ECON 205 2nd Edition Lecture 17 Outline of Last Lecture I International Trade and GDP modeling II Comparative and Absolute Advantage III The Federal Reserve Tactics Review IV Currency manipulation I Trade Balance Outline of Current Lecture I Current Economic Issue The Fiscal Clif II Exchange rate system III Marginal Propensity to Import and the Open Economy IV Aggregate Supply and Labor Force V Unemployment VI Inflation and its efects Current Lecture I Current Economic Issue The Fiscal Clif The fiscal clif is the current ongoing problem since 2007 that the US government without changing current policy will fall into increasing debt and higher unemployment In the past year the Congress has worked to resolve three issues Unemployment the expanding deficit and the national debt To fix the issues they proposed raising taxes to cover the deficit and lower government expenditures This contradicts economic theory which states that the government should lower taxes and increase gov t expenditures stimulating the economy from recession Priority should be to lower the unemployment rate from 8 to 4 by increasing expenditure and lowering taxes It will increase deficit and national debt but increase GDP growth rate To those who want to write 2 5 pages on the fiscal clif and if published receive a flat A in the course identify all points in the scenario and which policy changes will or have to be enacted II Exchange rate system The flexible and fixed rate gold standards are the two modern systems Most economies are flexible while some like China peg their currencies The Bretton Woods System was the postwar system established that based currencies on gold value and most major currencies were pegged to the US dollar However President Nixon discontinued it in the early 70s The IMF and World Bank are concerned with economic development and stability The IMF is short term concerned with currency exchange rates and economic development while the World Bank tries to help less developed nations through loans for economic development III Marginal Propensity to Import and the Open Economy Open Economies are economies that have GDPs equal to government expenditures consumption investment and net exports For open economies there is a marginal propensity to import the additional importation resulting from an increase in income IV Aggregate Supply and the Labor Force Aggregate supply depends on potential output and production cost The factors that go into determining the supply are input levels technology and efficiency production cost wages and import prices The aggregate supply curve is based on the costs of production labor capital management resource unions etc but they cannot be held constant Wages for instance will increase and decrease over time but market forces cannot control wages well due to unions Principally population determines the costs of labor In the population we have a certain labor force determined by the labor force participation rate i e people above 65 and under 18 are usually not in the labor force Then you look at the employed and unemployed statistics V Unemployment The duration of unemployment is usually less than five weeks as seen in 2003 However during our current recession unemployment has lasted up to a year or two Unemployment negatively afects the GDP due to lower investment and spending Additionally it has psychological efects people unemployed tend to feel depressed and worthless and leads to loss of valuable skills There are many types of unemployment Seasonal unemployment is unemployment that occurs at certain times of the year structural unemployment is what occurs when supply does not meet demand and cyclical unemployment is when the business cycle determines unemployment Sometimes cyclical and structural unemployment coincide leading to deeper and longer lasting unemployment VI Inflation and its efects Inflation means a rise in prices It is frequently caused by war in extreme cases but happens steadily each year Low inflation is considered ideal in the single digits and stable Galloping inflation is when inflation increases by 20 200 Hyperinflation is a more extreme case of galloping inflation when inflation rates can be in the thousands or millions of percent Major efects of inflation are income and wealth distribution as inflation reduces the value of savings and destroys some wealth Income if not adjusted to inflation also loses value Inflation distorts the value of things leading to economic inefficiency Thus the optimal rate of inflation is between 0 and 10 per year The demand pull inflation is when aggregate demand in an economy outpaces aggregate supply It is when the GDP rises and unemployment falls to rapidly Exports can also create demand pull inflation as if a foreign nation purchases large quantities of goods companies have to create new jobs and get more money The other common type is cost push inflation is a type of inflation that occurs when costs rise for a non negotiable good such as oil as seen during the 70s stagflation