Economics: The Matchup of the Century - Unemployment vs. Inflation

One of the ten main principles of economics is that society faces a short run trade off between unemployment and inflation. In other words, society has to have one or the other no matter what in the short run.

Here, we define the Phillips Curve, a downward sloping curve with inflation rate on the y-axis and unemployment on the x-axis. There is a negative correlation between inflation and unemployment.

We can explain the Phillips curve using the AG demand and shot run AG supply graph. When AG demand is high, the equilibrium is at a higher output and thus lower unemployment. However, the equilibrium is at a higher price level (aka more inflation). The opposite holds true for the converse.

In the long run, the Phillips Curve is actually vertical. Classical theory states nominal changes like inflation do not affect real variables like output and unemployment. This line is located at the natural rate of unemployment. This curve also shows how monetary policies do not affect unemployment in the long run, no matter what the Fed does.

The meaning of "natural" in the natural rate of unemployment is where the economy gravitates to in the long run. This does not mean it is socially desirable, it is just spontaneous. Government policies like removing unions would then be able to shift this vertical line, in this example it would move left (less unemployment with no unions since lower wages).

Unemployment rate = Natural rate of unemployment - a (actual inflation - expected inflation)
where the variable 'a' measures how unemployment responds to unexpected inflation.

Using the above equation, we can put together the short run and long run Phillips curves. Inflation and unemployment starts at the intersection of both. When inflation rises, in the short run the equilibrium moves off the long run curve and moves along the short run Phillips curve to a point with less unemployment. Then as people expect higher inflation, the short run Phillips curve shifts right so that at the same inflation rate the two curves once more intersect.

If a supply shock happens (i.e. a shift of AG short run supply curve), the Phillips curve shifts. In the case of a negative supply shock, the Phillips curve shifts rightward, giving policymakers a worse deal between unemployment and inflation.

To reduce inflation, it comes with a cost. According to the Sacrifice Ratio, and the graph with both long run and short run Phillips curves, reducing inflation temporarily increases unemployment until in the long run inflation is reduced and output returns back to normal. The estimated sacrifice ratio is 5, i.e. 5% annual output must be sacrificed for every reduction of 1% in inflation.

Another theory disagrees. According to other economists, there is something called rational expectations. If the government makes it clear to the people that they will reduce inflation and people believe, their expectations of inflation will reduce, immediately shifting the short run Phillips Curve to put inflation lower without having to increase unemployment temporarily.

Unemployment and inflation managed to be both very low in the 1990s in the U.S. because of declining commodity prices (like the fall of OPEC, recessions in Asian countries, etc. leading to a favorable supply shock), labor-market changes (the baby-boom is theorized to reduce the natural rate of unemployment since older people tend to hold stabler jobs), and technological advance (favorable supply shock).

Economics: What in the World is Monetary and Fiscal Policy?

This chapter really goes hand in hand with the previous chapter. I don't know why Mankiw separated them like this.

Recall the wealth effect, interest rate effect, and exchange rate effect that explains why the aggregate demand curve slopes downward. These 3 effects occur simultaneously to increase quantity demanded when price level falls and decrease quantity when price level rises. The interest rate effect is most important for the U.S.

Now we will define the theory of liquidity preference. We will make another graph. In this graph, money supply is vertical, since the supply is set and controlled by the Fed. The money demand slopes downward explained in the theory of liquidity preference by interest rate. If interest rate is high, one holds less money and saves it, thus reducing money quantity demanded. If interest rate is low, one holds more money (discourages saving) so increases money quantity demanded. So the interest rate goes on the y-axis and the quantity of money goes on the x-axis. The intersection of the money supply and money demand is the equilibrium interest rate.

An example of using the theory of liquidity preference: if price level increases, the quantity of goods demanded decreases. Money demanded increases to counteract the rising prices which then reduces interest rates.

If money supply increases, equilibrium interest rate decreases. This encourages investment and shifts the aggregate demand curve.

So when the Fed wants to change the economy by changing aggregate demand, the monetary policies they make can be described as changing interest rates or changing the money supply.

Then what is fiscal policy and how does that affect the economy? Certain policies that the government decides upon that affect long run economic growth are considered fiscal.

One fiscal policy is changing government purchases. If the government spends $20 billion domestically on fighter planes, the aggregate demand curve will shift right. This shift may not necessarily be exactly 20 billion. Because of the multiplier effect, the impact could be even greater. The multiplier effect happens because increased demand causes increases in wages and profits which encourage more and more spending in different rounds.

The MPC (marginal propensity to consume) is the fraction of extra income people decide to save. If the MPC is 3/4, then an increase of 20 billion yields 20 billion / (1 - 3/4) = 80 billion total impact. This 1/(1-x) formula comes from the infinite sum of a geometric series.

The multiplier effect extends to more than government purchases. It includes recessions and stock market booms and more.

Another side effect is the crowding out effect. This occurs because an increase in demand also increases spending and reduces saving. As saving reduces, interest rates rise and investment is discouraged. This effect makes shifts in aggregate demand less.

Another fiscal policy is tax changes. Tax cuts shift the demand right and tax raises shift the demand left. This includes investment tax credit too.

Should the government use policy to stabilize the economy? Currently, the U.S. government does, according to the Employment Act of 1946. It states that government should avoid being the cause of fluctuations and also respond to changes in the economy to stabilize aggregate demand.

Keynes argues that aggregate demand fluctuates from waves of optimism and pessimism. He says that government should always counteract these waves with economic policy.

Others argue against active stabilization of economy. The primary argument is that changes in policy usually come to late, and instead cause more fluctuation. These lags happen because fiscal policies must be confirmed by legislature and the president and monetary policy takes at least six months to have effects on employment or output.

Some policies act as automatic stabilizers. For example, the tax system is an automatic stabilizer. You pay less tax if you spend/earn less and pay more tax if you spend/earn more. Government spending on welfare and other income supports also acts as an automatic stabilizer. When in recession, spending increases on these supports which increases aggregate demand and counteracts the recession.

Although these automatic stabilizers are not strong enough to stop recessions completely, they have reduced the volatility of output and employment greatly. This is why many people argue against a balanced budget for the government that would eliminate the automatic stabilizers we have already.

Economics: Unpredictable Fluctuations and Why They Happen

A recession is a mild period of falling incomes and rising unemployment, and more severe is a depression.

There are 3 key facts for economic fluctuation:

• Economic fluctuations are irregular and unpredictable
• Most macroeconomic quantities fluctuate together (real GDP, personal income, corporate profits, etc.)
• As output falls, unemployment rises

Earlier we talked about classical economics and classical dichotomy and money neutrality. If the nominal variables changed, real variables still wouldn't be changed. A doubling in prices would make everything cost twice as much but wouldn't affect employment, etc. 

However, in the short-run, classical theory does not apply. It always takes time for all prices to adjust. Thus, we build the model of aggregate demand and aggregate supply. On the x-axis is the real GDP, the quantity of output. On the y-axis is the CPI/GDP deflator, the average level of prices. Remember that this is not simply another supply and demand chart, this is macroeconomics. 

The aggregate demand curve slopes downward, but why? Recall that Y = C + I + G + NX. 

• The price level and consumption (wealth effect): a decrease in price level raises the dollar value making consumers wealthier and more willing to spend, increasing quantity demanded.
• The price level and investment (interest rate effect): a decrease in price level decreases interest rate (since households save more as their money is worth more), and causes more investment and thus causes greater quantity of goods/services demanded.
• The price level and net exports (exchange rate effect): a decrease in price level makes the dollar depreciate and increases net exports, thus making the quantity of goods and services demanded increase.

Why might the aggregate demand curve shift?

• changes in consumption (concerns about saving vs. spending)
• changes in investment
• changes in government purchases (e.g. if the government wants to build more highways, it shifts right)
• changes in NX

Now we talk about the aggregate supply curve. In the long run, the aggregate supply curve is vertical because it represents a country's real GDP and depends on its supplies of labor, capital, and natural resources and on its available technology. This agrees with money neutrality (when price level changes, real GDP doesn't change).

The long run aggregate supply curve could shift from:

• changes in labor
• changes in capital
• changes in natural resources
• changes in technological knowledge

Note that short run fluctuations in output and price level should only be viewed as deviations from continuing long term trends of output growth and inflation.

Why does the short term aggregate supply curve slope upwards?

• sticky wage theory: wages are sticky (if prices are low, it is less profitable with the high cost of labor so firms cut workers and production in the short term)
• sticky price theory: prices take time to adjust since there are menu costs
• misperceptions theory: when overall price level drops, an individual could misperceive relative prices dropping and act accordingly. (e.g. farmers noticing wheat prices dropping before other product prices and responding by producing less wheat)

The short term aggregate supply curve shifts from changes in the expected price level. A rise in the expected price level reduces the quantity of goods and services supplied and shifts short tun aggregate supply curve to the left, and this statement works conversely as well.

If the aggregate demand curve shifts, for example to the left, output falls in the short run in order to maintain equilibrium with the short run aggregate supply. Since price level has dropped below expectations, eventually the short term aggregate supply curve shifts to the right, bringing output back to where the graph started at the long run aggregate supply curve. Policy makers could shorten the recession period by trying to increase aggregate demand curve by increasing government spending for example.

If the short run aggregate supply curve shifts, output temporarily decreases and price level increases. (This phenomenon is called stagflation: inflation and reduced output, stagnation). A wage-price spiral could occur, where workers demand more wages as prices increase. This causes an increase in firms' costs and makes the supply curve shift even further to the left. However, this eventually stops when the lower level of output and increased employment finally make wages decrease. The shift eventually then reverses to come back to equilibrium where output is back at the start at the long run aggregate supply curve. Policymakers could potentially mitigate the impact of the aggregate supply curve shift by increasing the aggregate demand so that equilibrium remains at the natural rate of output (called accommodating shift). This still causes an increase in price level though.

Economics: The Fundamentals of Macroeconomics (feat. MS Paint)

What determines an economy's trade balance and exchange rate and more? When we analyze an open economy, we must take into account multiple markets at once.

We first look at the market for loanable funds, where there is one interest rate and the money from savers get to borrowers.
Recall that S = I + NCO, savings equals domestic investment plus net capital outflow. The left side of this equation can be regarded as the supply of loanable funds. The right side can be regarded as demand. If interest rate rises, it encourages saving and increases supply, but discourages investment or demand. Interest rate also affects NCO; if interest rate was high, other countries would be encouraged to buy assets from us, making NCO lower.

The interest rate adjusts to bring supply and demand for loanable funds into balance. Demand = supply at equilibrium interest.

For foreign-currency exchange, NCO = NX, where NCO represents supply and NX represents demand. The supply of dollars comes entirely from NCO, and demand slopes downward. Real exchange rate determines the quantity demanded. The higher the real exchange rate the less demand for exports and foreign money as people buy domestic goods instead. Note the equilibrium exchange rate,

The link between these two markets is NCO. NCO has a negative slope when compared to real interest rate. The lower the real interest rate, people are more likely to invest in foreign assets instead of domestic ones. Putting them all together, 

Now we can see how different policies affect all these variables. 

If the government budget deficits, it takes away the supply from loanable funds. Supply shifts left, real interest rate moves up and quantity of dollars moves down, and real exchange rate increases (money appreciates in value), and NCO  (also NX) is reduced.

If an import quota or tariff is set by the government, net exports must rise as imports decrease. If net exports rise, the U.S. is selling more and other countries require currency exchange, making demand of foreign-currency exchange shift right. Real exchange rates rise but do not affect NCO. This is because although appreciation encourages imports while discouraging exports, the import quota balances it out to no change. Thus, trade policies do not affect trade balance. Recall NX = S - I. NX is not affected since savings or investment aren't affected either.

Finally, in the final scenario, imagine political instability and capital flight (people selling their assets in a place expecting it to collapse). If people move their assets elsewhere, there is an increase in NCO. The money needed to finance this movement shifts demand for loanable funds to the right, driving up real interest rate. Quantity of money also shifts right and this makes money depreciate.

Whew these graphs are hard.

Economics: What's my Dollar Worth in Other Countries?

In earlier chapters for simplicity we assumed that economies were closed. In reality, most economies are open economies that interact freely with foreign economies. 

Recall the definition of exports, goods/services produced domestically and sold abroad, and imports, goods/services produced produced abroad and sold domestically. Net exports is then exports - imports. Net exports is also called trade balance. If NX is positive, there is a trade surplus. If NX is negative, there is a trade deficit. If NX = 0, there is balanced trade. Factors of net exports include:

• consumer tastes of foreign/domestic goods
• domestic/foreign prices
• exchange rate of currencies
• income of consumers here and there
• costs of transportation

Net capital outflow (NCO) is purchase of foreign assets domestically - purchase of domestic assets from abroad; it's also called net foreign investment. Outflow comes in 2 forms: foreign direct investment (like opening a restaurant in Paraguay) and foreign portfolio investment (buying stock for a Bangladeshi company). The buyer has more control in the former. If NCO is negative, it's also called net capital inflow. Factors of NCO include:

• real interest rates on foreign/domestic assets
• perceived economic/political risks of holding assets abroad
• government policies that affect affect foreign ownership of domestic assets

An important identity is NCO = NX. For review, NX is the imbalance of exports over imports and NCO is the imbalance of foreign investment from domestic residents over domestic investment from foreigners. As an example, suppose you sold a computer to someone in Japan and get 10,000 yen. NX increases, and now you have the Japanese currency. Whatever you do with that money, you are investing in the Japanese economy, whether you put it in Japanese stock or give it to a bank to use; this makes NCO increase by the same amount.

Recall that Y = GDP, C = consumption, I = investment, G = gov. purchases. Y = C + I + G + NX. Then, Y - C - G = I + NX. Finally, S = I + NX where S = savings. Earlier we assumed NX = 0 in closed economies to make S = I. Now we see that S = I + NX or S = I + NCO. An economy uses saving for domestic investment and net capital outflow.

Now we move on to real and nominal exchange rates. The nominal exchange rate is the rate where one person can change a currency of one country for another. 80 yen per dollar is an example. Appreciation of a currency occurs if the currency fetches more of another currency, e.g. now it is 90 yen per dollar so the dollar appreciates. Depreciation occurs when the currency fetches less; e.g. the yen in the example scenario depreciates. The real exchange rate compares 2 goods/services of 2 countries. For example, 1 lb. of Swiss cheese for 2 lbs. of American cheese. It is calculated by nominal exchange rate * domestic price / foreign price. (Basically exchange the price of the domestic good into foreign price and divide by the actual foreign price).

Purchasing-power parity states that any unit of currency fetches the same real value everywhere. This is also called the Law of One Price. The logic behind this is that if, say, coffee is valued and priced more at Chicago than Miami, people would use arbitrage (selling the same product in different markets for profit) and move coffee from CHI to MIA. Then the price in CHI drops and the price in MIA rises to fulfill the law of supply and demand. This makes the prices equal in the end. Assuming purchasing-power parity, then nominal exchange rate equals foreign price / domestic price, and reflects the price levels of the countries.

The purchasing-power parity has limitations though. The first reason is that not all goods are easily traded. For example, if haircuts costs more in Paris, some travelers might not get haircuts in Paris and some hair cutters might move to Paris, but the differences might not be enough. Another reason is that there might be imperfect substitutes. For example, people could prefer German cars over American cars and pay more for them. Generally, the purchasing-power parity works alright and can predict nominal exchange rate pretty closely.

Economics: Is Inflation really "Bad"?

The increase of overall level of prices is called inflation, duh. Although nowadays we assume inflation is natural, in the past there have been incidences of deflation, when prices fell. When the prices increase dramatically, it is called hyperinflation. 

In this chapter, we will view inflation as the value of money dropping rather than price level increasing. What determines the value of money? Supply and demand of course! The Federal Reserve sets the supply on the x-axis (vertical line) while the demand curve is curved. On the y-axes, the value of money from low to high and price level from high to low is depicted. It is important to recognize that in the long run, the overall level of prices adjusts to the level where demand equals supply of money. 

The effects of how price level/value of money is affected by changes in the supply is called the quantity of theory of money.

Nominal variables are measured in monetary units like dollars. Real variable is measured in physical units like bushels. This separation of two categories is called classical dichotomy. Although inflation makes price levels increase, it doesn't change the value of the physical values. The irrelevance of monetary changes for real variables is called monetary neutrality. 

Velocity of money describes how many times money changes hands. V (velocity) = Price level * Quantity of Output (real GDP) / Quantity of M. If we write P = price level, Y = real GDP, and M = quantity of M, then we write V = (P * Y)/M and M * V = P * Y. This last equation is called the quantity equation. Velocity typically remains stable.

Nominal interest rate corresponds closely with inflation since real interest rates remain constant. This is called the Fisher effect,

Alright so I've still been spending too much time writing my blogs so I'm going to quickly answer the topic of the blog. The general premise is that inflation isn't as harmful as people think it is, inflation is actually monetarily neutral and only changes price levels but not actually the production, employment, real wages, etc. and doesn't affect real variables. However, economists have identified several side effects of inflation that might be large enough to not be negligible. 

1. The Inflation Tax: a tax on people that already have money. When money is printed, the money you have in your pocket loses value.

2. The Shoeleather Cost: time/effort that people have to spend rushing to put money into banks to prevent the inflation tax. This is more notable during periods of hyperinflation.

3. Menu Costs: all costs associated with firms having to change prices, whether dealing with unhappy customers to replacing catalogs.

4. Relative-Price Variability and the Misallocation of Resources: since inflation is constantly happening, prices might not always reflect the laws of supply and demand and misallocate the economy's scarce resources. Consumer decisions are distorted.

5. Inflation-induced Tax Distortions: many lawmakers overlook inflation when writing tax laws. Thus, when there is inflation, the tax burden increases on income from savings and capital gains (selling something later for a higher price). This problem also occurs with income tax. 

6. Confusion and Inconvenience: inflation changes the unit of account and can confuse people.

7. Arbitrary Redistributions of Wealth: this one is a big one. Inflation makes it easier for debtors to pay off loans in the short run whereas deflation makes the investor benefit. This last point shows that low inflation means a more stable inflation rate, since there is less random distribution of wealth.

Economics: These Green Worthless Pieces of Paper

This chapter discusses the monetary system. Why do people trust in the value of paper money even though it has no intrinsic value? Without money or currency people would have to barter, the exchange of one good or service for another. In such an economy, trade requires the double coincidence of wants, the unlikely occurrence that two people each have a good or service that the other wants. Thus, learning about the monetary system, especially in the long term, is very important in complex societies like ours.

What is money? Money is wealth, but economists define money as the set of assets in the economy that people regularly use to buy goods or services from other people. It has 3 functions: medium of exchange (item that buyers give sellers for a transaction), unit of account (measurement of prices and debts), and store of value (transferring purchasing power from present to the future). Liquidity of an asset describes how easily it can be changed into a medium of exchange (money is most liquid, unlike a house which takes effort to sell).

When money takes the form of a commodity with intrinsic value, it is called commodity money. An economy using gold as money (gold has intrinsic value on its own too) is operating under the gold standard. Cigarettes were used as commodity money in the Soviet Union and prisons. Money without intrinsic value is fiat money. A fiat is a decree or order. For example, paper money is fiat money. Fiat money requires the government to establish and regulate the system by prosecuting counterfeiters, and keeping expectations and social convention.

The quantity of money circulating in the economy is known as money stock. One major asset to include in the quantity is currency, the paper bills and coins in the hands of the public. It is the most widely accepted medium of exchange in the economy. Demand deposits, the balances in bank accounts that depositors can access by writing checks, must be included too. Other funds of other financial institutions must be included as well. Sometimes the line between money and assets cannot be easily drawn. Economists identify M1 as demand deposits + checks + other deposits + currency (~1.36 mil), and M2 as M1 + saving deposits + small time deposits + money market mutual funds + other minor categories (~6.3 billion).

Money outstanding could be held in foreign countries as a medium of exchange elsewhere because of its trustworthiness or by criminals. These factors are not included in domestic money stock.

The Federal Reserve System (Fed) is the system that regulates the fiat money of the U.S. It is an example of a central bank, an institution that oversees the entire banking system and regulates the money stock. It has 2 jobs: to regulate banks and ensure the health of the banking system, and to control the money supply (quantity of money mad available in the economy). Policies made are called monetary policy, in the U.S, the policymakers are the FOMC. These policies will be explained soon.

Now we talk about the banks and the money supply. Deposits that banks receive but don't loan are called reserves. 100-percent-reserve banking is when banks don't loan, they just hold the money. A T-account is a statement that shows a bank's change in assets vs liabilities. Analyzing a 100-percent-reserve bank is easy because these banks cannot influence the supply of money.

Banks can create money using fractional-reserve banking, when banks only keep a fraction of their deposits as reserves. This fraction is known as the reserve ratio. The Fed usually sets a reserve requirement, for banks to have some extra money. Some banks even carry excess reserves to be more confident. When a bank holds only a fraction of deposits in reserve, they create money when they loan since the depositor isn't using the money but still belongs to them and at the same time the borrower can use that money. They don't create wealth since the the borrower still has to pay back eventually, but they do increase the money supply. The money supply increases by the money multiplier = reciprocal of the reserve ratio. For example, a 10% reserve ratio yields 1/0.1 = 10 money multiplier. Thus, such a bank can make the supply given to them multiply by ten times. It turns out the higher the reserve ratio, the less of each deposit banks can loan out, the smaller the money multiplier.

The Fed uses 3 tools to control money supply. There's open-market operations, when selling or buying government bonds. By buying bonds, the Fed increases money supply by giving the public money in exchange for the purchased bonds. By selling bonds, the Fed reduces money supply by taking the public's money and giving them bonds. The Fed uses this most often since it can make small or large changes frequently without major changes in laws or bank regulations relatively easily. There's also changing reserve requirements. The Fed can tell banks the minimum amount of deposits banks must hold to change money multiplier and the money supply. A higher reserve requirement lowers the money supply, and vice versa for a lower reserve requirement. This tool is less used since it is inconvenient for banks. The discount rate is the interest rate on loans that the Fed makes to other banks. Banks borrow from the Fed if their reserves are too low whether from too many loans or withdrawals. A high discount rate discourages borrowing from the Fed and reduces money supply, and vice versa for a lower discount rate.

There are some problems in controlling the money supply. The Fed can't tell people how much to deposit in banks. The less people deposit, the less banks can use to loan and the less the money supply. The Fed also can't tell bankers how much excess reserve they can keep. If bankers became more cautious and kept excess reserves, less loans would be made and the money supply would decrease.

Bank runs are when depositors fear bankruptcy in a bank and rush to withdraw their deposits. Since banks loan out some of their deposits, they cannot have enough cash to repay all depositors. The bank is then forced to close its doors until some bank loans are repaid or a lender comes to help (like the Fed). Nowadays, bank runs are not a major problem. The FDIC ensures deposit safety.

As ABBA would say, "Money, money, money; Must be funny!"