank. For example, if the required reserve ratio is 0.20 (or, 20%), each bank must set aside 25% of demand deposits as cash in their vaults or as reserve with the Fed. This system of required reserve is called fractional reserve banking.

B. Actual reserve of a bank must exceed the required reserve, the excess amount is called excess reserve. For maximizing profit, banks aim to maintain zero excess reserve, i.e., they want, ideally, their actual reserve be just equal to the required reserve.

C. Fractional reserve banking allows banks to create money. Let me explain this with an example; see the table below. Assume that the required reserve ration (RRR) is 20% of demand deposits. For simplicity, consider all banks as one big bank.

D. In the above table, the required reserve ratio (RRR) is 0.20, and we started with an initial situation of $5,000 of demand deposits. We saw that a new deposit of $1,000 increased demand deposits from $5,000 to $10,000. That is, demand deposits increased by $5,000. In fact, a new deposit of $1,000 gets multiplied 5 times, or (1/RRR) times. This process is called money or deposit multiplier process, or money creation by banks.

E. Deposit multiplier (M) = 1/RRR.

F. Change in deposits or money supply = New deposit x Deposit multiplier.

G. Note that this formula gives the theoretical multiplier; actual multiplier is less than theoretical multiplier because there is a leakage from the multiplier process when banks are not able to fully loan out excess reserve and when people hold money in their pocket instead of banks.

VI. Three Ways of Controlling Money Supply: Fed has three policy tools available to change money supply in the economy. These tools change either the new reserve available to the economy or the size of multiplier that expands the size of money supply.

A. Changing reserve requirement ratio (RRR) is one tool. The higher the ratio mandated, the lower the money multiplier and, hence, the lower the money supply. That is, there is a negative relationship between RRR and money supply.

B. Changing discount rate (the interest rate Fed charges on amount it loans to commercial banks) is another tool. The higher the discount rate, the more expensive the borrowing and the less the commercial banks borrow from the Fed to meet demand for loans from their customers. In other words, discount rate and money supply are negatively related.

C. Open market operations (OMO) are the third kind of tool. The Open Market Committee of the Fed sits every 5 to 8 weeks and decides whether the Fed should buy or sell securities as a monetary policy. If the Fed buys securities, it pays money to the sellers, which enters to the banking system as new deposit and expands money supply. On the other hand, when the Fed sells securities, buyers pay money to the Fed. Money paid to the Fed is thus withdrawn from the banking system and money supply decreases. Buying of securities by the Fed increases money supply and selling of securities reduces it. If the Fed wants to increase money supply by $500 million and suppose RRR is 0.20 (i.e., multiplier is 5), then the Fed needs to buy securities worth only $100 million, which gets multiplied 5 times to become a total additional money supply of $500 million. Similarly, the Fed needs to sell securities worth only $100 million, if its objective is to reduce money supply by $500 million.

VII. Demand for Money and Nominal Interest Rate

A. People demand money for day-to-day transaction purposes, for precautions against risk (there is money if unexpected need arises due to unforeseen events or accidents), and for speculative reasons (there is money to buy goods if they become available at bargain prices). These demands are respectively called transaction demand, precautionary demand and speculative demand.

B. All these forms of demand depend on income of the person (the higher the income the more the money demand), price level (the higher the price level, the more money is needed to buy goods and services), and nominal interest rate on savings (the higher the nominal interest rate, the more the loss of potential interest income that could be earned from savings as opposed to holding money balance). Income and price level together determine expenditures and, thus, the demand for money balance. Fixing income and price level, money demand is inversely related to nominal interest rate, as nominal interest rate is the opportunity cost of holding money. Draw a graph with amount of money (M) in the horizontal axis and nominal interest rate (i) in the vertical axis and a downward sloping line from the left in the vertical axis. This line represents demand for money (MD), showing that at higher nominal interest rate, lower amount of money would be demanded. MD is drawn for some level of income and price level. The curve will shift if income or price level or institutional factors/financial innovations in the market change. Increase in income or price level would shift MD to the right.

C. In the above graph, draw a vertical line somewhere in the horizontal axis to denote the fixed amount of money supply. The amount of money supply is determined by the Fed, irrespective of the nominal interest rate. In fact, an objective of the monetary policy is to change interest rate in the market. Call this vertical line MS.

D. The intersection of MS and MD gives the equilibrium market interest rate. This graph presents the situation in the money market.

E. Note that if the Fed increases money supply (draw another vertical line to the right of MS), nominal interest rate would decrease. In the initial situation, people were holding money balances consistent with the initial interest rate. Through increased money supply if the Fed wants people to hold more money, nominal interest rate in the market must go down to lower the opportunity cost of holding money.

• Modern View on Effects of Money Supply. When money supply changes, it has two effects: direct and indirect. Direct effect changes consumption directly and, thus, changes aggregate demand (AD) too. Indirect effect channels the change in consumption or AD through a change in loanable funds market. A change in money supply changes savings, thereby interest rate, and thus consumption. Let us consider an increase in money supply to trace the two effects below.
• Direct effect. When money supply in the economy increases (by one of the three policy tools of the Fed discussed above), it increases the money balance of the people above their initial level. It may prompt them to spend some of the excess money balance; this increases consumption expenditures and, thus, AD.
• Indirect effect. Although people spend some of the excess money balance, they may save some. This increases savings in the economy, i.e., the supply of loanable funds in the economy, decreasing real interest rate. Lower real interest rate encourages increase in interest-sensitive expenditures in the economy, like purchase of new cars, houses, and also new investments. These increase AD.
• Note that both direct and indirect effects reinforce the change in AD in the same direction. When AD changes in the economy, this would change both price level and output in the economy (draw an AD-AS graph and convince yourself that a shift of AD changes both PI and Y). In other words, changes in money supply induce both nominal and real changes.
• Monetary Policy
• The discussion above explained the potency of monetary policy to effect changes in the economy. The Fed, therefore, uses monetary policy to correct macroeconomic problems in the economy. It uses expansionary monetary policy during recession and restrictive monetary policy during inflation.
• Expansionary policy increases money supply. This is done by either lowering RRR or lowering discount rate or buying securities. Draw an AD-AS graph for recession and show restoration of long-run equilibrium with shifting of AD to the right, caused by an expansionary policy.
• Restrictive policy decreases money supply. This is done by either increasing RRR or increasing discount rate or selling securities. Draw an AD-AS graph for inflation and show restoration of long-run equilibrium with shifting of AD to the left, caused by a restrictive policy.
• Alan Greenspan, the Fed Chairman, recently reduced discount rate twice as preemptive strikes against possible recessionary trend of the economy. Obviously, Greenspan believes on the above effects of monetary policy and, thus, uses monetary policy actively to pursue macroeconomic goals.
• Like in the case of fiscal policy, mistiming of monetary policy is also an issue, for the same reasons we discussed in case of fiscal policy.
• Activist and Nonactivist Strategies of Stabilizing Economy
• We learned about a number of schools of economic thoughts and theories; some believe in active role of the government in stabilizing economic swings, whereas others believe in letting the market work them out. For example, Keynesian economists belong to the first group and Classical and New Classical economists belong to the second group. The first group chooses activist strategy and the second group chooses nonactivist strategy for stabilization of economic swings.
• Activist strategists recommend implementing counter-cyclical fiscal and monetary policies. Countercyclical policies mean expansionary policy during recession but restrictive policy during inflation. This strategy is based on the belief of market's general inability to correct economic swings or the ability to correct swings only after a long delay. On the other hand, economists in the nonactivist strategy camp find active involvement of the government unnecessary and even ineffective. They argue that fiscal and monetary policies are most likely to be ill-timed because there are time lags in identifying recessionary or inflationary trend of the economy, in formulating appropriate policies, in implementing the policies, and also in policies actually impacting the economy. According to them, ill-timed policies introduce more uncertainties and confusion in the economy. Therefore, they preach "hands-off" approach on the part of government.
• Judging by his actions, the current Chairman of the Fed, Alan Greenspan is an activist, as he believes in preemptive strikes to stabilize the economy. In the last seven weeks (during Sep-Nov 1998), Greenspan reduced interest rates thrice not to let the economy slide to recession.