ECON 201 Midterm Review 2 Debt Deflation Irving Fisher Economy slips into depression wage prices fall deflation borrowers default bank failures depression Desire to avoid debt deflation is why the Federal Reserve targets a low positive rate 2 No deflation since WWII True Costs of 1 Tax all anticipated or not reduced the real value of cash Suppose 10 000 was kept in a safe if was 10 the real value of cash will 10 a Can only avoid by keeping wealth in the financial system or something with interest baring form ex Banks businesses stock bonds b Empirically cash is a small fraction of US aggregate wealth tax is not that important for the aggregate US economy c Tax is more important where cash is more prevalent i Poor people underground economy ii Less developed countries 2 Menu Stockholder costs real resource costs incurred by businesses and households in response to a Changing prices more frequently is costly ex Change menu catalog b Time costs on households ex Spending time searching for low prices c Time spent going to the bank to avoid Tax Although for low moderate costs are not large During hyper inflation 100 they are significant What causes hyper inflation Rapid growth of money supply Govt s print too much because they have high budget deficits that they cannot finance by selling government bonds there last resort is printing to pay debt SECTION TWO The classical model of the business cycle popular pre 1930 s Main tool social production possibilities frontier PPF Represents economies resource technology change capabilities and supply constraints Classical Model says 1 1 Absent interference in free market society will always be somewhere on PPF a In this case by defining economy always at full employment y y UR UR b Frictional UR is consistent with classical view 2 Business cycles in the classical view primarily due to supply shocks changes in resources technology that shift PPF in or out a Typical Boom Favorable supply sock ex Internet invented good weather farming scientific breakthrough i Outward shift of PPF y ii Result Yb Ya Leisureb Leisurea Employmentb Employmenta Favorable supply shock shits PPF out production rises real value wage from market value increases encourages households to work more in market less time to leisure home production employment rises b Typical recession adverse supply shock ex oil embargo bad weather natural disaster Inward shift of PPF y i ii Result Yb Ya Leisureb Leisurea Employmentb Employmenta Adverse supply shock PPF shifts in productivity decreases real wages decrease households substitute away from market work towards home production and leisure employment falls Employment changes in response to supply shocks are caused by voluntary substitution between market work and leisure home production due to real wage change 3 Other possible sources of business cycle fluctuations in classical model a Preference shifts between market output and leisure ex During WWII surge of patriotism in US households were willing to give up leisure and home production to increase market output of war goods 2 b Government regulations can cause inefficiencies that leave economy inside PPF i ex If we impose new green house gas rules production inside PPF recession 4 Recessions in classical view are NOT driven by a lack of aggregate demand AD businesses inability to sell products a Says Law Supply creates its own demand b For any given level of y firms produce they will pay an amount equal to y in factor payments wages interest profits c Those payments will then be spent buying y Constraints on output according to classical view Resources and technology supply shocks Preferences between market y and leisure production Government regulations 5 No rule for government stabilization policy a Gov t should not fight recessions recessions in general are efficient responses to supply shocks or preference changes Shortcomings of Classical View 1 Cannot explain the Great Depression a No changes in resources technology preferences or regulations that could explain the massive drop in y and employment b Eventually massive amounts of unutilized resources in 1932 y was far inside PPF 2 Cannot explain fluctuations over business cycle adequately a Classical view employment decreases during recession because low wages cause people to voluntarily give up work b BUT real wages barely fall during recession c In reality most unemployed during recession is involuntary Workers without jobs would gladly trade places with those employed at current wage Substitution effect higher wages increased labor supply Income effect higher wages consume more of everything including leisure 3 John Keynes British economist convinced by depression that classical view was wrong 1936 book general theory of employment interest and money lays out alternate diagnosis remedies for depression MAIN FEATURES OF KEYENES MODEL 1 No supply constraints Firms are willing able to produce any level of output at fixed prices as long as demand is sufficient 2 Level of Y in equilibrium constrained by amount of aggregate demand AD How much people government business want to buy Say s Law does not hold supply does not automatically create its own demand 3 Business cycles caused by aggregate demand shocks a Recessions are due to low demand 4 Role for government stabilization policy Gov t should fight recession by increasing aggregate demand Building blocks of Keynesian model Equilibrium output limited by aggregate demand how much a firm can sell o If y AD equilibrium o Y domestic output AD worldwide demand for domestic products o If y AD firms will adjust y in the direction of AD to meet equilibrium o Y AD excess supply inventories of un sold goods will pile up and firms must cut y o Y AD excess demand inventories run out lines of unsatisfied customers and firms will increase y no supply constraints Firms do not adjust prices PRICES ARE FIXED Components of AD C I G NX X M o C spending by domestic households consumption o I investment spending by domestic firms households o G domestic gov t purchases of goods services o NX net exports of AD for domestic output must exclude X which are sales of domestic output overseas AD for domestic output must subtract imports M since part of domestic C I and G goes to foreign products Keynesian consumption equation C A MPC DI o What determines household spending Income higher take home pay household spending increase Wealth more wealth more spending 4 According to Keynesian consumption
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